Insider Trading Standard Turned Inside Out by Federal Court Action
Although prosecution of insider trading cases has a long history in the United States, how to define what actually constitutes “insider trading” under our securities laws has recently been called into question not only by our courts, but also by Congress — throwing the enforcement arm of the Securities and Exchange Commission (SEC) into a no man’s land.
The SEC describes illegal insider trading as referring generally “to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.” “Tipping” by people with inside information, as well as the trading of securities by those who receive the information — tippees — are culpable. But courts throughout the years have differed as to the proof that must be presented to convict insiders, setting different precedents, eroding prior standards, and setting new ones.
While there is no SEC regulation or law that specifically defines insider trading (action is brought under the general Rule 10b-5 fraud standard), courts have generally refined the legal standard through rulings over the years, the most prominent being the Supreme Court ruling in Dirks v. SEC.
In Dirks, the Court held that for a tipper to be found guilty, there needed to be a showing of personal benefit, which was not limited to “pecuniary gain” but could also include reputational benefit. An element for weighing the culpability of tippees was whether the tippee knew or should have known that the information received was from one with a fiduciary duty.
Breaking with precedent, in December 2014, the Second Circuit Court of Appeals rocked insider trading law by issuing its decision in United States v. Newman, a case being cited as dramatically redefining the elements of what is needed to convict. Breaking with prior decisions (including that of the Supreme Court in Dirks), the court in Newman overturned the prior convictions of two former hedge fund managers who had been found guilty of insider trading. In doing so, the court concluded that the tipper of information had not received a pecuniary benefit and that it was not proven that the persons he tipped knew the information was disclosed by an insider for a personal benefit. Although both the SEC and the Department of Justice (DOJ) have filed for rehearing of the case, the effects of Newman are already being felt.
Just last week, former Goldman Sachs Director Rajat Gupta, who is serving a prison term for his insider trading conviction, filed to have his conviction overturned in light of the “new” Newman standard. And in a strategic move, prosecutors have voluntarily sought dismissal of pending insider trading cases that may not be winners under this change in law, with an option to bring them later. No shift in legal standards would be complete, however, without the intervention/attention of Congress.
On 27 February, Representative Stephen Lynch (D-Mass) introduced a bill (H.R. 1173) that would make insider trading a federal crime. On 11 March, Senators Jack Reed (D-RI) and Robert Menendez (D-NJ) introduced their own bill to ban insider trading. Neither bill has sought to define exactly what would constitute “material” nonpublic information for purposes of finding culpability.
As the SEC and DOJ seek rehearing of the Newman case, the question is whether the undoing of Newman and a return to status quo would be enough or whether Congress will decide to enact legislation that definitively defines the elements of insider trading in a federal law. The race is on.
See related blog post: Court Muddies Water on Insider Trading, but CFA Institute Code and Standards Are Clear
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