Supreme Court Leaves Insider-Trading Law Alone

By Matt Levine

Commentary December 15, 2016 at 05:03 AM

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The basic idea of insider trading law is that if you work for a company, and you get important secret information about that company in the course of your work, you can't steal that information and use it for your own benefit. If you are the chief executive officer of the company, and you know that earnings will be disastrous, you can't sell your stock. If you are an investment banker working for the company, and you know it is going to be acquired at a big premium, you can't buy its stock. That information belongs to the company and its shareholders, and you have a duty to them, and you would violate that duty if you traded on it for your own benefit.¹

This isn't particularly about trading. It's about misusing the company's information for your own profit, violating your duty to act in the shareholders' interest. And so you don't have to trade to be guilty of insider trading.²Otherwise it would be too easy to get around the law. You could just sell the information to someone else, and he could trade on it, and pay you out of his profits. From the point of view of insider trading law, that's just as bad as if you had traded yourself: Either way, you are violating your duties to the company and its shareholders by misusing their information for your own financial benefit. You've just changed how you get that benefit. So you are still guilty of insider trading. (And so is he, as part of your plot to violate your duties by trading on corporate information.)

Similarly, if you just give the inside information to your spouse, or your child, and they trade on it, that's pretty much the same thing as you trading on it. You're keeping it in the family; misusing the shareholders' information for your spouse's benefit is no less corrupt than misusing it for your own benefit. And if you give the information to your cousin, or brother-in-law, or best friend from college, and they trade on it (without kicking any profits back to you) … I mean, that's not quite the same thing. Your best friend's money isn't interchangeable with yours. But it's pretty close. Using your corporate information to benefit your buddy has the same aura of corruption as using it to benefit yourself. And so, again, you and he are guilty of insider trading.

What if you just randomly give the information to a stranger, and he trades on it? This is a hypothetical beloved by lawyers and judges, but it is dumb. No one would do that, so don't worry about it.³

Instead, worry about the actual reason that insiders sometimes give information to people who trade on it, and who don't pay them a kickback for the information, and who are not their friends or family members. Mostly, the way that happens is that someone calls up an insider and says, "Hey, I am an investor in your fine company, and I would like to ask you some questions about it." And the insider says, "Sure, go ahead, what would you like to know?" Because the insider works for the shareholders, who own the company, and if the shareholders have questions then it is only polite for the company to try to answer them. It is also good for the company: Companies tend to like it when their share price goes up – insiders might even think that they have a fiduciary duty to make the share price go up — and helping investors understand the company is a good way to get them to buy more shares and make the stock go up.

Now, it's not as simple as that paragraph makes it sound. There are many rules and pitfalls involved when insiders talk to investors, and most companies don't let most insiders do it at all, because it is a tricky process best left to specialists. (The specialists are called "investor relations" employees, though CEOs and chief financial officers typically also do a lot of investor-relating.) And there are rules – Regulation FD – that prohibit companies from disclosing "material nonpublic information" to one shareholder without disclosing it to everyone. So if you called up a company's head of corporate development and asked, "Hey, got any mergers coming," she'd almost certainly decline to answer.

But those complications shouldn't obscure the awkward but unavoidable fact that shareholders talk to companies all the time, and the companies tell them stuff, and the shareholders trade. Bill Ackman once called the CEO of a company whose shares he owns to ask, "Mike, is there any fraud going on at the company?" Large-cap U.S. public companies had an average of 88 one-on-one meetings – each! — with investors in 2015. Perhaps they are just meeting for fun? But "investors pay $1.4 billion a year for face time with executives," in the form of commissions to investment banks whose research analysts help arrange some of the meetings. Perhaps they are paying all that money just to socialize? But "investors who meet privately with management make more informed trading decisions in periods when they meet, increasing their position before periods of high returns and decreasing their positions before periods of low returns." The simple story, that investors talk with management because they want to learn stuff about the companies, and that they do learn stuff, and that it informs their trading, really does seem to be the right one.

And that's okay! I mean, the company might get in a little bit of trouble for violating Regulation FD, if it too blatantly discloses secrets to favored shareholders, but you don't see a ton of that.⁴As for insider trading, the rough rule is:

If an insider trades on inside information himself: bad.
If he sells it to someone else to trade on: bad.
If he gives it to a close friend or relative to trade on: bad.
If he gives it to an investor as part of his job, and the investor trades on it: kind of fine.⁵

All of this has been the rule since the U.S. Supreme Court decided the case of Dirks v. SEC in 1983. Dirks gave us the "personal benefit" test: The Supreme Court held that an insider is guilty if he discloses information to someone who trades, and he "receives a direct or indirect personal benefit from the disclosure." (Category 2.) The court added: "The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend." (Category 3.) But you need to fit one of those categories (or trade yourself) to be guilty; just giving the information away with no personal benefit and no close relationship isn't insider trading. It's just … sort of … investor relations.

Today the Supreme Court decided another case, Salman v. United States, in which an investment banker gave inside information to his brother, who then traded on it. Under the existing law, this was obviously insider trading. And so the Supreme Court said: This was obviously insider trading. The decision is brief,⁶unanimous, uneventful and barely worth discussing; the court seemed incredulous that the case even made it this far. "We adhere to Dirks," wrote Justice Samuel Alito, "which easily resolves the narrow issue presented here":

Our discussion of gift giving resolves this case. Maher, the tipper, provided inside information to a close relative, his brother Michael. Dirks makes clear that a tipper breaches a fiduciary duty by making a gift of confidential information to "a trading relative," and that rule is sufficient to resolve the case at hand. As Salman's counsel acknowledged at oral argument, Maher would have breached his duty had he personally traded on the information here himself then given the proceeds as a gift to his brother. It is obvious that Maher would personally benefit in that situation. But Maher effectively achieved the same result by disclosing the information to Michael, and allowing him to trade on it. Dirks appropriately prohibits that approach, as well.⁷

Yeah, I mean it really is that easy. Why are we even talking about this?

Well, here is why.

A few years ago, the U.S. Attorney for the Southern District of New York, Preet Bharara, realized that insider-trading law could be expanded beyond the usual cases of CEOs tipping their golf buddies and investment bankers tipping their brothers. He realized that "real" investors — hedge funds, mutual funds, asset managers — also get lots of information from corporate insiders. Sometimes they do this in ways that are clearly insider-trading violations. (Like: Writing the insiders large checks in exchange for the information.) But even when they don't – when they just call up investor-relations employees and say, "Hey, I am an investor in your fine company, and I would like to ask you some questions about it," and the investor-relations employees answer the questions — it can be made to look like insider trading to a jury. I mean, here's some rich hedge-fund guy talking to the company, and then trading based on what he learned. Isn't that obviously illegal? To the average juror, of course it is. Legally, it might not be, but that wasn't a huge problem, because the courts didn't take the "personal benefit" requirement too seriously. If the insider and the investor were just on polite terms, if the investor offered the insider job advice or talked vaguely about maybe one day going on vacation together, that was probably enough for the "personal benefit" test. The job advice was a bribe, the vacation talk was evidence of a gift to a friend, whatever, good enough.

And then, two years ago, in its Newman decision, the U.S. Court of Appeals for the Second Circuit said: No, actually, Dirks meant what it said. You need a real "personal benefit" to be guilty of insider trading. Just talking to the investor-relations guy isn't enough. An insider who gets a real kickback, or who really intends to gift the information to a close friend or family member, can be guilty of insider trading, but polite chitchat with the IR guy isn't enough. "If that were true, and the Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity."

This blew a lot of people's minds, in part because it marked the end of Bharara's much-publicized crackdown on hedge funds, and in part because some of the court's language in Newman was kind of aggressive and inscrutable.⁸But the result was obviously right under the Supreme Court's Dirks decision, and under the basic logic of insider trading, which is that an insider who gives away information for his own corrupt purposes commits insider trading, but one who gives away information more or less as part of his job does not. And the government tried to appeal the Newman decision, and the Supreme Court declined, because it was clearly right.

And today the Supreme Court disposed of the Salman case, which was also clearly right. In passing, it also pared back some of Newman's intemperate language:⁹

To the extent the Second Circuit held that the tipper must also receive something of a "pecuniary or similarly valuable nature" in exchange for a gift to family or friends, Newman, we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.

But this doesn't affect the basic holding of Newman, which is that getting inside information from an insider without any personal benefit or relationship isn't insider trading. And Preet Bharara's celebration of today's ruling isn't quite right:

Today, the U.S. Supreme Court unanimously and 'easily' rejected the Second Circuit's novel reinterpretation of insider trading law in U.S. v. Newman. In its swiftly decided opinion, the Court stood up for common sense and affirmed what we have been arguing from the outset – that the law absolutely prohibits insiders from advantaging their friends and relatives at the expense of the trading public. Today's decision is a victory for fair markets and those who believe that the system should not be rigged.

Newman wasn't a "novel reinterpretation" of the law; it was just a straightforward application of the Dirks "personal benefit" test. So was Salman. None of this, really, is news; none of these decisions have changed the law. The law has remained consistent since 1983, except for the brief period when Bharara was able to expand it to cover trades without any personal benefit.

Of course, there's a reason he was able to do that: The lines here are pretty blurry. If you tip your brother, or your closest friend, and he trades on it, that's illegal insider trading under Dirks and Salman. But what if you tip, like, your eighth-closest friend? And he's a hedge fund analyst who covers your company? And your job involves talking to hedge-fund analysts? When does talking to a shareholder as part of your job at a public company become tipping a "trading relative or friend"? All of these questions were left vague after Dirks, and they're left just as vague after Salman. The government asked the Supreme Court to expand the law — arguing "that a gift of confidential information to anyone, not just a 'trading relative or friend,' is enough to prove securities fraud" — and the court declined.¹⁰

There's another reason, though, that Bharara was able to expand the law for a while: It's kind of hard to believe that the law is what it is. Even the Supreme Court has trouble with it. At oral argument in this case, Salman's lawyer said: "Analysts talk to company insiders all the time, and it's essential to the free flow of information to the marketplace that that occurs." And Justice Sonia Sotomayor broke in to say: "Wait a minute. First of all, that's no longer true. There's regulations that stop that, talking to analysts." To which I say: 88 times per year! Per company!

Legally, conceptually, this is all pretty easy stuff. Insiders who corruptly misuse corporate information to benefit themselves and their buddies are guilty of insider trading. Investment analysts who diligently research companies, including by calling up the companies and asking them questions, are not. There are some gray areas, but in most practical cases you can tell which is which. But prosecutors, jurors and even some judges can't quite believe it. They want insider trading law to be about fairness, to vindicate the idea that "the system should not be rigged," and to punish fat-cat hedge fund managers who get more access to companies than the average investor. That's not what the law is, really, but because the law doesn't match up very well with the average person's intuitions, it will always feel a bit unstable. Even if it never really changes that much.

^¹This oversimplifies because, you know, it's not all that simple. There is also the "misappropriation" theory of insider trading, which is basically: If you're an investment banker for the acquiring company, you can't buy the target's stock, even though you have no duties to the target. Or: If you're a Wall Street Journal columnist, you can't buy the stock mentioned in your column before the column comes out, even though you're not an "insider" at all. You have a duty to someone else (the acquirer, the Journal), and you can't use their information for your benefit. In practice "misappropriation" and "classical" insider trading raise many of the same issues.

Also, the company itself can't buy or sell its own shares while in possession of material nonpublic information, because that too might be a fraud on the shareholders, though that is sort of a weirder one. It doesn't come up all that much.

Also tender offers are a whole other thing.

²Someone has to trade, though; just misappropriating the information and not trading on it doesn't make it insider trading. This isn't much of a practical concern.

³The classical answer under modern U.S. insider trading law is "you (and he) are fine," but that isn't legal advice, not only because I am not a lawyer, but also because there are no real cases about it, because it never comes up, because it is dumb.

⁴As I've pointed out before, even when a U.S. court of appeals found that "the evidence showed that corporate insiders at Dell and NVIDIA regularly engaged with analysts and routinely selectively disclosed the same type of information" that prosecutors and the Securities and Exchange Commission concluded was illegal material nonpublic information, the SEC never brought a Regulation FD case against either company. Regulation FD violations — where a company improperly discloses information without any personal benefit — just don't get the same attention as insider-trading cases.

⁵But there's a big exception there. To avoid Regulation FD problems, the company might ask the insider to promise not to trade on the information. And if the insider makes that promise, and then trades, he is guilty of insider trading. (Because he had a duty to the company, because of that promise, and violated it for his own benefit.) This is the issue in the Leon Cooperman insider trading case, where — as is often the case — there's a dispute over whether he was ever actually asked not to trade.

⁶I mean, 12 pages, which is short for a Supreme Court opinion anyway. A lot of that is background anyway. There is almost no reasoning in the opinion, because there doesn't need to be: There's a Supreme Court precedent directly on point. Usually when that happens, the Supreme Court just doesn't bother with a case.

⁷Citation omitted.

⁸In particular, the court sort of vagued up the question of whether a gift to a friend or relative can be insider trading:

To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee's trades "resemble trading by the insider himself followed by a gift of the profits to the recipient," see 643 U.S. at 664, we hold that 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.

I don't know what that means, and you shouldn't spend a lot of time worrying about what it means, because it's not the law anyway.

⁹Citation omitted. The reference is to the weird passage quoted in the previous footnote. The "to the extent" means that the Supreme Court doesn't know what that passage means either.

¹⁰A good question to ponder is: In what contexts you give gifts to people who are not your relatives or friends?

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