On Monday, October 5, the Supreme Court declined to wade into the issue of what constitutes “insider trading.” The Court’s decision to deny the Solicitor General’s petition for certiorari makes sense—the lower court’s decision is probably correct so far as it goes, there were vehicle problems in the case, and there is not a clear or deep division among the circuits. But eventually, the Supreme Court will need to grapple with the headless monster that the crime of “insider trading” has become.
While insider trading is the go-to crime for Hollywood financial thrillers, it is surprisingly ill-defined. Insider trading is not a federal crime in the sense that there is statute prohibiting it. The closest Congress has come is the 1934 Securities Exchange Act, which makes it illegal to employ “any manipulative or deceptive device” in “connection with the purchase or sale of any security.” 15 U.S.C. § 78j(b). That statute empowers the Securities and Exchange Commission to issue “such rules and regulations” as it deems “necessary or appropriate in the public interest.” Id.
But rather than promulgate clear rules that people who trade securities can understand, the SEC has issued a regulation prohibiting the following: employing “any device, scheme, or artifice to defraud,” or “engag[ing] in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,” in “connection with the purchase or sale of any security.” 17 CFR § 240.10b-5. The entire edifice of insider trading law is built atop that vague regulation, known as Rule 10b-5.
The dominant form of insider trading is known as the “classic” theory. That theory prohibits a corporate insider (like the CEO) from trading on inside information. Such trading is fraudulent, the theory goes, because the CEO is breaching his fiduciary duty to the people he is trading with—all of whom are either current owners of the CEO’s company (for people who sell shares to the CEO), or future owners of the CEO’s company (for people who buy shares from the CEO). Since the CEO owes a fiduciary duty to his company’s shareholders, the courts have ruled that he engages in a “deceptive” practice when he uses his confidential knowledge to trade against those shareholders.
Because this crime has no direct textual basis, the SEC, DOJ, and the courts are—in a very real sense—making things up as they go, using common-law-style adjudication rather than textual analysis of a criminal provision. And they are doing so against a legal backdrop where trading on properly obtained inside information is legal and part of being a good financial manager; there is no “general duty between all participants in market transactions to forgo actions based on material, nonpublic information.” Chiarella v. United States, 445 U.S. 222, 233 (1980). Courts are thus delineating the legal lines in the context of criminal prosecutions that seek to put people in prison for conduct that prosecutors have decided (after the fact) falls on the criminal side of these doctrines.
That brings us to United States v. Newman, No. 15-137, which, on October 5, the Supreme Court declined to hear. That case turns on a subset of the above doctrine under which somebody who pays an insider for information, and then trades on that information, becomes liable for insider trading. Under this theory, the liability of the person who pays for inside information (called the tippee) derives from the liability of the insider who provides information in exchange for payment (called the tipper), who, remember, is liable because that insider is breaching a fiduciary duty to shareholders.
In Newman, the government prosecuted two hedge fund portfolio managers for trading on information that originally came from insiders at Dell and NVIDIA. As the Second Circuit’s opinion explains, the defendants “were several steps removed from the corporate insiders and there was no evidence that either was aware of the source of the inside information.” The government’s theory was that because the defendants were “sophisticated traders,” they “must have known that information was disclosed by insiders in breach of a fiduciary duty, and not for any legitimate corporate purpose.” The defendants moved for a judgment of acquittal, arguing that the relevant corporate insiders received no personal benefit for their “tips” and that, even if the insiders did receive some benefit, the defendants had no idea that any such benefit existed—since, again, they were several people downstream from the initial tip—and so they couldn’t be guilty of insider trading.
The Second Circuit agreed and vacated the defendants’ convictions. It took the above doctrine as given, but explained that “the insider’s disclosure of confidential information, standing alone, is not a breach.” “[W]ithout establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the Government cannot meet its burden of showing that the tippee knew of a breach.” The Second Circuit further held that the personal benefit the insider receives for the tip must be something meaningful and concrete. While that benefit can be inferred from a personal relationship, it must be “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.” Otherwise, “the personal benefit requirement would be a nullity,” which would, in turn, seem to mean that everyone who trades on inside information would be in the crosshairs.
The Solicitor General sought certiorari on the second issue only—i.e., what constitutes a “benefit” for purposes of insider-trading liability. And that might be one reason why the Court declined review. Had the Court agreed with the Government and reversed on that issue, the convictions would likely have remained invalid. Even with that reversal, the Government still failed to prove the defendants in Newman knew about whatever benefit the insiders might have received. The Supreme Court generally does not review questions that are not essential to the judgment below.
While the Supreme Court’s decision to deny review is understandable and certainly good news for the defendants, it is unfortunate for the law of insider trading generally—an area that needs a fresh look from the Court. Criminal statutes are supposed to set clear rules, not trap the unwary. But in Newman, two financial analysts were prosecuted for trading on inside information—itself perfectly legal—without prosecutors showing either that the source of the information was bribed to disclose it, or that these defendants even knew where the information came from. It is possible that these defendants are just sophisticated wrongdoers; but it seems equally likely that they fell victim to an aggressive legal theory that captures conduct never before deemed criminal.
The Supreme Court has been sensitive in recent Terms to the problem of ensnaring minor wrongdoers in exotic applications of federal criminal law. This is clear in, for example, decisions like United States v. Bond, which vacated DOJ’s use of the chemical weapons treaty to prosecute a domestic dispute, and United States v. Yates, which vacated DOJ’s use of Sarbanes-Oxley to prosecute a fisherman’s destruction of undersized grouper. The theme unifying these decisions is that the government shouldn’t put people in prison for conduct that does not clearly violate the federal criminal laws.
That theme has direct application to the law of insider trading. Congress has never prohibited insider trading, instead kicking the tricky issue of defining the crime to the administrative state. And the SEC has, in turn, punted too—opting against a clear definition of insider trading and choosing to instead leave the doctrine to exposition by courts in judicial decisions reviewing criminal convictions and enforcement actions. That after-the-fact lawmaking is not fair to individual defendants (like the two people in Newman) and is not, in any event, a good way to make policy.
There is widespread disagreement about whether insider trading should be illegal in the first place. Particularly in such a tricky area, the right way to make law is through legislation following debate (or a regulation issued following notice and comment) that enacts forward-looking text establishing the crime in terms that are clear enough for people to understand what is illegal. The right way to make law is not, as is currently happening, to leave things to enforcement officials limited only by judicial decisions rendered in the inherently ad hoc context of individual prosecutions or enforcement suits. Those officials have an understandable incentive to push the boundaries, without, perhaps, sufficient sensitivity to counterarguments that would persuade dispassionate policymakers. And the judges reviewing specific enforcement actions inherently lack the global perspective (and resources) of a policymaker drafting a statute or regulation.
For all these reasons, should DOJ continue aggressively enforcing the insider trading prohibition against criminal defendants, the Supreme Court should eventually intervene and require that Congress or the SEC promulgate clear rules that DOJ can enforce without risk of ensnaring the unwary. Basic rule of law principles require such clarity. And providing it would give much greater legitimacy to all future insider-trading convictions DOJ obtains.
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James M. Burnham is an associate at Jones Day who practices appellate and criminal defense litigation. The views expressed in this Article are solely those of the author and do not necessarily reflect those of the law firm with which he is associated.