Judge Engelmayer ()
The following is an edited version of a keynote address delivered by Southern District Judge Paul Engelmayer to the Securities and Litigation Enforcement Institute of the New York City Bar on Oct. 16.
Today, I intend to share some thoughts on the state of insider trading law, in the wake of the decision of the U.S. Court of Appeals for the Second Circuit in United States v. Newman.
Newman is one of the most important and provocative decisions in years in the area of insider trading. It defines, in this circuit, the standards for liability in cases involving tippers and tippees, that is, where a defendant has traded on confidential information that traces back to a public company insider. And it has opened up a spirited debate about what those standards ought to be.
By way of recap, the defendants in Newman were two portfolio managers. They were alleged to have traded on information obtained through a chain tracing back to corporate insiders, and to have made $4 million and $68 million, respectively, for their funds. Overturning their convictions, the Second Circuit directed that judgments of acquittal be entered because the evidence was legally insufficient. And it addressed the elements of insider trading in terms that lawyers and scholars have widely viewed as modifying, or muddying, the standards for tippee liability.
After the U.S. Department of Justice’s petition for a writ of certiorari was denied, Southern District U.S. Attorney Preet Bharara said the decision would leave “an obvious roadmap for unscrupulous investors” and give them “a bonanza,” and create a category of insider trading that “will go unpunished going forward.”
Many commentators similarly were quoted as lamenting that a last clear chance had passed, for the foreseeable future, to clarify “the rules of the road” with respect to tippee liability.
One defense lawyer said that what the investment community needs are “clear green lights [and] red lights,” but that, after Newman, the law of tippee liability is today “an ambiguous flashing yellow.” And another, who had been a prosecutor in the 2011 Raj Rajaratnam trial, said that the standard for liability articulated in Newman would complicate future prosecutions.
I plan to address three questions. First, how did the law reach this point? Second, what are the implications of the current state of affairs, where the standards for tippee liability are widely seen as uncertain? And, third, where might the law go to attain greater clarity?
So: How did the law reach this point?
The answer starts with this: Unlike virtually every country that is home to a securities exchange, the United States does not have a statute that defines insider trading.
The EU countries, including the U.K., have such statutes. Japan has one. So do Australia and Canada; China and Indonesia; Malaysia, Singapore and Vietnam; and Bulgaria, Cyprus, Jordan, Paraguay, Slovakia, and Slovenia. To put things in perspective, in the event that insider trading breaks out within the 998 square miles that comprise Luxembourg, there is a statute in place to cover that, too.
But not in the United States. There are federal laws that cover two narrow areas of insider trading. The STOCK Act prohibits trading by Congress and its staff based on inside knowledge. And the Williams Act prohibits trading based on an undisclosed tender offer. But otherwise, despite efforts from time to time to pass a general insider trading statute, the U.S. Code is silent.
Insider trading instead has been punished under the anti-fraud provisions of Section 10b of the 1934 Securities Exchange Act, and its implementing Rule, 10b-5. These prohibit manipulative and deceptive devices in connection with the purchase or sale of securities. But they were not enacted with insider trading in mind. When the SEC adopted Rule 10b-5 in 1942, there was famously no debate on it at all, save that one commissioner, Sumner Pike, declared, in voting yes: “Well, we are against fraud, aren’t we?”
And so, the development of U.S. insider trading law has been left to the federal courts. The U.S. Supreme Court and the Second Circuit have developed this body of law, ad hoc, case by case, essentially from scratch, effectively as a matter of federal common law.
The critical doctrinal move in developing insider trading doctrine, I would submit, was the Supreme Court’s decision, 35 years ago, to anchor it in corporate law concepts of fiduciary duty. That is not the approach taken in other countries.
The court’s intellectual leader in conceiving thusly of the insider trading offense was Justice Lewis Powell. Among the many important securities law decisions that Powell wrote were two foundational insider trading decisions: Chiarella v. United States, in 1980, and Dirks v. SEC, in 1983.
There’s a fascinating article by Professor A.C. Pritchard, drawing upon Powell’s papers, about his securities law jurisprudence. He writes that Powell was concerned about reading §10b too broadly. The SEC and Justice Department were pursuing far-reaching applications of §10b, based on the notion that a purchaser or seller had a “duty to the market.”
Powell worried that these approaches might impose a “parity of information” requirement, or close, on market participants. He felt, based on his years of experience as a corporate and boardroom lawyer, that this could discourage useful market research and impede market efficiency.
And so, in Chiarella and Dirks, Powell, with a conceptual assist from Justice John Paul Stevens in Chiarella, built insider trading doctrine around the existing fiduciary duties of corporate insiders. The effect was to create a federal common law of fiduciary duty for the limited purpose of the insider-trading offense, while not expanding the duties that corporate insiders already had.
Let me unpack that. For 20 years after Rule 10b-5 was adopted, it was not used to combat insider trading. In 1961, the SEC brought its first insider trading administrative action, in the Cady Roberts case; in 1968, it brought its first enforcement action, in Texas Gulf Sulphur.
The early cases involved trading by executives, who bought on confidential information that would cause the company’s stock to rise. For example, in Texas Gulf Sulphur, a mining company had discovered valuable mineral ore, and the insiders bought stock and call options. Finding fraud, the lower courts reasoned that the executive had had a fiduciary duty either to disclose the information to the shareholder with whom he was trading, or to refrain from trading.
In the 1970s and the 1980s, prosecutors began to bring insider trading cases under 10b-5, and not only against insiders, but also against others, including tippees. In response, the courts developed two distinct theories of insider trading liability, the “classical theory” and the “misappropriation theory.”
The classical theory covers cases where an insider breaches a fiduciary duty to shareholders. Powell articulated it in Chiarella. The critical element is that, for the insider to have breached a fiduciary duty by disclosing information, he must have acted for his personal benefit. That’s what made the disclosure an act of self-dealing. It’s not a breach of fiduciary duty to accidentally let non-public information slip. And it’s not a breach to reveal such information in an attempt to benefit the corporation, say, in a discussion with an analyst. Those may be mistakes, but they’re not breaches of the insider’s fiduciary duty.
And here is Powell’s critical corollary. For a tippee­—the recipient of inside information—to be liable, the tipper must be liable too. A tippee’s liability is derivative of the insider’s liability. And so, for the tippee to be liable, the insider must have disclosed the information in breach of his fiduciary duty, meaning in anticipation of personal benefit.
Unless the insider did so and the tippee knew that he had, the tippee did not violate 10b-5. As Powell wrote in Dirks: “[T]he test is whether the insider personally will benefit, directly or indirectly, from the disclosure.” Otherwise, “there has been no breach of [fiduciary] duty to stockholders.”
The misappropriation theory is based on a breach of a different duty: the duty a person entrusted with confidential information has to its source. So, a law firm employee who accesses the firm’s database can be prosecuted for trading on information about a client’s upcoming merger. And an employee of a corporate printer can be prosecuted for trading on information in a draft deal document.
The theory is that such a person engages in deception by pretending loyalty to the source, while secretly converting its information for his own gain. The misappropriation theory is said to have been developed out of the U.S. Attorney’s Office here, and to have been the brainchild of a brilliant lawyer who headed the securities fraud unit and later the criminal division, Larry Pedowitz, later a leader of the criminal defense bar.
The Second Circuit first accepted the misappropriation theory in 1981, in, ironically, the case of United States v. Newman, and famously applied it in 1986, in United States v. Carpenter, when it affirmed the conviction of a Wall Street Journal reporter who had traded ahead of the publication of the Journal’s “Heard on the Street” column. In 1997, the Supreme Court accepted the misappropriation theory in United States v. O’Hagan, involving a law firm partner who traded on confidential client information.
Quid Pro Quo in ‘Newman’
That brings me to the current Newman case. Newman arises under the classical theory. The key question Newman raises is what it means for there to have been a “personal benefit” to the corporate insider.
The government’s evidence in Newman as to how the two corporate insiders had personally benefitted from tipping the person nearest to them in the chain leading to the defendants was this: One insider had gone to school and worked with the tippee, and received career advice from the tippee around the time of the tipping. The other insider was a family friend who had socialized with the tippee.
This evidence, the Second Circuit held, was too thin to show that either insider had received a “personal benefit” in exchange for their tips. The circuit acknowledged that Dirks had stated that the insider’s personal benefit could be reputational and that it could be the benefit that one would obtain from “making a gift of confidential information to a trading relative or friend.”
But, the circuit also wrote this—and this prose is what has made Newman controversial. The government, the circuit wrote, may not “prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature.” Instead, to the extent “a personal benefit may be inferred from a personal relationship between the tipper and tippee,” “such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”
This, in turn requires “evidence of a relationship between the insider and the recipient that suggests a quid pro quo from the [recipient] or an intention to benefit the [recipient].”
Seeking review, the Justice Department argued that the panel had made new law by requiring, to show a personal benefit arising from such a tip, proof of an “exchange” or a “quid pro quo” or a potential “pecuniary” or similarly valuable “gain” for the insider.
The government argued that this standard would allow an insider, with impunity, to give a gift of nonpublic information to a casual friend, and for the friend to trade on it. As long as the insider had not expected something of value in return, the insider and the tippee would not be liable. This, the Justice Department argued, would “hurt market participants, disadvantage scrupulous market analysts, and impair the government’s ability to protect the fairness and integrity of the securities markets.”
Newman’s language regarding the personal benefit requirement was imprecise and confusing, the government said, and would complicate efforts to prosecute tippers and tippees.
The defendants, opposing certiorari, focused on the part of Newman that restated the standard in Dirks. They depicted Newman as a routine application of Dirks that broke no new ground.
With the denial of certiorari, we are left with no definitive word on how to read the decision.
Current State of Affairs
So, that is how we came to this point. What are the implications of the current state of affairs?
The answer is, Houston, we have a problem. The problem is a lack of clarity involving an area of law of vital importance to the integrity of our securities markets. As to tippers and tippee, there is, I submit, an undesirable level of uncertainty today about what is and is not punishable as insider trading.
If you read what the bar, and legal commentators, and disinterested people have been writing, there is genuine uncertainty as to what will qualify as a personal benefit so as to make a tipper liable for revealing inside information and a tippee liable for trading on it. Thoughtful people in good faith are reading Newman‘s discussion about personal benefit very differently.
Why does this matter? Well, think about the predicament the lack of clarity creates, for a host of affected parties.
Consider first a U.S. attorney in this circuit. He’s in a bind. Assume he has evidence that a CEO has disclosed an upcoming spike in corporate earnings to a person he’s playing golf with. “I don’t expect anything from you,” the CEO has said to the golf partner, “and we’re not particularly close. Here’s some information. Live long and prosper.” The golf partner trades on the tip and makes boatloads of money.
What is the U.S. attorney to do? Pre-Newman, the prevailing view, it’s safe to say, would have been that the CEO’s intent to benefit even a casual acquaintance like the golf partner would have met Dirks‘ personal benefit standard. But given Newman‘s articulation of that standard, our hypothetical U.S. attorney would have to ask himself: Is there sufficient evidence of a personal benefit to get to a jury?
And, if you’re the prosecutor, what do you do at trial when the defense asks for a jury instruction right out of Newman—including that there must be “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” On what basis can you oppose that instruction? And if that instruction is given, what is your jury argument as to how that standard has been met?
The U.S. attorney will surely view the CEO’s deliberate leak of market-moving earnings news to the golf partner, and the golf partner’s trading on it, as wrongful and as detrimental to honest participants in the securities markets. I doubt anyone in this room would disagree. But does the law give him the tools to fight it?
Note what Bharara said after certiorari was denied in Newman. He said he would have to think “long and hard” about bringing charges in cases involving unilateral gifts of confidential information. He has refused to disarm. He hasn’t said he wouldn’t bring such a case. He has wisely left the sword of Damocles hanging, to keep a deterrent in place. But, in the end, in such a case, given Newman, would he let the sword fall?
Now imagine that you’re a hedge fund compliance officer. Your traders have heard about the golf course tip. They want to trade on it. Their job is to make money. And your research analysts want to cultivate more information like it. Your job is to assure compliance with the law. Before Newman, virtually all established compliance policies and procedures at financial institutions would have prohibited employees from soliciting and acting on the golf course tip. But what can you advise your analysts and traders about what the line is now between lawful and unlawful information gathering?
Suppose you want to keep your pre-Newman policies in place. You’re prudent. You know it’s possible that Newman will be held not to have changed anything. Maybe your fund conducts business outside the Second Circuit, where Newman does not apply. And other sources of law, like SEC Regulation FD, may counsel restraint.
But suppose your fund’s competition is exploiting the post-Newman gray area. They are aggressively going out and getting information, like the golf course tip, which is traceable to an insider but where there’s no evidence of an exchange or pecuniary benefit. Your analysts and traders are clamoring to keep up. Do you have the authority to hold the line?
Where legal rules are unclear, there is going to be a risk of a race to the bottom. There’s going to be a risk that less scrupulous analysts who are willing to harvest information by means previously thought unlawful will benefit. And there’s going to be a risk that firms and funds with more robust compliance cultures will be left behind.
And other constituencies are affected by the divergent readings of the law post-Newman. There are securities lawyers like you, who have to advise clients about the legality of trading. There are criminal defense counsel, who have to advise clients whether to plead or fight. There is the SEC, which must decide whether to initiate enforcement action. And there are the insiders and the market participants, whose conduct and rights are implicated by the legal rules we set.
Reflecting on this brought to my mind a Supreme Court quote, from a totally different area of the law. It comes from the 1992 decision in Planned Parenthood v. Casey, where the court, after years of being asked to cut back on Roe v. Wade, reaffirmed it. The court’s controlling opinion was jointly written by Justices Anthony Kennedy, Sandra Day O’Connor, and David Souter, which itself was unusual. And, in their first sentence, explaining the decision to reaffirm and clarify the parameters of the abortion right, the three Justices wrote this: “Liberty finds no refuge in a jurisprudence of doubt.”
That principle equally applies to the way society defines its crimes. No one benefits when the reach of such laws is significantly in doubt. Not traders; not prosecutors or regulators; not defense counsel or in-house counsel or compliance personnel; and certainly not the securities markets and the people who work in them.
And that brings me to my final question: From where might clarity be obtained as to this corner of insider-trading law?
One possibility is that a case will reach the Second Circuit, or the Supreme Court from another circuit, that raises these issues. But it’s anybody’s guess whether a case that presents the personal benefit issue and reaches appeal will come along soon.
More broadly, I submit that we need to look beyond the courts, and to the democratic process, to set liability standards in this area. Newman is a reminder that, when it comes to defining the bounds of criminal liability, the common-law adjudicative process has its limitations.
For good reason, criminal law in this country is overwhelmingly a creature of statute. We leave it to our democratically chosen legislatures to define our crimes. True, many statutes use words like “fraud” which courts are called upon to interpret. But when what is at stake are the rules of the road in the complex, dynamic and heavily regulated world of the securities markets, does it make sense to leave it to courts to fill in all the content and to define all the contours of criminal liability?
When it comes to insider trading, the Supreme Court and the courts of appeals have done, on the whole, a remarkable job fleshing out the doctrine. We can all agree on that. But one result of delegating so much lawmaking to the courts, save for spot areas where Congress has acted, has been to leave insider trading law as something of a patchwork quilt.
Here’s an illustration. Suppose you’re at a barbeque this weekend and you overhear talk of an upcoming tender offer for a public company. Under the Williams Act and implementing SEC Rule 14a-3, you can’t trade on it.
Liability doesn’t require that someone breached fiduciary duty. But, now suppose, five minutes later, you overhear talk of the same company’s upcoming earnings announcement. Or its discovery of a huge oil field. Or of the imminent firing by the board of its entire C-Suite. That material non-public information you can trade on, unless there’s been a fiduciary duty breach that you know of, because there’s no statute on point and Powell’s fiduciary duty test controls.
There’s another problem caused by the delegation of lawmaking. A court cannot always anticipate problems not presented by the case at hand. The judiciary’s institutional competence does not extend to seeing around corners.
So, one can fairly question, for example, whether the fiduciary duty framework that Powell put it in place is the right framework—the right paradigm—for considering all of the insider-trading problems of today.
Consider a remote tippee, say a research analyst far downstream in the chain of information flow. He may have obtained a preview of an earnings announcement through a chain six or eight people long. The communications among these people may have been through email and text and Snapchat, and in person and by phone.
Does it make sense to ask, as the measure of liability, whether the remote tippee is aware whether the insider at the start of the chain stood to receive, in exchange for his disclosure, a benefit from the person in the chain closest to him? How realistic is it that a remote end-of-the-line tippee would ever know that? And why would a remote tippee ever ask?
If we are trying to tailor the definition of insider trading to the behavior that society is prepared to condemn as morally wrongful and worthy of a criminal sanction, aren’t there better questions to ask about the tippee’s state of mind?
For example: Did the tippee know that the confidential earnings announcement to which he had been tipped off had not been disclosed for a proper purpose? Circumstantial evidence will much more often enable an answer to that question.
They say that to a carpenter with a hammer, every problem looks like a nail. To Powell 35 years ago, the fiduciary duty framework was what he knew. No doubt it made sense in the context of Chiarella. And it certainly appears to have been a good fit for the cases that predominated in the early 1980s. But Newman shows that there are other contexts in which applying the fiduciary duty framework may be akin to forcing a square peg into a round hole.
So, add me to the growing list of judges, and commentators, and scholars who are asking, isn’t it time the United States had an insider trading statute?
As a matter of self-government, shouldn’t our representatives be the ones to make the subtle judgments of public policy that are embedded in insider trading law? Shouldn’t they be the ones to decide where the line is to be drawn between trading that society encourages and trading that it regards as destabilizing and unfair?
And even if these questions might once have been left for the courts, it’s not viable for the courts today to overhaul the longstanding construction of Section 10b. A vast body of doctrine, including tippee cases beginning with Dirks, has grown up around Powell’s fiduciary duty framework. What was once an acorn is now a mighty doctrinal oak.
It’s not for the courts to overhaul that approach, even as to a corner of insider trading doctrine. In statutory cases, under stare decisis, courts are not supposed to set aside an established construction. The notion is that if Congress is displeased, it can amend the statute.
And the SEC isn’t the complete answer either. It has a vital role: It can issue regulations for the purpose of civil and enforcement liability. But there are real issues about the extent to which such regulations can set the boundaries of criminal liability. Recently, Justice Antonin Scalia made this point with characteristic force. He wrote that deferring to the SEC’s interpretation of §10(b) in Rule 10b5-1 to uphold an insider trading conviction “collide[s] with the norm that legislatures, not executive officers, define crimes” and would “replace the doctrine of lenity with a doctrine of severity.”
It’s anyone’s guess whether a Supreme Court majority would run with that. But an SEC attempt to modify insider trading standards for use in a criminal case would run headlong into Scalia’s concern, especially if done to overturn a court decision interpreting the same statute.
And so, realistically, if anyone is to reconsider the rules of liability for insider trading, even if just to address the tipper-tippee context where the need for greater clarity is particularly apparent, it must be Congress.
Congress has acted quickly before to fill holes that have become apparent in our criminal laws. After the Supreme Court in 1987 struck down the honest services doctrine of mail and wire fraud, Congress responded the next year by passing an honest-services statute. And after a scandal arose in 2012 after a 60 Minutes expose about congressional insider trading, Congress promptly passed the Stop Trading on Congressional Knowledge Act that I referred to earlier.
My understanding is that several proposed bills have begun to percolate. Whatever substantive standard Congress may adopt, let’s hope that Congress will step up here as in those instances. Let’s hope it will engage with the important issues highlighted by Newman, and establish by statute clear rules to guide market participants.
“Liberty finds no refuge in a jurisprudence of doubt.” Here’s hoping that when this group meets again next year, there has been some resolution of the doubt.