On Insider Trading, There Ought to Be a Law
The biggest problem with U.S. insider trading laws is that the U.S. has no insider trading law.
It’s true. The nation’s seminal securities statute, the Securities Exchange Act of 1934, while broadly outlawing securities fraud, never even employs the phrase “insider trading.” And over the subsequent 83 years, while Congress has occasionally increased the penalty for insider trading, it has never gotten around to defining what it is.
As a result, federal prosecutors, the Securities and Exchange Commission and the federal courts have engaged for decades in an ongoing tussle over what constitutes illegal insider trading, with the boundaries constantly shifting, to the detriment of, well, justice. Wednesday’s decision by the U.S. Court of Appeals for the Second District to uphold the insider trading conviction of Mathew Martoma, the former portfolio manager for Steven A. Cohen, is just the latest proof that we would all be better off if there were, you know, a law.
This is not to suggest that Martoma doesn’t deserve the nine-year prison sentence he’s currently serving. The guy pretended to befriend an elderly doctor in order to get proprietary information about a clinical trial for a promising Alzheimer’s drug. That information saved Martoma’s firm, SAC Capital Advisors, hundreds of millions of dollars when the doctor gave him advance word that the drug’s results were underwhelming. Oh, and Martoma paid the doctor $1,000 almost every time they met.
And yet the Second Circuit took this simple, straightforward case and inexplicably used it to upend a previous insider trading case that had been decided by the same court (though different judges) less than three years earlier. It also turned its back on a 34-year-old Supreme Court case that has long been the controlling decision. And the ruling almost certainly ensures that the line that delineates illegal insider trading from legal trading on proprietary information will continue to shift. It’s really kinda nuts.
That controlling decision was the 1983 ruling in the case of Dirks v. S.E.C. Ray Dirks was a securities analyst who in the 1970s caught wind of a huge Enron-like fraud involving a high-flying company called Equity Funding Corporation of America. After a former employee laid out the fraud to Dirks, he made it his mission to investigate and expose what the company was doing.
He tracked down the company’s biggest investors to tell them what he had heard. (Not all of them believed him.) He tried to grill the company’s accountants. He pushed the Wall Street Journal to pursue the story. Belatedly, after New York State regulators uncovered evidence of the fraud, the S.E.C. got involved and shut Equity Funding down. Its top executives went to prison.
You’d think that Dirks would be hailed as a hero for exposing wrongdoing. Instead, because some of the big investors Dirks tipped off had sold their Equity Funding stock, the S.E.C. charged him with aiding and abetting insider trading. He lost his job and was banned from working for any New York Stock Exchange member firm.
Even more incredibly, both the district court and the appeals court agreed with the S.E.C. It wasn’t until the case got to the Supreme Court that sanity prevailed. The S.E.C. had long taken the position that anyone — anyone at all — who had material nonpublic information was guilty of insider trading if he or she traded on that information, or divulged it to someone who then traded on it. Dirks’s lawyer 1 argued — and the Court agreed — that Dirks had done nothing wrong in passing on the information because his original source, the ex-employee, had no fiduciary duty to Equity Funding. He was free to divulge anything he wanted to about the company.
What’s more, the Supreme Court said that for insider trading to take place, the tipper (the ex-employee in this case) has to receive a “personal benefit” from the tippee (Dirks), and that had clearly not happened. The ex-employee was motivated by his desire to expose the fraud, not by the hope that Dirks would give him something in return.
The reason for establishing the personal-benefit requirement was precisely to protect whistleblowers like Dirks, who obtain proprietary information in the course of their work and then pass it on to others or trade on the information. To put it another way, it was meant to place some needed restraints on prosecutors and the S.E.C.
Over time, however, the definition of “personal benefit” became so watered down as to be rendered meaningless, a trend that reached its apotheosis when then-Manhattan U.S. Attorney Preet Bharara prosecuted former hedge fund managers Todd Newman and Anthony Chiasson in 2012. The two men were both significantly removed from the insider tips that made their way up the chain to them. They argued that they had no idea they were getting inside information from their junior colleagues. And they certainly had no way of knowing whether the tippers, executives at Dell Computer and Nvidia Corp., had received a personal benefit from the tippees.
Indeed, the judge didn't even require the jury to consider the personal-benefit issue in its deliberations. Both men were found guilty.
When the appeal was heard by the Second Circuit, the three-judge panel ripped into Antonia Apps, the assistant U.S. attorney representing the government. And when the panel overturned the convictions of Newman and Chiasson, it stressed the importance of the personal benefit as set out in the Dirks ruling — indeed, the judges said it had to be something tangible, not just, say, the promise of friendship. They even concluded that not only were the two hedge fund managers innocent, but that everyone up and down the chain had committed no crime because there was no personal benefit involved. 2
Bharara complained bitterly that the Newman decision would make it far more difficult to bring insider trading cases. He was right. The court was clearly slapping him down for stretching the definition of insider trading. The line, which had been loosening for years, was now much narrower.
Martoma’s conviction could have been upheld by the Second Circuit simply by noting that he had given a rather obvious personal benefit to the tipper: cold hard cash. Instead, the two judges who voted to affirm the conviction went out of their way to eviscerate the personal-benefit standard, arguing that the very act of giving someone inside information creates a personal benefit to the insider. In effect, this means that the personal-benefit limitation no longer exists, and there are no longer limits on who prosecutors can charge with insider trading. Prosecutors couldn’t be happier.
Will the Second Circuit’s latest decision last? I doubt it. For one thing, the third judge on the panel, Rosemary Pooler, wrote a powerful dissent. For another, the judges who were on the original Newman panel are still members of the court. That means that there's a higher-than-normal chance that the entire Second Circuit will decide to review the decision.
There is also the likelihood that some prosecutor will bring an insider trading charge in a case where there is clearly no personal benefit. Or that a Trump-appointed prosecutor will decide to go after journalists who obtain inside information as part of their job. Courts will once again have to decide where the line is, and how to interpret the Dirks decision.
Prosecutors, of course, like the fact that insider trading has no statutory definition. It gives them a lot of leeway. But everyone who has potential access to inside information ought to have clear guidance on what's legal and what's illegal. Wednesday’s decision creates just the opposite: more uncertainty and more likelihood that what constitutes insider trading will keep changing.
As someone once said, there ought to be a law.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Dirks’s lawyer, who took his case pro bono, was David Bonderman—yes, David Bonderman the billionaire head of TPG Capital, the private equity firm he co-founded nine years after winning the Dirks case.
Bharara wound up dropping charges against seven other people as a result of the Second Circuit’s ruling.
To contact the editor responsible for this story:
Jonathan Landman at email@example.com