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    12.12.14 Commentary: Professor Arthur Pinto on the Need to Reform Federal Insider Trading Law
    Professor Arthur Pinto

    In the recent well-publicized federal court case United States v Newman, the U.S. Court of Appeals for the Second Circuit overturned the insider trading convictions of two portfolio managers who allegedly profited by receiving confidential information through tips. The court correctly interpreted existing law as requiring that those who receive a tip of confidential information and trade must not only know that the insider breached a duty when confidential information was tipped, but that the insider did so in exchange for a personal benefit.

    Currently, there is no statutory definition of insider trading, and this requirement of breach of duty and personal benefit by the insider who tips is based upon a long history of case law development. This history clearly illustrates why our nation’s confusing law of insider trading needs reform and we would do well to look to approaches by other countries for a statutory definition.

    The basis of most United States insider trading law is a statutory section 10(b) of the Securities and Exchange Act of 1934 -- New Deal legislation intended to address the 1929 stock market crash. Section 10(b) authorized the Securities and Exchange Commission (SEC) to issue rules for the protection of investors or public interest. In 1942, the SEC issued Rule 10b-5, a broad anti-fraud rule in connection with the purchase or sale of securities. Neither Section 10(b) nor Rule 10b-5 ever defined or even mentioned insider trading, but given Congressional concerns both were viewed as a tool against it.

    Today, insider trading law remains murky, largely because of court interpretations of what Congress meant when it outlawed under Section 10b any “deceptive device or contrivance.” Traditionally, there is no deception if one does not disclose material information to others. But if there is a fiduciary duty or special relationship with others involved, disclosure is required. Insider trading usually takes place when someone trades on material nonpublic information without disclosing that information. In other words, there needs to be a duty to disclose for there to be a deceit. As a result, in the 1980 Chiarella v. United States case, the U.S. Supreme Court required a “duty to those one trades with” in order for there to be a deception as required by Section 10(b). Thus, insiders who trade on inside information about their company are liable because of their failure to disclose. Their liability stems from the fiduciary duty to the actual or prospective company shareholders.

    The prosecutor’s problem in the Newman case was that the accused -- the “tippee” -- received material nonpublic information not directly from an insider but from others who had been tipped. The U.S. Supreme Court in the 1983 Dirks v. SEC case held that liability for someone who receives a tip stems from a requirement of some breach of duty by an insider who originated the tip -- the “tipper.”

    Raymond Dirks was an analyst of the insurance industry and broker dealer. A former employee of Equity Funding told Dirks of massive frauds at the insurance company. After Dirks investigated and confirmed the fraud, he had his clients sell the stock, avoiding massive losses. A majority of the Court viewed Dirks as doing his job rather than violating the law of insider trading. The Court was concerned that if analysts were not able to ferret out important information, then the efficiency of the markets could be harmed. In order to protect such tippees from liability, the Court indicated that tippee liability derives from the tippee believing the tipper is violating a fiduciary duty, as well as his or her own duty if they do so for personal gain.

    Thus the element of personal gain by a tipper was added to the law of insider trading. The dissent in Dirks pointed out there was nothing in the law that required a personal gain when someone who is a fiduciary tips confidential information. But as a result of Dirks, there can be no liability for tippees unless insiders who tip have breached their fiduciary duty by both disclosing material confidential information and personally benefiting from the tip. In Dirks, the tipper had no personal connection to Dirks, nor did he profit in any way from the tip, so he was not liable. Consistent with this reasoning, the court in  Newman found no liability for the tippees because the prosecutor failed to prove that either defendant knew of any personal gain from the insider.    

    The personal benefit test not only creates hurdles for prosecutors but results in a confusing definition of insider trading. While the Court in Dirks suggested a potentially broad view of personal benefit, including reputational benefits from tipping and gifts, the is considerable uncertainty in regard to the parameters of such a test. For example, in Dirks if the insider who tipped was hoping for future employment with Dirks or had a history of exchanging gifts, there could be a personal gain, and Dirks would have been liable. There needs to be fact-specific inquiries on personal relationships in order to prove liability.

    Personal gain is one of many problems that have developed under U.S. insider trading law. In order to apply insider trading to market information, the Supreme Court extended the duty requirement of Rule 10b-5 to nontraditional insiders under the misappropriation theory. Insider trading liability extends to those who trade on information they misappropriated or stole from the source of the information. The key to liability is establishing a duty to the source, which requires courts to again analyze relationships. For example, a husband and his broker escaped liability under Rule 10b-5 because he did not have a history of confidences associated with the information with his wife when she disclosed family information about a tender offer. Yet there was liability under a different SEC rule, 14e-3, which outlaws possession and trading on nonpublic information about a tender offer without an issue of duty or relationships. Had the information been about a merger, there would have been no liability since Rule 14e-3 deals only with tender offers.

    Clearly, insider trading law in the United States is difficult, confusing and overly dependent upon factors that are not relevant to the policies underlying the insider trading prohibitions, including honesty and market integrity. Is there any less harm to these policies if someone with insider information tips without a personal benefit, hence no liability? Is there less harm if traders have not violated their employment contract? Is there less harm if the information concerns a merger instead of a tender offer?

    The time has come for Congress to define insider trading. Around the world, countries that want to encourage their stock markets have followed the example of the U.S. and outlawed insider trading. Nevertheless, many of those countries have defined insider trading without the baggage of requiring a duty or personal gain. It's time for the United States to follow suit.

    -Professor Arthur Pinto