Court Could Redefine Insider Trading

Artur Davis

Wall Street Journal

January 28, 2011

WASHINGTON (MarketWatch) – Last year, the Supreme Court threw dozens of political and financial corruption cases into disarray, and left prosecutors and district judges scrambling.

They created this chaos by reining in the Department of Justice’s over-reliance on a vague, ill-defined “honest services” statute that had been pressed into use too often, and by reminding us that our Constitution demands that the power of jail and punishment demands specific notice of what is criminal and what is not.

It could well happen again – this time, in the context of insider trading. For decades, without a single federal criminal or civil statute ever using the actual words “insider trading,” regulators and prosecutors have expanded the definition and reach of the concept with only an occasional glance by the Supreme Court and no clarification at all by Congress.

Relying on language in the Securities and Exchange Act of 1934, which makes it a violation to commit a deceptive act in connection with the purchase or sale of a security, courts and regulators for years defined a garden variety of insider-trading cases that were familiar to any reasonably knowledgeable investor. You can’t use non-public, proprietary information from your company, or from anyone to whom you owe a fiduciary duty, to make a securities transaction. You also can’t cash in on a tip from someone you know has a fiduciary duty to the source of the information.

Broader interpretation

Congress left the courts’ interpretations of insider trading alone. Then, in 1997, in U.S. v. O’Hagan, without the underlying law ever having changed, the Supreme Court approved a broader category of insider-trading cases based on the concept of “misappropriation.”

Under this rule, a trader is on the hook if he obtained information in a deceptive manner from a source with whom he has a “confidential” legal relationship; it does not matter that the source of the information neither controls the stock nor is engaged in buying or selling the shares.

The facts in O’Hagan are not sympathetic – a lawyer makes a trade when he learns about a non-public merger his partners are handling – but this is not the kind of insider case that prevailed for over 60 years, where one party exploits his insider status to manipulate the market value of an entity that has put its trust in him.

Now, as the political pressure builds to widen accountability for Wall Street’s playing too fast and loose, prosecutors and regulators are raising questions that could reshape the securities laws at the expense of clarity and predictability.

For example, in what circumstances is it a crime to share insider information when a defendant does not actually make a trade and does not personally profit from what he shares?

The Supreme Court has explicitly said that a defendant in an insider-trading case must have a personal benefit at stake, and it is unclear what they would think of Don Chu, a Korean businessman recently charged in the Southern District of New York with being the middleman between investors and insiders. The complaint filed in the case describes Chu on tape telling a friend that “I want to help you make money,” but the government’s theory of how he derived his own gain from playing match-maker is unclear.

Similarly, in U.S. v. Shimoon, a high-profile case just filed in the same jurisdiction, a number of defendants are corporate employees charged with disclosing inside information about their business. But the complaint is sketchy on whether all the defendants knew who was getting the information, much less whether they knew it was a basis for trading in the market, as opposed to buying products or starting a rival business.

Then there is the celebrated Martha Stewart investigation. She was targeted for a trade based on a tip from her stockbroker. She did not abuse either a fiduciary or confidential relationship and there was no evidence that she knew her broker had either.

Misconduct should be spelled out

In Skilling v. United States, the case handed down just seven months ago involving former Enron Corp. CEO and President Jeffrey Skilling, the Supreme Court weighed in against another vague, ambiguous criminal statute that was becoming one of the handiest tools for prosecutors, the “honest services” statute. The Supreme Court vacated part of his conviction and sent his case back to the lower courts.

The court held that the statute can only apply to a well-established core of cases alleging corporate or political wrongdoing, namely those involving bribes and kickbacks. There will be no more using the statute to pounce on legislators who don’t fill out conflict of interest forms, and no more using the statute as a general backstop any time investor fraud or bad accounting is suspected.

It’s not that concealing conflicts of interest, or misleading investors is a good thing. It is just not the misconduct that is clearly spelled out under either the “honest services” statute itself or the prevailing cases that existed 22 years ago when Congress passed the statute.

Let’s apply the Skilling methodology to an insider-trading case circa 2011. The Supreme Court would be hard-pressed to read Congress’ intent at all. The core securities laws that were passed in the 1930s don’t even contain the term “insider trading,” and it goes without saying that the market at work in FDR’s first term is a distant shadow of the market at play in the last two decades when insider trading has ripened as a source of federal criminal liability.

Congress, under the rule of Republicans in 2002 and Democrats in 2010, has overhauled the structure and reach of financial services laws but has never gotten around to addressing whether it likes what courts and government lawyers have done with the evolution of insider-trading standards.

It is possible that the three justices who wanted to scrap the “honest services” statute altogether and at least two other sticklers for congressional intent, Chief Justice John Roberts and Justice Samuel Alito, will be especially troubled by another example of Congress punting its constitutional duty to write laws that define wrongdoing. That would be a radical result but one Democratic and Republican Congresses have invited by their flat refusal to clean up the record on what securities laws mean in a modern, complex economy.

Judges writing the laws

If the court were to do exactly what it did in Skilling, it would narrow insider trading cases to a core set of well-established offenses. In addition, while precedents are rarely reversed, it is entirely possible that to the Roberts Court, O’Hagan’s “misappropriation” theory is vulnerable. It looks suspiciously like judges rather than Congress rewriting a law.

Critics of Wall Street morality might argue that a more limited approach to insider trading laws would have bad consequences as to transparency or the levelness of the investor playing field.

But the real issue is the inherently democratic idea that vague, ill-defined laws invite excess and overreaching.

Moreover, in our system, it is elected legislative bodies that get to draw the lines between the lawful and unlawful. The courts’ only genuine task is to figure out what those legislators meant and to make sure that when lawmakers were doing their painting, they were within the lines of the Constitution.

Don’t be surprised to see the same Supreme Court that unsettled the waters with Skilling have some interesting things to say about an “insider trading” law that has never been legislatively defined and keeps getting pushed into newer, more unfamiliar territory.

Artur Davis was a Democratic congressman from Alabama from 2003 to 2010. He works for the law firm SNR Denton in Washington, specializing in white-collar crime and securities litigation.