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Flawed laws

20 May 2011 By Reynolds Holding

Raj Rajaratnam’s wrongs have hidden the flaws of insider trading laws. The crimes that the Galleon Group founder committed were clear. But many U.S. situations, like the trading indiscretions of Berkshire Hathaway’s David Sokol and transactions by members of Congress, turn on rubbery legal concepts with gray areas. With a related trial opening this week and more in the pipeline, the time is right for lawmakers to provide greater clarity.
Illegal insider trading is essentially the use of material, nonpublic information to buy or sell stock – with a breach of some duty of trust required along the way. What’s material or a duty is often confusing. That’s largely because courts defined the terms in various ways as they created the law case-by-case. No statute offers clear guidance.
The confusion allowed Rajaratnam’s lawyers to argue that tidbits from corporate insiders weren’t material in the overall collection, or mosaic, of data he gathered to make an investment decision. In his case, the jury didn’t buy it.
But there’s a legal argument that Sokol, the fallen heir-apparent to Warren Buffett, didn’t trade on material information when he bought about $10 million worth of stock in Lubrizol – even though Berkshire later acquired the specialty chemical company at Sokol’s urging. The argument would go that Sokol could not have known whether Berkshire would buy the company when he bought the shares, so even the knowledge that Buffett would consider the deal might not have been material in a legal sense.
And though Berkshire’s board concluded that Sokol broke the company’s rules, it isn’t clear that he breached a legal duty of trust. That’s because in buying Lubrizol shares he may not have relied on any information he learned from being at Berkshire. If U.S. authorities do go after Sokol, the precise order of events – and whether he owed Berkshire a duty not to trade – will probably be central to the case.
The concept of duty gets more complicated when a corporate insider doesn’t trade, but tips an investor who does. The insider doesn’t breach his duty, legally speaking, unless he means to profit. That makes it harder for the authorities in cases like the one against former Goldman Sachs board director Rajat Gupta.
The Securities and Exchange Commission has accused Gupta of tipping Rajaratnam about Goldman’s earnings and Buffett’s $5 billion investment in the firm in 2008. But it’s not clear how Gupta intended to benefit. He might have wanted to help his long-time friend – which could be enough under the law – or to boost the value of his investment in Galleon’s funds. But the lack of evidence on this point may explain why the government filed an administrative action against Gupta rather than a criminal one, which would have required a much higher standard of proof.
The duty question becomes still trickier when members of Congress and their staff are involved. In this realm, insider trading prosecutions are all but unknown. Washington insiders may get advance knowledge of legislative or regulatory actions that can send a company’s shares soaring. Some aides, for example, bought Bank of America stock just before federal stress tests in 2009 revealed a banking industry healthier than feared. And a 2004 study found that stock portfolios modeled on those of U.S. senators beat the market’s returns by a whopping 12 percentage points a year, on average, between 1993 and 1998.
The problem for regulators is that senators and representatives don’t seem to owe anyone a legal duty to keep confidential what they learn in Congress, meaning they can trade with impunity. That’s not necessarily true for their staff members, who are employees of the U.S. Senate or House, but regulators have generally given staff a pass.
Two representatives in March reintroduced a bill that would bar federal employees from profiting on information learned through their official positions. The prohibitions would be straightforward: no trading on nonpublic knowledge obtained within Congress, no disclosing such information for investment purposes, and required reporting of all trades over $1,000.
The bill’s passage is far from assured, and the world of private business is a lot more complicated than the halls of Capitol Hill. But once Congress finishes addressing its own insider-trading problems, it might do well to look at how the law has developed and clarify what is and isn’t allowed for the rest of the nation.


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