Life is unfair, and life in the stock market is now just a little more unfair after the fallout from a precedent-setting federal appeals court decision that narrowed the definition of illegal insider trading. Congress could strike a blow for fair trading by writing an insider trading law with broader coverage, but securities law experts who favor such a step recognize that it is not going to happen, certainly not with this Congress.
U.S. Attorney Pareet Bahrara, the prosecutorial scourge of Wall Street, went into federal court last week [Oct. 22] with his head between his legs to drop charges against half a dozen confessed insider traders and a seventh who had been convicted after a jury trial. Bahrara acted under the compulsion of the Supreme Court’s decision earlier this month [Oct. 5] confirming the setback he suffered late last year in two separate insider trading cases.
The ruling by the influential New York-based Second U.S. Circuit Court of Appeals does not affect the most straightforward type of insider trading: stock trades by the insider himself or herself based on what securities law calls “material, non-public information.” But the ruling, issued in December 2014, will make it harder to prosecute a second category of cases. In those cases, an insider (called the “tipper”) leaks confidential information to a third party (called the “tippee”) who then uses the information to make money in the market before the general investing public gets a clue.
Bahrara’s office won securities fraud convictions and long prison sentences against two hedge fund managers. Todd Newman and Andrew Chiasson made millions as the end users of a network of market analysts who cultivated contacts with insiders at high-tech companies to get tipped about earnings reports before their release.
Newman made $4 million from the inside-information facilitated trading and was sentenced after his conviction to 54 months in prison. Andrew Chiasson made $68 million for the hedge fund he managed and owned in substantial part and was sentenced to 78 months. But the Second Circuit reversed those convictions and took the extra step of barring prosecutors from trying again in a retrial.
Writing for the unanimous three-judge panel, Judge Barrington Parker Jr. said the convictions could not stand because the prosecutors had failed to show that the “tippers” had gotten anything for leaking the information. A conviction in such cases, the court held, requires “an exchange that is objective, consequential, and represents at least a potential gain [for the tipper] of a pecuniary or similarly valuable nature.” Parker, a Democrat elevated to the Second Circuit by President George W. Bush, was joined by two Republican appointees: Ralph Winter and Peter Hall.
Parker said Bahrara’s office had prosecuted Newman and Chiasson on the basis of a “doctrinal novelty.” In appealing the case to the Supreme Court, the government countered by calling the Second Circuit’s decision “novel” and “unprecedented.” The government argued that the appeals court had contradicted an earlier Supreme Court decision, Dirks v. Securities and Exchange Commission (1983), that found passing information to a relative or friend sufficient to establish insider trading liability.
The tippers in the Newman and Chiasson were, oddly, never prosecuted, charged civilly, or immunized. The prosecutors never established their motives for leaking information, but common sense suggests that they felt a sense of self-importance as they gave up valuable information to friendly acquaintances in a bar and that they also hoped for some kind of payback from their friends sometime if not immediately. But that hope is not enough for a criminal prosecution under the Second Circuit’s decision.
At the time of the ruling, the New York Times financial columnist James B. Stewart wrote that this kind of insider dealing “undermines investor confidence in the integrity of the market and creates the perception of a rigged game stacked against the average investor.” In the ruling, Parker is unsympathetic. “Nothing in the law requires a symmetry of information in the nation’s securities markets,” he wrote.
Securities law expert Peter Henning at Wayne State Law School in Detroit is similarly unmoved. “On Wall Street, they’re all sharks,” Henning, a former SEC enforcement lawyer, says. “If you want to swim with sharks, be careful.”
The cases that Bharara dismissed last week included one good-sized shark: Michael Steinberg, a former high-ranking employee at the notorious SAC Capital, whose founder, Steven A. Cohen, has so far escaped prosecution altogether. Steinberg was convicted after trial; the six other cases dropped were against defendants who pleaded guilty, some of whom testified in the Steinberg, Newman, or Chiasson trials.
Many average investors will be surprised to learn that there is no statute that makes insider trading illegal. The prosecutions stem from the SEC’s interpretation of the broad anti-fraud Rule 10(b) that has been upheld and shaped by the courts. Congress has been urged to write a statute to make the rules clearer and more definite.
Henning and fellow securities law expert Thomas Hazen at the University of North Carolina Law School are among those who want Congress to do just that. One approach would be to establish a bright line that trading on confidential information is illegal putting tipper and tippee alike in the crosshairs. Hazen said a congressional staffer asked for some advice on the issue, but he doubts that this Congress will actually tackle the subject. So for now insiders in the Second Circuit's territory can leak and their friends can trade just as long as nothing more than friendship is exchanged.