Everyone can thank Preet Bharara for one thing. His swath of insider trading prosecutions is forcing amplification of the law, especially the criminal law of insider trading. That body of law has been underdeveloped and at times stagnant. The Second Circuit’s important decision in United States v. Newman, however, shows that the common law process doesn’t necessarily lead to calmer waters.
Part of this is inevitable. The law of insider trading never had the intellectual heft to withstand sustained pressure in the form of large numbers of criminal prosecutions, which place special demands on the law because of their stakes. It’s not the courts’ fault if basic principles of criminal responsibility do not fit smoothly with aspects of an unwieldy, path-dependent body of statutory and decisional law that originated in civil lawsuits and altogether different forms of market chicanery.
Some of what is unwelcome about Newman, however, does belong at the feet of Judge Barrington Parker and his panel colleagues, who indulged in needless overreach in their opinion that could well impede what ought to be legitimate insider trading prosecutions.
Let’s start with the trouble in the law that the court couldn’t avoid. First, as I have explained at length (see Duke Law Journal Dec. 2011), and as others have observed, the crime of insider trading makes a bad fit with the law of fraud because the gravamen of the wrong consists in cheating the market by not following its now well-established rules. (There is circularity in this principal, I admit. But the ban on insider trading is now so settled as a rule of the road in major securities markets that its circular origin doesn’t matter anymore.) The offense often can be styled, provided the fact pattern fits, as a form of deception on someone—a person to whom duties are owed who rightfully assumes the offender is not engaging in such cheating. But the deception is a consequence of the cheating, not the other way around.
As is now well known, this means that some cases that look kind of like cheating might not be insider trading because they can’t quite be recast as fraud. Indeed, that is why we got O’Hagan and misappropriation liability: to adopt a new theory that shoehorns one recurring form of cheating into the law of fraud.
The second problem with the settled law before Newman is that Dirks was a bad case with which to set down the law for tipping liability. Dirks’ insider source was not your typical tipper (of the sort, for example, Bharara has been after). He was a whistleblower (about securities fraud!). So the Supreme Court took up tipping liability for the first time with a case that required, perhaps above all, that there be an exception to such liability.
Thus we got the limitation that only trading that results from selfish tipping (tipping for “personal benefit”) is prohibited. Trading on public-spirited leaks, as well of course as trading on careless ones, is fine. In punishing Dirks, albeit lightly, the SEC seemed to be undermining fraud deterrence—a bit like the Obama Administration chasing down those who leak to the press information about the likes of torture and illegal wiretapping.
Let’s pause, though, to remember that Dirks is really about the rule not the exception. Once insider trading was made an offense, the courts had to come along at some point and say that trading on unlawful tips is also a crime. While I’m not generally a formalist about law, the point follows inexorably. These cases are the market equivalent of the inside job. If I work at the midtown jewelry store, I can’t avoid liability for stealing the diamonds by passing the code to the security system to my shadowy friends in Jersey and then arranging to be in the Bahamas on the day of the heist.
Another unfortunate thing about Dirks, which was avoidable even after the cert grant, was the Court’s brief and opaque statement that a tippee is liable if, and only if, he “knew or should have known” that the tipper breached his duty of confidentiality selfishly. This left the impression that negligence might be enough to be liable for insider trading, at least in a civil case. That statement conflicts with other cases saying securities fraud requires at least recklessness, not to mention with the general idea that fraud, or at least serious fraud, isn’t really something one can do just by being careless.
In Newman, the Second Circuit was stuck, like the many courts before it, with having to fit insider trading into the law of fraud and with Dirks’ strong language about a public-spirited exception to the rule against using tips to circumvent the prohibition on insider trading.
There thus can be no quarrel with—and there is no novelty in—the Newman court’s statements that the Dell and NVDIA earnings release tips must have been made for the purpose of personal benefit (though not necessarily in return for actual benefit) and that Newman and Chiasson must have had some scienter with respect to the selfishness of the leaks. The trial judge didn’t tell the jury that it had to find all of that, so the instructions were in error under Dirks.
I would have expected the matter to end there, with an order that the case be retried with the correct instruction. Then a jury would decide if the government could show the necessary elements beyond a reasonable doubt. This is an exceedingly common form of reversal of a criminal conviction. Bad instruction, new trial. Then we see what happens with Newman and Chiasson.
In the meantime, if we are inclined, we maybe use this appellate decision as an occasion to reopen the discussion about whether there might be a better rule—perhaps one that could be imposed legislatively—for policing the stratagems of tippers and tippees without making criminals out of those who trade on the fruits of whistleblowers or loudmouths in elevators.
How about a rule that says don’t, in the words of O’Hagan, “misappropriate confidential information for securities trading purposes, in breach of a duty to the source of the information”—and don’t knowingly trade on the fruits of such a breach? Perhaps we can do away with the complexities and oddities of the “personal benefit” inquiry, which I’m told has no provenance in first principles of agency law.
There are many options for protecting the public-spirited whistleblower, like Ronald Secrist of Equity Funding of America, who tipped Raymond Dirks. One would be to provide, whether by statute or common law analysis, that such disclosures are not duty breaches at all, regardless of the issue of personal gain, and that those who trade on information they believe to have been whistle-blown therefore are not liable. After all, the proper whistleblower wants her information, whether immediately or eventually, in the hands of the market, not a favored few who can profit when revelation of fraud drives down price.
Alas, the Newman court was only getting started. Instead of cleanly stopping at “bad jury instruction, we need decide no more,” it went ahead with “while we’re at it, all the fact finding was wrong in this case and we declare the evidence insufficient as a matter of law and dismiss this prosecution forever.”
To take its argument that considerable extra distance, the court felt compelled to engage in some damaging straw manning. Judge Parker kept saying that the prosecution’s legal theory was “novel” and was based on the discredited idea that the prohibition on insider trading equates to a right to parity of information in markets. (It was big of the court, I must say, to admit that it had been the worst offender in this regard with its sweepingly misguided dicta in the old Texas Gulf Sulphur opinion.)
The government was not arguing for a parity of information rule. It was arguing for the standard rule that you can’t tip in breach of a duty to your employer so someone else can pocket the profits from a secret you were supposed to keep. The distance between these two theories is vast. The court was really disagreeing with the prosecution about what could be proven in Newman’s and Chiasson’s cases. So why say this?
To be sure, the prosecution (and the trial court) genuinely diverged from the appellate court on a matter of law when it came to the question of scienter, or what criminal lawyers prefer to call mens rea. But again Judge Parker straw manned. He suggested that arguing that the tippee need not know that the tipper breached for personal benefit was an argument for strict liability (that is, no mental state required at all), citing the deeply inapposite case of Staples v. United States (which was about whether a machine gun possessor needed to know that his AK-47 was fully automatic).
In criminal law, there is a big difference between saying a statute requires no mens rea at all (strict liability “all the way down”) and saying that the mental state requirement applies to some elements of the offense but not all of them. The latter analysis is a question of statutory interpretation with regard to the particular offense, not a matter of some general requirement for all federal criminal laws. The prosecutors in the Southern District of New York have not been arguing that recipients of tipped information who trade are strictly liable.
There is also the question of what level of mens rea applies, not just of which elements of the crime carry any mental state requirement. Judge Parker made a big move in saying that the statutory requirement that all criminal violations of the 34 Act be committed “willfully” means that the insider trading violator must have realized that “he was doing a wrongful act under the securities laws.” (Though, later in the opinion, he seems to walk back that mens rea requirement to simply knowledge of a duty breach.) Actually, Judge Parker had made this move in an earlier opinion he wrote in an insider trading case, United States v. Cassese, a panel decision that drew a dissent from Judge Reena Raggi.
What happened to Dirks’ “knew or should have known”? Dirks, of course, was a civil SEC enforcement, not a prosecution. But Judge Parker gave us no reason why the move from civil to criminal takes us all the way from negligence to his rule, bypassing recklessness, knowledge, willful blindness, and purpose. Willfulness, as the Supreme Court has repeatedly said, is a “word of many meanings” in the federal criminal code. What Congress means by it depends on the context. In the tax code, it requires knowledge of illegality (see the Supreme Court’s amusing opinion in Cheek v. United States), meaning that ignorance of the law is a defense in tax. The federal courts have never suggested that mistake of law is a defense to securities fraud.
A last beef with the court’s excessiveness, and then I’ll conclude by explaining why this all matters. Judge Parker’s lengthy and unnecessary journey into the question of sufficiency of the evidence in the Newman and Chiasson prosecutions looks suspiciously, based on what the court said, like it was motivated by a general interest in pushing back against Bharara’s move against insider trading in the hedge fund industry.
The court’s opinion explicitly carries water for the “mosaic of information” theory that has been a defense in most or all of these prosecutions, including at the trial of the flagrant and craven inside trader Raj Rajaratnam. Manhattan juries—including at the trial of Newman and Chiasson, of course—have rejected the extremely well-lawyered argument that the hedge fund defendant traded not because of illegal tips but because of skilled detective work using lots of little (and public) clues from the market and plugging them into algorithms.
The appellate court’s adoption of this argument, over the finding of the jury that heard it, lowers my confidence that the court got the law of insider trading right or even gave this case its best possible intellectual effort. I admit this is a gut feeling. But it’s strong. Perhaps it could be put this way: Where have you gone, Henry Friendly?
In conclusion, I’m not giving this opinion a bad review to serve as the legal equivalent of a film critic. I’m genuinely worried about the problem of tipping chains. The court repeatedly scoffed at how the number of steps (as many as three or four) in the tipping chains in Newman made the prosecutors’ case suspect and “novel.” But it is a bedrock idea in all systems of criminal law that those who help crimes, and conspire to commit them, must be punished along with the principal actors.
A major reason we have those rules is so that core criminal prohibitions—don’t kill others, don’t rob banks, don’t engage in insider trading—do not prove to be Maginot Lines. People who commit crime for profit, especially sophisticated professionals of all stripes, plan how to do what they want to do in ways that make it more likely they’ll get away with it. This is as true of Bernard Madoff as Tony Soprano.
In the world of insider trading, we have learned of late (thanks to determined prosecutors), that we’re dealing with brokers who meet in Grand Central Station and eat the handwritten notes they pass to each other, and associates at AmLaw 100 firms who use burner cell phones to discuss the documents they saw in the conference rooms where deals were closing. If the main reason to have an insider trading prohibition is to maintain retail investor confidence—to avoid the dreaded lemons market—then I’m a lot more concerned about multi-layered conspiracies among traders and lawyers than about the occasional tip on the golf course to the likes of Phil Mickelson.
Never mind whether Newman and Chiasson should have gone to prison. This breed of professional needs to expect to be punished for insider trading even when confidential corporate information is passed down the line in ways designed to create deniability about just who leaked it and why.
We could certainly make that harder to do by adopting statutory reforms that finally decouple insider trading from the law of fraud and do away with quirks of that troubled relationship, perhaps including the personal benefit element. But, in the meantime, the job of the law and those who enforce it has been made harder by the Newman court’s needless efforts to steepen the climb, in the Second Circuit at least, for prosecution of downstream market players in insider trading conspiracies.
The preceding post comes to us from Samuel W. Buell, Professor of Law at the Duke University School of Law.