It must be fun to go after insider traders. They’re rich people who cheat to make themselves richer. Drag them in front of a jury of ordinary people, show that they made money trading on information that ordinary people don’t have, and wait for the guilty verdicts to roll in. It’s how Preet Bharara, the U.S. Attorney for the Southern District of New York (which includes Manhattan), compiled an 85–0 record in insider trading cases (broken only in July this year).
Only, that’s not what the law says. Earlier this week, in United States v. Newman and Chiasson, the Second Circuit overturned two convictions on the grounds that the prosecution failed to show that the initial sources of confidential information received a personal benefit for passing on tips and that the defendants (who were three or four steps removed from the original tippers) knew of any such personal benefit. If you read that whole previous sentence and you didn’t go to law school, you should now be confused. I teach this stuff in law school, and I find it confusing — or, at least, I was confused by how Bharara was winning all these cases.
The law governing this type of insider trading is Dirks v. SEC, 463 U.S. 646 (1983), a Supreme Court case. If you didn’t go to law school, you may be surprised to find that a court case is the “law,” but that’s the way it is. The statute at issue is section 10(b) of the Securities Exchange Act of 1934, which essentially forbids the use of “any manipulative or deceptive device or contrivance” in connection with securities trading; the regulation applying the statute is rule 10b-5, which (for present purposes) prohibits fraud or deceit in connection with securities trading; but what that actually means was decided by the Supreme Court in Dirks.
The first thing to understand is that trading on material, non-public information is not inherently illegal. The SEC wanted it to be illegal, but the Supreme Court rejected that interpretation because trading on inside information doesn’t necessarily involve fraud or deceit. If you find a Picasso at a flea market on sale for $50, you don’t have to tell the seller that you know it’s a Picasso; it’s only fraud if you lie or mislead the seller. Simply buying a stock because you believe it is highly likely to go up in value is neither fraud nor deceit; one might argue that it’s the basis of most stock trading.
Instead, the deceit that makes insider trading (sometimes) illegal, in this type of case, is the fact that, when an insider trades on the basis of confidential information or passes that information to an outsider, she is violating her fiduciary duty to keep that information private and only use it for her employer’s purposes — a duty she owes to her employer. The deceit is that she’s deceiving her own company.
Now, the Supreme Court could have stopped there — any leaking of confidential information that does not serve the purposes of the employer breaches the fiduciary duty and can serve as the basis for an insider trading conviction — and Newman and Chiasson would have lost their appeals. But the problem was that, in Dirks v. SEC, the source of the leak was a good guy: an insider who knew that his company was cooking the books and who wanted to expose the fraud. The defendant, Dirks, was an analyst who helped uncover the fraud and also advised his clients to sell stock in the company. To cover this situation, the Supreme Court said this:
Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure. … Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.
And there’s the loophole. To secure a conviction, one of the elements that the prosecution has to prove is a personal benefit (or perhaps only the expectation thereof) to the initial tipper. This immediately opens up a huge gray area. If Mark Zuckerberg leaks an earnings announcement to his poor friend from high school out of pity or altruism, what personal benefit could he possibly be expecting to receive in return? Perhaps recognizing the loophole it had just opened, Supreme Court went on to classify a “gift of confidential information” as a breach of fiduciary duty, but that contradicts what it had said in the previous paragraph about “personal gain.” The underlying problem here is that fiduciary breach and personal gain are not equivalent: there are ways to breach a fiduciary duty that do not involve personal gain — no matter what the Supreme Court says.
The underlying problem here is a common one: court opinions are often abysmally written. They are vague about what’s a simple fact of the case, what’s a necessary factual premise, what’s a legal holding, and what’s a mere observation. Often they are internally contradictory. And the Supreme Court is a particularly serious offender because so often it is trying to use unclear language to paper over a difference of opinion within the majority.
Since Dirks, however, prosecutors and judges have tried to squeeze the loophole shut, and juries have played along. In Newman, the prosecution claimed that it only needed to show a fiduciary breach, not personal benefit. But the Second Circuit finally called foul, stating, “the corporate insider has committed no breach of fiduciary duty unless he receives a personal benefit in exchange for the disclosure.” (In Newman, the original sources were never charged with wrongdoing.) Because that personal benefit is an essential element of the offense, the prosecution must also prove that the defendant tippee also knew about that personal benefit — otherwise the tippee would have no reason to know that there was a fiduciary breach, and hence no reason to know that trading on the information would be illegal.
Of course, most tippee insider trading is still illegal. In the classic case, the tipper gets some kind of kickback from the tippee, or the tippee is a close relative of the tipper, so a benefit to the tippee counts as a benefit to the tipper. And Dirks still allows prosecutors to go after someone who makes a “gift of confidential information.” But once the chain of tippees starts getting long, it gets harder to prove that the ultimate trader knew that there was something wrong with the original leak. This requirement makes it easier to run the kind of scheme that SAC Capital allegedly did, in which the ultimate portfolio managers actively avoid learning where their nonpublic information originally came from.
Am I happy about this? Well, the part of me that has been wondering why the courts haven’t applied the letter of Dirks is somewhat satisfied. But I think Dirks was misguided to begin with. The “personal benefit” test should never have been put there in the first place, because you can have a fiduciary breach without a personal benefit; breach of fiduciary duty, which is easier to show, should have sufficed. (Under this standard, Dirks himself might have been found culpable — Dirks wasn’t a criminal case, as the SEC only sought to censure him — but it’s not entirely clear whether simply stating that your company is a fraud counts as a breach of fiduciary duty.) Dirks’s personal benefit requirement, as interpreted by the Second Circuit, will make it much easier to get away with insider trading, as long as you take sufficient pains to cover your tracks. In other words, if you’re upset about this outcome, it’s the Supreme Court’s lousy reasoning in Dirks that you should be upset about.
In any case, the whole insider trading crusade, in my opinion, has been an attention-getting sideshow. Here’s a partial list of criminal or potentially criminal activity by financial institutions in Manhattan over the past several years that are more important:
- Fraudulent marketing and distribution of CDOs, synthetic CDOs, etc.
- LIBOR fixing
- Bribery and other violations of the FCPA
- Obtaining confidential information from government agencies such as the New York Fed
- Pursuing foreclosures on the basis of fraudulent documents
- Enabling Bernard Madoff’s Ponzi scheme
Maybe the one silver lining of this opinion is that the Southern District could spend a little less time on insider trading and a little more on something that actually matters.