A precise definition, an absolute prohibition or something in between?
Two senior hedge fund managers slip out of their insider trading convictions because the government couldn’t prove they knew whether the corporate insiders who initially divulged the tips they ultimately traded on were paid off for doing so.
Some, like me, would say who cares whether they knew about the original pay-off, certainly in the case of professional investors who wouldn’t have traded on those tips unless they came from reliable, inside sources.
But the recent Second Circuit decision in Newman is now defying the Supreme Court, or Congress, to decide once and for all whether material, non-public information should be treated as inherently toxic or restricted only in certain circumstances.
What Newman hath wrought
Today, trading on MNPI by itself is not illegal.1 Only MNPI that is illegally obtained is currently restricted. To the Supreme Court, that’s when MNPI is passed on by a tipper who breaches a duty of confidentiality – directly or indirectly – to the issuer of the security or its shareholders. Once MNPI is tainted, it cannot be traded on by the original or any downstream tippee.
In a 1983 case called Dirks, the Supreme Court went even further and held that MNPI doesn’t become tainted unless the tippee who ultimately trades on it knows that the original tipper got paid for his breach.
That’s what underpinned the decision in Newman which has now called into question numerous insider trading convictions and guilty pleas that were based on the assumption that the quid pro quo test in Dirks could be met by simply proving that the initial tipper and tippee were friends, neighbors or business associates.
According to Justice, the Second Circuit’s holding in Newman would “dramatically limit the government’s ability to prosecute some of the most common, culpable, and market-threatening forms of insider trading.”
The Justice Department has asked the Second Circuit to reconsider the case en banc. Interestingly, the government’s brief doesn’t challenge the relevance or viability of Dirks, but argues instead that the defendants actually met its knowledge test. According to Justice, the Second Circuit’s holding in Newman would “dramatically limit the government’s ability to prosecute some of the most common, culpable, and market-threatening forms of insider trading.”
What Newman does is raise the thorny question of whether it makes sense to continue down our current judicial path of adding nuance after nuance to insider trading precedent or to scrap our piecemeal approach in favor of a blunderbuss prohibition of all trading on MNPI. Because of the importance of that question to the securities markets, the case is likely to go up to the Supreme Court no matter what happens en banc in the Second Circuit.
If the Supreme Court reaffirms Newman, the government fears that hedge fund managers, research analysts and other investment professionals will develop clever ways to insulate themselves from their original insider tips. Steven Cohen, for example, managed to steer clear of all the ‘black edge’ that was found streaming into SAC Capital.
Reversing Newman and gutting Dirks, on the other hand, would move the Court closer to those who believe the mere possession of MNPI should paralyze its possessor (so-called ‘possession theorists’). As it has developed, insider trading law didn’t go in that direction for fear it would chill the aggressive, but legitimate, corporate research that optimizes the stock market. Still, an outright government prohibition wouldn’t be unprecedented since the SEC adopted that very policy back in 1980 in regard to tender offers.2
Who gets the ‘hot potato’?
It may turn out that the Supreme Court never gets to resolve this critical issue since Congress has taken a serious interest in insider trading regulation since Newman and the spate of now-upsettable convictions that preceded it. In the past two months, Democratic senators Jack Reed of Rhode Island and Robert Menendez of New Jersey and Republican congressman Stephen Lynch of Massachusetts have introduced legislation effectively adopting the ‘possession theory’ and outlawing the use of MNPI in all securities trading.
If those bills turn out to be too radical a step for lawmakers to pass, one compromise solution may be to establish a rebuttable presumption that any MNPI relating to a trade derives from an inside source who should not have divulged it.3 That may sound subtle to some, but, in a criminal prosecution, the defendant would have to overcome that presumption and that might just be enough to forestall a lot of market misbehavior.
1 The Supreme Court so decreed in Chiarella (1980), which was cited in Newman.
2 SEC Rule 14e-3 prohibits trading on information about a tender offer by anyone who knows it came from someone connected to the transaction.
3 The EU moved in that direction last year with the passage of its Market Abuse Regulation which presumes that anyone who trades in a security while in possession of MNPI has used it illegally in connection with the trade.