Corporations are subject to broad criminal liability for the insider trading of their employees.  Critics have noted that this results in a harsh irony.  “After all,” as Professor Jonathan Macey notes, “it is generally the employer who is harmed by the insider trading.”[1]

Of course, not all employers of insider traders are innocent.  But I am convinced that critics like Professor Macey are on to something.  Namely, the current enforcement regime is absurdly overbroad in that it affords no principled guarantee to corporate victims of insider trading that they will not be indicted or punished for the crimes perpetrated against them.

Corporate Criminal Liability Generally

The U.S. Supreme Court laid out a basic two-part test for when corporations may be held criminally liable for the acts of their employees in New York Central & H.R.R. Co. v. United States: (1) the employee must perform the criminal act within the scope of his employment, and (2) the corporation must be an intended beneficiary of the act.[2]  A guiding policy rationale behind the court’s decision was that recognizing corporate criminal liability in these circumstances was necessary to create otherwise absent incentives for firms to police the criminal conduct of their own employees.

Courts have subsequently interpreted the New York Central elements so expansively that some suggest the test itself has been rendered “almost meaningless.”[3]  The practical reality is that whether a corporation is charged for the crimes of its employees is less a function of the two-part New York Central test than it is a matter of prosecutorial whim.[4]  This breadth in prosecutorial discretion leaves corporations extremely vulnerable.[5]

For example, the Department of Justice’s recent Yates Memorandum requires that corporate entities turn over “all relevant facts” in order to receive “any” cooperation credit.[6]  This broad demand serves to illustrate just how far the Justice Department has managed to leverage its virtually limitless prosecutorial discretion to force firms to effectively “[sign] on as deputy prosecutorial agents” against themselves and their employees.[7]

Recall, however, that a guiding policy behind New York Central’s recognition of corporate criminal liability was to fill an enforcement gap.  Effectively deputizing firms to perform a law-enforcement function was precisely the Supreme Court’s objective.  The court reasoned that the harm of occasionally punishing an innocent corporation (and its shareholders) for the crimes of the firm’s employees would ultimately be outweighed by the benefit of fewer criminal victims (due to increased efforts at self-policing).

Even keeping this broad policy justification in mind, however, corporate criminal liability in the context of insider trading is in most cases irrational.  For it turns out that in three of the four circumstances under which a corporation is subjected to criminal liability for the insider trading of its employees, it (or its shareholders) is by theory of law also the principal victim of that same trading.  This leads to the absurdity that the victim is held liable for the crime, a result that was clearly not contemplated by the New York Central Court.

True Insider Trading Under the Classical Theory

Under the classical theory of insider trading liability, when a true insider (whether the issuer itself, a board member, senior management, or a low-level employee) profits by trading in the firm’s shares based on material nonpublic information, the fraud is said to be perpetrated on the counterparty.  In such cases, the counterparty will always be a current or prospective shareholder who, as such, is owed a fiduciary or similar duty of trust and confidence that warrants disclosure prior to trading.  The insider profits by deception, and the current or prospective shareholder with whom she trades is the victim of this deception.[8]

Corporate criminal liability exposes firms to significant monetary fines.  Moreover, history suggests that the uncertainty accompanying a criminal indictment alone can cause a corporation’s sources of capital to evaporate, ultimately resulting in the firm’s collapse.  Who suffers these consequences?  As Professor John Hasnas explains, “[t]o the extent that such a loss cannot be passed along to consumers, it is the owners of the corporation, the shareholders, who incur the penalty.”[9]  But, while almost all corporate criminal liability forces innocent shareholders to bear the punishment, the case of insider trading under the classical theory is unique in that, as demonstrated above, the theory of criminal liability itself also identifies these same shareholders as the victims.  Consequently, shareholders are forced to suffer the crime and the punishment.

True Insider Trading Under the Misappropriation Theory

As a number of scholars have pointed out, there is no reason that true insiders cannot also incur liability for insider trading based on the misappropriation theory.[10]  When a true insider incurs liability under the misappropriation theory, the fraud is actually perpetuated on the issuer.  The Supreme Court explained that “[a] company’s confidential information . . . qualifies as property to which the company has a right of exclusive use.  The undisclosed misappropriation of such information, in violation of a fiduciary duty . . . constitutes fraud akin to embezzlement.”[11]

The irrationality of derivative corporate criminal liability for the true-insider trading of its employees under the misappropriation theory is even more blatant than under the classical theory.  The absurdity of holding a firm criminally liable for its employees’ embezzlement is palpable, but this is precisely what corporate criminal liability for true-insider trading amounts to under the misappropriation theory.

 Source-Employee Outsider Trading

“Source-employee” outsider trading arises under the misappropriation theory.  It occurs where an employee secretly trades on her employer’s confidential information concerning another firm.  Take, for example, the case of Carpenter v. United States.[12]  In that case, a Wall Street Journal reporter was prosecuted for trading in advance of the publication of his daily stock-picking column.  The column was popular and usually had an impact on stock prices.  The Journal’s policy was that, prior to publication, the content of the column was the Journal’s confidential information.  The reporter traded in violation of this policy.

Under the current test, there is nothing other than the exercise of prosecutorial discretion that prevented the Journal from being indicted for the reporter’s trading in Carpenter.  This, as Professor Macey pointed out, is “ironic in light of the fact that the Supreme Court ‘went to great lengths to indicate that the [Journal] had been victimized’.”[13]

When Corporate Criminal Liability for Insider Trading Does Make Sense

There is one form of derivative corporate criminal liability that makes sense, what I refer to (for lack of a better term) as “third-party” insider trading.  Such trading occurs where the violation of fiduciary or similar duty of trust and confidence that makes the trading fraudulent is committed against someone other than the trader’s employer or shareholders in the trader’s firm.

Imagine that Timmy, a trader for the hedge fund ABC Capital, pays an insider at Big-Strike Mining Corporation for material nonpublic information concerning the company’s recent discovery of a major gold deposit in North Dakota.  Timmy purchases all the Big Strike shares he can get his hands on for ABC Capital.  ABC makes millions after the announcement, and Timmy receives a generous bonus.

Who are the victims of Timmy’s insider trading?  As explained above, under the classical theory, the counterparties to the trading are the victims, and under the misappropriation theory, Big Strike is the victim.  ABC Capital is not a victim under either theory.  Moreover, Timmy’s trades benefited ABC and were squarely within his scope of employment under New York Central.  Consequently, by contrast to the three other types of derivative corporate insider trading already analyzed, holding ABC Capital derivatively liable for Timmy’s insider trading does not suffer from the irrationality of holding the victim liable for the crime.

Moreover, consider the ABC Capital example in light of the policy considerations informing New York Central.  Despite the risk that corporate criminal liability will often punish innocent shareholders for the crimes of the firm’s employees, the court held that such liability was warranted where, absent the incentives for self-regulation imposed by the threat of corporate criminal liability, there would be no other effective means of protecting the public from morally hazardous incentives set by the corporation.  This is precisely the situation presented by third-party trading through hedge funds like ABC Capital and other financial service firms.

Conclusion

The court in New York Central recognized that “there are some crimes, which in their nature cannot be committed by corporations.”[14]  I have suggested that true insider trading and source-employee outsider trading (as I have defined the terms here) are crimes that cannot be committed by a company, and the law should be reformed to reflect this.  Corporate criminal liability in these circumstances yields the absurd result of punishing the victims for the crime.  Prosecutors should, however, continue to enjoy discretion to hold corporations liable for the third-party insider or outsider trading of their employees.  Nothing I have said here impugns or would affect individual liability for insider trading under any theory.

ENDNOTES

[1] Jonathan R. Macey, Insider Trading: Economics, Politics, and Policy, 65–66 (1991).

[2] 212 U.S. 481, 494-95 (1909).

[3] Pamela H. Bucy, Corporate Ethos: A Standard for Imposing Corporate Criminal Liability, 75 Minn. L. Rev. 1095, 1102 (1991).

[4] United States v. Sun-Diamond Growers of Cal., 138 F.3d 961, 970 (D.C. Cir. 1998) (providing “the only thing that keeps deceived corporations from being indicted for the acts of their employee-deceivers is not some fixed rule of law or logic but simply the sound exercise of prosecutorial discretion.”).

[5] John Hasnas, The Centenary of a Mistake: One Hundred Years of Corporate Criminal Libaility, 46 Am. Crim. L. Rev. 1329, 1354 (2009).

[6] Memorandum from Sally Quillian Yates, Deputy Att’y Gen’l, U.S. Dept of J., to Heads of Dep’t Components and All U.S. Attorneys,Individual Accountability for Corporate Wrongdoing 3-4 (Sept. 9, 2015) available at https://www.justice.gov/dag/file/769036/download.

[7] Hasnas, supra note 5, at 1354.

[8] See, e.g., Chiarella v. United States, 445 U.S. 222, 228 (1980).

[9] Id. at 1339.

[10] See, e.g., Donald C. Langevoort, Insider Trading: Regulation, Enforcement & Prevention § 6-1 (West vol. 18, 2015) (“Virtually all cases that could be brought [under the classical theory] can also be styled as misappropriation cases.”).

[11] United States v. O’Hagan, 521 U.S. 642, 654 (1997).

[12] 484 U.S. 19 (1987).

[13] Macey, supra note 1, (quoting Harvey L. Pitt & Karen L. Shapiro, Securities Regulation by Enforcement: A look Ahead at the Next Decade, 7 Yale J. on Reg. 149, 240-241 (1990).

[14] 212 U.S. at 494.

This post comes to us from Professor John P. Anderson of Mississippi College School of Law. It is based on his recent paper, “When Does Corporate Criminal Liability for Insider Trading Make Sense?,” available here.