How to Get Away With Insider Trading

http://www.nytimes.com/2016/05/23/opinion/how-to-get-away-with-insider-trading.html

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ANOTHER lurid case of insider trading has been uncovered: The former chairman of Dean Foods has admitted giving insider information to a well-known professional sports bettor in Las Vegas because he was mired in gambling debts. The sports bettor made an estimated $43 million over five years from this information, according to federal prosecutors. A second beneficiary of stock tips was the professional golfer Phil Mickelson, who had gambling debts of his own.

The prosecutors and the Securities and Exchange Commission deserve credit, but it’s a mixed victory: Neither the United States attorney nor the S.E.C. is prosecuting other people who benefited from the stock tips, including Mr. Mickelson. Why not? A serious shortfall in our law has hampered prosecutors and allowed insider traders — particularly those further down the chain of information — to dance around the rules.

Our insider trading law has become overly complex and burdensome for two reasons. First, neither Congress nor the S.E.C. has ever defined “insider trading” in a comprehensive way. So our laws are largely made by judges who, bound by precedent, rarely update law to fit new circumstances.

Second, our laws seek to balance different goals. The United States (unlike some other nations) does not adopt a simple “parity of information” approach under which one cannot trade on material facts that are not publicly available. United States law also values market efficiency: We want to encourage people to seek new information about companies through legitimate research. So the law basically prohibits trading on nonpublic information only when it has been wrongfully obtained or used.

This rule was first articulated by the Supreme Court in a 1983 decision, Dirks v. S.E.C. The defendant, Raymond Dirks, was a star securities analyst who heard from a whistle-blowing employee that an insurance company named Equity Funding was hiding that it was hopelessly insolvent. Mr. Dirks confirmed this and informed the authorities (including insurance regulators and the S.E.C.), all of whom, in typically bureaucratic fashion, took no action.

He next turned to journalists, but they would not report on his findings for fear of libel suits. When he told his clients, these investors reacted immediately by dumping their stock so that the company’s share price plummeted. Finally, the press paid attention, and the fraud was revealed.

Mr. Dirks was widely regarded as the hero of this story, a private-market equivalent of Woodward and Bernstein. But an embarrassed S.E.C. went after Mr. Dirks for insider trading. When the case reached the Supreme Court, it, too, saw Mr. Dirks as the hero and reshaped the law to give security analysts a protective safe harbor: The “tippee” who is given the inside information is liable only when the “tipper receives a direct or indirect personal benefit from the disclosure” — in effect, a bribe of some kind.

Unfortunately, this has proved too safe a harbor, frustrating prosecutors by insulating remote tippees who are several steps removed from the original tipper. In United States v. Newman, the Court of Appeals for the Second Circuit reversed the convictions of two hedge fund managers who made some $72 million virtually overnight by trading stocks based on the still-unreleased earnings of companies. The 2014 ruling said that, even if the defendants knew the information had been improperly leaked, they could not be convicted unless the government proved “that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.”

The “personal benefit” rule makes ignorance bliss. The sophisticated trader will understand that he is insulated from liability so long as he does not learn that a personal benefit was paid or promised. “Don’t ask, don’t tell” may become the new industry code of behavior. The rule overlooks how the “favor bank” can work in a cozy industry like finance.

The Newman decision is making prosecutions harder. Since he became United States attorney for the Southern District of New York in 2009, Preet Bharara has won more than 80 insider trading convictions in just a few years, but in the wake of Newman, at least 14 of those convictions have been overturned, and that number is likely to rise.

Although the S.E.C. has resisted defining insider trading for decades, legislation now seems the best answer. We should eliminate the need to prove a “personal benefit” to the tipper, but not overrule the rest of the Dirks case. Thus, a trader who knows (or recklessly disregards) that his information was wrongfully obtained should be liable regardless of the benefit to the tipper. But someone who trades on market gossip or an analyst’s projection should not be liable.

A workable reform bill is not hard to draft. I worked on one such bill, introduced last year by Representative James Himes, Democrat of Connecticut, with Republican co-sponsors, that does basically what has been outlined above.

If a presidential candidate of either party wants to show that he or she has not been “captured” by Wall Street, the best signal would be support for insider trading legislation and a promise to prod Congress to enact it. If Washington can ever agree on anything, Washington can agree on that.