Leading insider trading expert William Wang has a very timely post up at the Blue Sky Blog reminding us of the potential uses of mail and wire fraud in insider trading prosecutions and how they can fill the gaps in insider trading law under Rule 10b-5. (I leave to another day whether that's a good thing.)
Gilotta, Sergio, The Regulation of Outsider Trading in EU and the US (May 15, 2015). Available at SSRN: http://ssrn.com/abstract=2605792
This paper examines the regulation of outsider trading in EU and the US, highlighting the differences between the two legal systems and investigating the main implications of the different regulatory choices made in the two jurisdictions. Outsider trading can be defined as the sale or purchase of listed securities on the basis of material nonpublic information by individuals who do not qualify as “insiders”. While US law leaves considerable room to outsider trading, EU law unconditionally prohibits it. Constraining outsiders’ exploitation of material nonpublic information has a sound efficiency-grounded justification, but an unconditional ban on all informed trading by outsiders appears harmful: it hinders investors’ incentives in ferreting out new information, decreasing market efficiency and increasing agency costs of publicly traded firms. US law, with its selective limitation of outsider trading, appears largely immune from these consequences. EU law, to the contrary, has the potential to carry on such drawbacks.
I really enjoyed Michael Perino's new paper A Scandalous Perversion of Trust: Modern Lessons from the Early History of Congressional Insider Trading (March 9, 2015), available at SSRN: http://ssrn.com/abstract=2575835:
The Stop Trading on Congressional Knowledge Act of 2012 (the “STOCK Act”) affirms that members of Congress are not exempt from insider trading prohibitions. Legal scholars, however, continue to debate whether the legislation was necessary. Leveraging recent scholarship on fiduciary political theory, some commentators contend that because members owe fiduciary-like duties to citizens, to their fellow members, and to Congress as an institution, existing insider trading theories already prohibited them from using material nonpublic information for personal gain. These arguments, while plausible, are incomplete. They rely on broad conceptions of legislators as fiduciaries, but provide scant evidence that members violate institutional norms when capitalizing on confidential information, a crucial step for fitting their trading into existing legal doctrines.
This Article fills that gap. Like other scholarship on governmental fiduciaries, it examines the foundational norms in Congress, focusing specifically on an episode not previously discussed in the literature. In 1778, Samuel Chase, a member of the Second Continental Congress, used his knowledge of plans to purchase supplies for the Continental Army to reap a substantial profit by cornering the market for flour in his home state. This Article documents the reaction to the Chase scandal and demonstrates that from the earliest days of the institution congressmen expected that members would not attempt to use confidential information for financial gain. Alexander Hamilton and other critics universally concluded that Chase had committed a “scandalous perversion of [his] trust.” This episode and other evidence compiled here strongly suggest that the STOCK Act was unnecessary to hold members of Congress liable for insider trading.
Of course, I was one of those who thought the STOCK Act was necessary. Perino's analysis of the relevant history almost persuades me I was wrong. Almost.... ;-)
SEC Solicitor Jacob Stillman said the Newman decision would lead to confusion because it altered the recognized standard for the personal benefit that must be shown to establish insider liability. ...
Deputy Director of Enforcement Stephanie Avakian said that the Second Circuit’s decision impacted only a subset of the Commission’s insider trading cases, but could still affect its ability to bring some cases, and, therefore, could hurt efforts to maintain investor confidence in the fairness and integrity of the markets.
Nonsense. In a recent amicus brief in the Newman case filed by yours truly, Todd Henderson, and Jonathan Macey, we explained that:
The panel’s opinion in Newman is both a correct application of the personal benefit test adopted by the Supreme Court in Dirks v. SEC and an important corrective to the government’s drive to expand the limits of insider trading liability. As the Dirks court appreciated, in the economically critical area of analyst-insider communication, a liability standard that is overly broad or unclear will deter market participants from seeking quality information on which to trade and thereby damage the healthy functioning of capital markets. The Supreme Court fashioned the personal benefit test accordingly, to draw a clear line between permissible and impermissible information gathering, so that analysts and investors would know when trading was permissible and not be needlessly deterred from seeking the best information available to them.
The government now seeks to dilute the Supreme Court’s test to the point where it would become, in the Newman court’s words, “a nullity.” Newman op. at 22. Under the government’s interpretation of personal benefit, almost any non- public insider disclosure could qualify, and the recipient of information would have no way of determining when trading on that information was permitted. The government’s misreading of Dirks would fundamentally undermine the policy imperatives that led the Supreme Court to adopt the personal benefit test as an important market-protective limit on insider trading liability, and would deter valuable analyst-insider communications, to the detriment of the market and of all market participants.
I recommend that the SEC read it before they misspeak again.
I was intrigued by another amicus brief filed on the defendants’ behalf. Not the brief by onetime SEC defendant and billionaire sports team owner Mark Cuban, but the one by three professors as famous in the securities law biz as Cuban is in the rest of the world. Stephen Bainbridge of UCLA, Jonathan Macey of Yale and Todd Henderson of the University of Chicago argued in a brief docketed Thursday that the 2nd Circuit panel in the Newman and Chiasson case was exactly right on what constitutes a personal benefit to a corporate insider. (As it happens, the same three, along with Allen Ferrell of Harvard, also filed an amicus brief backing Mark Cuban when the SEC appealed the dismissal of its case against him to the 5th Circuit.)
Wait one second. How come Macey and Henderson got bold typeface but not yours truly? (Update: The squeaky wheel gets the bold typeface.)
The professors said that despite the SEC’s arguments in Dirks for the prohibition of all trades based on material, non-public information, the Supreme Court concluded blanket insider trading rules would “ultimately damage the overall health of the market, because they limit the incentives of market participants to seek out information on which to trade.”
Instead, the professors’ brief said, the Supreme Court came up with the “personal benefit” test, which was supposed to draw an objective line between tips passed by a corporate insider with an improper motive and information provided innocently. The Dirks opinion did say that an insider’s improper purpose can be to enrich a friend, but, according to the securities professors, the court “was not endorsing the proposition that an insider who discloses inside information to a ‘friend’ is therefore seeking a personal benefit.”
... The professors contend that the government interpretation – which the Justice Department and the SEC want the 2nd Circuit to enshrine in a reconsideration of the Newman and Chiasson decision – would undermine the free-market policy concerns at the heart of Dirks. They urged the 2nd Circuit to deny the government’s petition.
Bainbridge said in an email that he’s done about 10 such amicus briefs in his 25-year career and that the Newman filing reflects views he has been espousing on his blog, ProfessorBainbridge.com, for about a year.
In reversing the convictions of Anthony Chiasson and Todd Newman for trading on information received through a chain of tips, the appeals court described what was necessary to show that the original tipper had received a benefit for passing on the information, a requirement to prove this form of insider trading. ...
Although the Newman decision appears to create a “buddy exception” to insider trading, prosecutors can still pursue cases based on friendship as long as there is some evidence of a benefit that could be considered valuable. There are cases in which information is passed simply because the recipient is a friend, but often something more valuable is exchanged when confidential information is doled out secretly. ...
The United States Court of Appeals for the Second Circuit has made proving insider trading more difficult in tipping cases but did not erect an insurmountable hurdle.
Go read the whole thing.
Dealbook reports that:
Federal prosecutors are seeking to reverse, or at least narrow, a crucial insider trading ruling that overturned the convictions of two hedge fund managers last month, DealBook’s Matthew Goldstein and Ben Protess report. Preet Bharara, the United States attorney in Manhattan, is asking the same three-judge panel that issued the ruling to revisit its decision, according to a filing on Friday. As an alternative, Mr. Bharara’s filing proposes the legal equivalent of a do-over in a process known as en banc.
I hope that the court will deny these requests. As I have explained before, Newman was demonstrably correct. See this post for details.
Bloomberg reports that:
A federal appeals court ruling that makes it harder to obtain insider-trading convictions was called “dramatically” wrong in the U.S. government’s first formal response to the sweeping decision.
In the Dec. 10 ruling tossing the convictions of two fund managers, the court said that, to be found guilty of insider trading, defendants must know their tips came from someone who not only had a duty to keep it secret but also got a benefit for leaking it. ...
The ruling “dramatically (and in our view, wrongly) departs from 30 years of controlling Supreme Court authority and, in so doing, legalizes manipulative and deceptive conduct that no court has ever sanctioned,” prosecutors said in a court filing Monday.
Wow. The government's argument is itself so dramatically wrong as to border on being deceptive. In fact, the case in question -- US v. Newman -- got it exactly right, as I explain in this post.
I'm particularly flummoxed by this claim made by the government:
The government’s response came in a case against four men who admitted trading on tips about IBM Corp.’s $1.2 billion purchase of the software company SPSS Inc. The information originated with a lawyer working on the deal. The judge in that case asked prosecutors about the effect of the appellate ruling. ...
They said the decision shouldn’t affect the IBM case because the four men admitted “misappropriating” or stealing the information. The government shouldn’t have to also show any personal benefit was traded for it, the prosecutors said.
In my book, Insider Trading Law and Policy, I explain that the government has made this argument before and lost:
The Eleventh Circuit has held that the personal benefit requirement applies to tipping cases brought under the misappropriation theory of liability, rejecting an SEC argument to the contrary. SEC v. Yun, 327 F.3d 1263 (11th Cir. 2003).
In its desperation to continue the war on insider trading (which reliably generates headlines, budget increases, and career advancement for prosecutors), the government has frequently stretched precedent to the breaking point. But this appears to take the proverbial cake.
With the sad passing of my friend and mentor Henry Manne, it seems appropriate to point out that he is one of the few American legal scholars whose works have been collected into a single set of three edited volumes. The Collected Works of Henry G. Manne consists of:
Volume 1, The Economics of Corporations and Corporate Law, includes Manne's seminal writings on corporate law and his landmark blend of economics and law that is today accepted as a standard discipline, showing how Manne developed a comprehensive theory of the modern corporation that has provided a framework for legal, economic, and financial analysis of the corporate firm.
Volume 2, Insider Trading, uses Manne's ground-breaking Insider Trading and the Stock Market as a framework for many of Manne s innovative contributions to the field, as well as a fresh context for understanding the complex world of corporate law and securities regulation.
Volume 3, Liberty and Freedom in the Economic Ordering of Society, includes selections exploring Manne's thoughts on corporate social responsibility, on the regulation of capital markets and securities offerings, especially as examined in Wall Street in Transition, on the role of the modern university, and on the relationship among law, regulation, and the free market.
I was honored to be chosen as the editor for the second volume. You can download my introduction, Manne on Insider Trading, from SSRN: http://ssrn.com/abstract=1096259
I got this email from a staffer to a Democratic Congressman from New England:
Our boss ... is concerned with the recent 2nd Circuit Court of Appeals decision in the insider trading case against Todd Newman and Tony Chiasson. It seems that the appeals court relied on the Supreme Court's intent in a 1983 ruling, Dirks v. the Securities and Exchange Commission, which said a person could be guilty of insider trading only if he knew that the corporate insider leaking the information was breaching a duty to the company. When defining a breach, the court explained that "the test is whether the insider personally will benefit," adding, "Absent some personal gain, there has been no breach of duty.” This seems like a very narrow standard, and our boss is interested in introducing legislation to prohibit insider trading outright. We saw you quoted in a recent New York TImes article on the subject and are hoping to arrange a time for a call to discuss ways to broaden the standard to prohibit all insider trading.
To which I responded:
Why on earth would you want to prohibit all insider trading? It seems to me that the Newman court got it exactly right, as I explained in this blog post.
For a more detailed discussion of the state of insider trading law and the rationale for prohibiting some--but not all--insider trading, see my essay Regulating Insider Trading in the Post-Fiduciary Duty Era: Equal Access or Property Rights, in Research Handbook on Insider Trading 80 (Edward Elgar Publishing; Stephen M. Bainbridge ed. 2013), which I attach.
You can download a pre-publication draft of the essay here. Or, better yet, you could buy one of my books:
After Gregory Bolan quit as a research analyst for Wells Fargo & Co. in Nashville, Tenn., his former colleague, trader Joseph Ruggieri, gave him a set of keys to Mr. Ruggieri’s Manhattan apartment to help him as he interviewed for jobs in New York.
This seemingly innocuous favor was cited by the Securities and Exchange Commission, when it filed civil charges last year against both men alleging insider trading.
The agency said the gesture of friendship helped demonstrate that Mr. Bolan benefited from allegedly tipping Mr. Ruggieri about his upcoming market-moving reports on several stocks from April 2010 through March 2011, when they still worked together.
Now, the supposed benefit is at the center of a courtroom battle—the latest in a string of legal challenges stemming from a landmark appeals-court ruling in December that raises the bar for prosecutors and the SEC in proving insider trading.
The two men intend to file a motion Thursday, seeking the dismissal of all charges against them as a result of the appeals-court ruling, according to Mr. Bolan’s lawyer, Sam Lieberman. The men deny wrongdoing and say the SEC’s case doesn’t meet the new standard set by courts. ...
Prosecutors and the SEC “in a lot of ways…have been quite cavalier” about assuming that friendships are sufficient to satisfy the personal-benefit test in insider-trading cases, said Stephen Bainbridge, a law professor at the University of California, Los Angeles. That’s set to change, he added: “The days when you could just allege that [the tipper and trader] were buddies and talked to each other are clearly over.”
From the NYT:
Added Stephen M. Bainbridge, an insider trading expert at the University of California, Los Angeles School of Law: “It’s always been a problem to gerrymander insider trading into fraud.” ...
The best limiting principle might well be a statute. “I think the law should be clear rather than vague,” Professor Bainbridge said. “The law ought to put you on notice what you can and cannot legally do.” This seems especially true when a person convicted of violating it faces jail time.
In order to show a violation, prosecutors must now prove “a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or valuable nature.” The government cannot prove the existence of this kind of benefit from “the mere fact of a friendship, particularly of a casual or social nature.” A tip to a golfing buddy, a college roommate, or a neighbor, without more, is apparently no longer improper.
I disagree with Perino's claim that this represents "a much narrower view than previous courts." To be sure, the US Supreme Court's decision in Dirks v. SEC held that:
The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.
But does this mean that all gifts give rise to liability under Dirks? I don't think so. As I wrote in my book Insider Trading Law and Policy:
The question of what constitutes the requisite personal benefit was posed by well-known economics blogger Megan McArdle in connection with the insider trading case against prominent Wall Street executive Rajat Gupta:
Rajat Gupta, formerly a director at Proctor and Gamble and Goldman Sachs, has been indicted on multiple counts of passing insider information about the companies he was supposed to be helping to oversee. He is alleged to have delivered this information to Raj Rajaratnam, the hedge-fund manager who just got 11 years for insider trading.
… This is a very interesting case, because Gupta is not accused of having directly profited from the tips. He’s accused merely of having used them to build his relationship with Rajaratnam.
… [I]nsider trading cases usually require proving that the insider who delivered the information did so for some gain. That gain doesn’t have to be immediate, or in cash, but it does have to be something that you can point to and say “That’s what he got out of it”.
“Rajaratnam’s goodwill” is slightly more nebulous than I believe usually goes to trial. And that’s not just because you have to spend hours in court arguing about whether this is actually valuable. It’s also because without a gain, there’s less in the way of a paper trail. ...
McArdle was not the only commentator who raised this issue in connection with the Gupta case. University of Chicago law professor Randal Picker opined that:
According to Wayne State University Law School professor Peter J. Henning in a recent New York Times article, there are complications to each aspect of this case. ...
Proving Gupta received a personal benefit from his alleged tips to Rajaratnam is likely the hardest aspect of the case for the Department of Justice. In Dirks vs. SEC, the Supreme Court said that to prove insider trading by a tipper, “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.” The indictment itself is surprisingly muted on this aspect, merely stating that Gupta “provided the inside information to Rajaratnam because of Gupta’s friendship and business relationships with Rajaratnam. Gupta benefitted and hoped to benefit from his friendship and business relationships with Rajaratnam in various ways, some of which were financial”. Gupta’s lawyer, in contrast, stated that during the time in question his client lost his entire investment in the Galleon Fund. It will be interesting to see what evidence prosecutors have to demonstrate how exactly Gupta benefitted (especially since the financial relationships between Gupta and Rajaratnam cited in the indictment occurred mostly from 2003 through 2006, well before 2008).
Any analysis of this issue must start by recognizing that Gupta was not charged with insider trading as such. Instead, he was charged with the related offense of tipping information to an outsider who then used it to trade. As a tipper, Gupta could be held liable if the government showed—as it succeeded in doing—that he (a) disclosed material nonpublic information to Rajaratnam (b) in return for a personal benefit (c) expecting Rajaratnam to trade. The question raised by McArdle goes to the second prong; namely, whether Gupta making tips “to build his relationship with Rajaratnam” rises to the requisite personal benefit. In short, it does.
Dirks itself held that the tipper can be held liable when he ““receive[s] a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.” The court further explained that “The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.” As the Second Circuit later explained, by this formulation “the Supreme Court has made plain that to prove a § 10(b) violation, the SEC need not show that the tipper expected or received a specific or tangible benefit in exchange for the tip.” In that case, the court held that “The close friendship between [tipper] Downe and [tippee] Warde suggests that Downe’s tip was ‘inten[ded] to benefit’ Warde, and therefore allows a jury finding that Downe’s tip breached a duty under § 10(b).” If a “close friendship” is not too nebulous, getting on the good side of a major player in the hedge fund industry is a very easy case. The Gupta case thus can be instructively contrasted with SEC v. Maxwell, which rejected tipper liability on grounds that the alleged tipper was unlikely to receive any future pecuniary or reputational benefit from giving tips to his barber. As a major hedge fund manager, Rajaratnam was no mere barber.
As Thomson Reuters’ Accelus blog explained:
In S.E.C. v. Sekhri, the court both distinguished and refined the concept of personal benefit as an element of insider trading:
The first part of Sehgal’s argument fails because it is based on an overly narrow interpretation of the rule stated in Dirks. While Sehgal is correct in arguing that the evidence must show that Sekhri sought some personal benefit from disclosing the nonpublic information to Sehgal in order to have breached his fiduciary duty, he ignores the remainder of the Court’s statement.... While noting that the insider must seek to benefit from disclosing inside information, the Supreme Court noted that “[t]here are objective facts and circumstances that often justify [the] inference” that the insider benefitted from the disclosure.... For example, “[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.” .... (emphasis added (by Court)). Thus, when Sekhri disclosed insider information to his father-in-law, Sehgal, it may be inferred that Sekhri received some personal benefit from the gift of information. Likewise, the burden of proof shifts from the SEC to Sehgal, and Sehgal must prove that his son-in-law derived no benefit from the disclosure in order to negate the inference that Sekhri benefitted from the transaction.
In the case of Gupta and Rajaratnam, the two men, in addition to years-long friendship, had a number of investments together.
Not surprisingly, the jury apparently had no difficulty finding the requisite personal benefit, as it convicted Gupta of multiple counts of illegal tipping.