The U.S. Supreme Court has been ducking insider-trading cases for almost 20 years, leaving investors, prosecutors and even judges confused about what is and isn’t allowed. On Wednesday, the top tribunal will hear arguments in a lawsuit that could finally clear things up.
It’s the case of Bassam Salman, an investor convicted of trading on confidential information received from the brother of a Citigroup banker, who also happened to be Salman’s brother-in-law. The issue: Did the banker get paid for his original tip? Why that even matters is a tortuous tale.
No statute clearly defines insider trading, so judges have sketched its outlines case-by-case. Early on they struggled with a balancing act: ensuring trades weren’t rigged in favor of privileged insiders while encouraging the legitimate research that promotes market efficiency. In practice, that meant prohibiting the use of significant corporate secrets – but only if there was some duty to keep them confidential.
The Supreme Court in 1983 settled on a comprehensive approach. It came in the case of securities analyst Raymond Dirks, who had learned from a whistleblower of an accounting scandal at Los Angeles insurer and mutual-fund conglomerate Equity Funding. Foreshadowing attempts to expose Ponzi schemer Bernard Madoff decades later, Dirks warned the Securities and Exchange Commission about the fraud to no avail. He then told his clients, who quickly dumped their stock, prompting regulators to take notice.
Rather than treat Dirks as a hero, however, the SEC sued him for insider trading. The Supreme Court came to his aid with a new rule: He couldn’t be liable unless his source, the whistleblower, got some “personal benefit” for passing along the information. The benefit could be money or a valuable favor, even the satisfaction of helping a relative or friend. The point was to ensure only bad guys – and not resourceful analysts – would be punished.
Prosecutors compensated by interpreting “personal benefit” broadly, suggesting even leaks between casual acquaintances could qualify. In 2014, however, the U.S. appeals court in New York cut back, overturning the convictions of two hedge-fund managers who traded on fourth-hand information. There was no evidence that the duo knew whether the original sources at Dell and Nvidia received a benefit for their tips – or that any benefit existed. And even if the sources leaked the information out of friendship, the court said, there had to be some valuable quid pro quo.
Bassam Salman pounced on that language to argue for reversing his 2013 insider-trading conviction, claiming he didn’t know whether his banker brother-in-law received anything for his tips. The appeals court in San Francisco said that didn’t matter: The original tips passed between brothers, proof enough of an intended benefit. And if the earlier New York decision could be read to suggest otherwise, it was wrong. Faced with an apparent conflict between appeals courts, the Supreme Court took Salman’s case.
The law’s state of confusion is reflected in complaints like the SEC’s last month against Leon Cooperman and his $5 billion-plus hedge fund, Omega Advisors. The lawsuit contends Cooperman broke his promise to an Atlas Pipeline Partners executive not to trade on confidential information about the company’s planned sale of a business. Cooperman essentially stole the information from the executive, the agency alleges, so there was no tip – and no need to prove a personal benefit. The Justice Department isn’t so sure. It has held off filing charges until the Supreme Court resolves the Salman case.
Most likely, justices will uphold Salman’s conviction, suggest the New York court went too far and affirm their ruling in the Dirks case. That would preserve an important precedent while closing a loophole that suggested friends and relatives could freely share secrets.
It is conceivable Salman could win, but that outcome would have been far more likely if Justice Antonin Scalia was still alive. Scalia generally believed only Congress, not the courts, could define crimes, and he viewed the criminal prohibition against insider trading as suspect at best. Without him on the bench, the court almost certainly won’t go that far.
The court may, however, finally muster the courage to modify Dirks and clean up insider-trading law. A good start would be to dump the personal-benefit test and punish investors who trade on secrets they know were improperly obtained. People could still use legitimate scoops and research, but couldn’t skirt liability by willfully ignoring any personal benefit to the source. Beside, benefits are too easily concealed as favors owed in the chummy world of Wall Street.
A safer move would be to leave any changes in the law to the lawmakers. Yet Congress has done nothing with several insider-trading proposals introduced shortly after the 2014 Newman and Chiasson decision, and any legislation might be riddled with lobbyist-inspired loopholes. It’s easy to imagine an exception allowing, say, the pharmaceuticals industry to share confidential information about new drugs.
The Supreme Court has its own gridlock issues, of course, with the Scalia vacancy leaving only eight members who sometimes split four to four. The justices nevertheless are the nation’s best hope when it comes to clarifying insider-trading matters. It’s time they laid down the law.
Reynolds Holding is a senior fellow and editor-at-large at Columbia Law School.