Insider Trading: There Oughta Be a Law-Or Not: A Recent Appeals Court Ruling Has Congress Thinking about Adopting a European Approach to Insider Trading

By Booth, Richard A. | Regulation, Fall 2015 | Go to article overview

Insider Trading: There Oughta Be a Law-Or Not: A Recent Appeals Court Ruling Has Congress Thinking about Adopting a European Approach to Insider Trading


Booth, Richard A., Regulation


The campaign against the supposed evils of insider trading suffered a major setback last December when the Second Circuit Court of Appeals overturned the conviction of two hedge fund managers who had traded on tips about technology companies Dell and NVIDIA. In essence, the court ruled in United States v. Newman that the prosecutor did not prove the traders knew the information was improperly disclosed by the source "tipper." So the traders had no legal duty not to trade on the tip.

The Newman decision has prompted the usual shock-shock from legal scholars and other critics because the defendants had assembled so-called expert networks in such a way that they would never need to know the details of why a source spilled the beans. The argument seems to be that if we know the defendants traded on material nonpublic information of the sort that must have come from an improper source, we should convict them--somehow. In other words, there oughta be a law.

Columnist James B. Stewart argued in the New York Times that Congress needs to enact a statute to replace the common-law case-by-case approach to insider trading. As he points out, in the European Union it is simply illegal to trade on material nonpublic information irrespective of how one obtains it. And to date four bills have been introduced in Congress that would adopt essentially that approach.

Bad idea. Such a law would severely reduce incentives for market research and render the market less efficient. Wiry dig for gold if you cannot keep it when you find it? Trading on nonpublic information drives market prices to the correct level more quickly, giving investors added assurance that they get the best possible price when they trade. But before we get too deep into the policy weeds, we should be clear about the law as it stands.

TIPPING AND FIDUCIARY DUTY

There is no law against trading on nonpublic information just because it is nonpublic (with one minor exception for information about a planned tender offer). Ironically, Congress has enacted statutory penalties for insider trading but it has never been able to agree on what constitutes insider trading. Rather, the definition of insider trading depends on judge-made (common) law and is based on the general legal duty that information entrusted to one for business purposes may not be used for personal gain.

To be specific, the U.S. Supreme Court held in Dirks v. SEC (1983) that to be found guilty of insider trading, the receiver of the tip--the "tippee"--must know (or at least should know) that the source tipper violated a fiduciary duty or similar obligation--for example, to an employer--in disclosing material nonpublic information. This usually requires some evidence that the tipper was effectively bribed (although it may suffice to show that the tipper wanted to make a gift of valuable inside information to the tippee).

In Newman, prosecutors prevailed on the trial court not to require any such evidence as to the motivation of the tipper. Again, the problem with this argument is that it is not per se illegal to trade on inside information in the United States. Rather, the information must have been disclosed improperly and the tippee must (or should) know so. But there was zero evidence in Newman that the defendants knew that the tipped information had been improperly disclosed.

Still, it is not completely clear under the law that a prosecutor must prove a personal benefit (or gift) to get a conviction--although Newman now says so. Rather, it is (or should be) enough that a tipper violated a duty to the source of the information-disclosed it improperly--irrespective of motivation.

It is important to consider the language used by the Supreme Court. What the Court said when it laid down the law in Dirks was:

   A tippee assumes a fiduciary duty to the shareholders of a
   corporation not to trade on material nonpublic information only
   when the insider has breached his fiduciary duty to the
   shareholders by disclosing the information to the tippee and the
   tippee knows or should know that there has been a breach. … 

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