Court Conflict Raises Question of Who Decides the Law, and the Breaker

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Justice Antonin Scalia called into question whether courts should defer to the S.E.C. to determine what constitutes insider trading.Credit Jessica Hill/Associated Press
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It is a basic principle taught in every American government class: Congress enacts the laws and the executive branch enforces them. If only life were so simple. No law is perfectly clear, and circumstances change over time, opening up statutes to new interpretations.

So now a web of administrative agencies interpret laws by adopting myriad rules, with violations subject to civil enforcement actions and even criminal prosecutions. In a recent statement, Justice Antonin Scalia of the Supreme Court called into question whether courts should defer to the Securities and Exchange Commission to determine what constitutes insider trading when a prison term can turn on fine distinctions between a permissible transaction and a violation.

Justice Scalia raised the issue of who should decide what rises to the level of a crime in connection with the Supreme Court’s denial of a request by Douglas F. Whitman to review his securities fraud and conspiracy convictions. Mr. Whitman was a hedge fund manager caught up in the government’s sprawling investigation into insider trading that involved evidence that he received tips from Roomy Khan, who also provided information that led investigators to pursue Raj Rajaratnam.

One issue in his appeal was the legal standard for proving that a defendant traded “on the basis of” confidential information. Under the approach taken by the United States Court of Appeals for the Second Circuit, which oversees the Federal District Court in Manhattan, where Mr. Whitman was prosecuted, the government had to show he knowingly possessed the information when he traded. In other federal appeals courts, however, the prosecutors must prove that the information was at least a significant factor in the decision to trade, not just that a defendant was aware of it.

The Justice Department files more insider trading cases in Manhattan than anywhere else, at least in part because of rulings like this that make it easier to win convictions, even when the defendant has nothing to do with New York. For example, a defendant who worked for a law firm in Silicon Valley pleaded guilty last week to insider trading even though he had no discernible connection to Manhattan other than the fact that the stocks he bought with confidential information taken from the firm were traded through stock exchanges there.

The issue of what proof is required to show trading on the basis of confidential information has generated what is known as a circuit split. This type of issue can draw the Supreme Court’s attention to resolve the dispute so that federal law is applied uniformly throughout the country. But a majority of the justices did not see fit to address this issue when they turned down Mr. Whitman’s request.

Justice Scalia, joined by Justice Clarence Thomas, questioned the basis for the appeals court’s approach, which relies on an S.E.C. rule that provides its own interpretation of what constitutes trading on the basis of inside information. He asserted that “a court owes no deference to the prosecution’s interpretation of a criminal law.” Insider trading law was largely created by judges, and Justice Scalia is calling on the judiciary to take control of determining its scope, not the S.E.C. through its rules.

In 2000, the S.E.C. adopted Rule 10b5-1, which defines “on the basis of” as trading when “the person making the purchase or sale was aware of the material nonpublic information” at the time of the transaction. Of course, the agency has an interest in taking a position that makes it easier to prove a violation because it acts as both a regulator of the market and an enforcer of its rules.

If civil enforcement were the only remedy for an insider trading violation, then a broad interpretation expanding the prohibition might not be troublesome. But a violation of the securities laws and any S.E.C. rules promulgated under them can be the subject of a criminal prosecution as long as the government shows the defendant acted “willfully” — a notoriously muddled standard. Thus, sentences for insider trading have ranged from the two-year term that Mr. Whitman received up to the 11 years for Mr. Rajaratnam, which can be based on an expansive reading of the law.

The potential for a criminal prosecution based on an administrative regulation led Justice Scalia to note that “legislatures, not executive officers, define crimes.” Moreover, a principle for interpreting criminal laws is the “rule of lenity,” which calls on courts to construe the scope of a law narrowly when a violation can result in a prison term. An administrative agency often has the opposite incentive so that it has the authority to reach a broader array of conduct.

The issue of who decides what a law means is complicated because the Supreme Court has also said that courts ought to defer to an administrative agency when a law is not clear. Under the court’s decision in Chevron U.S.A. Inc. v. Natural Resources Defense Council, an agency’s interpretations of ambiguous laws should be “given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute.”

Justice Scalia questioned whether the deferential approach should apply to rules that can result in criminal prosecutions, especially when the agency is so intimately involved in the enforcement of the law. The S.E.C. and the Justice Department have worked hand in glove on insider trading cases over the last few years, with simultaneous criminal and civil charges being filed almost as a matter of routine.

Despite questioning the reliance on Rule 10b5-1 in upholding Mr. Whitman’s conviction, Justice Scalia agreed with the decision to deny the appeal of his convictions because that issue was not raised in the petition for review. So he is sending a signal to future insider trading defendants who challenge their convictions to raise this issue directly so that it can be properly framed for review, noting that “I will be receptive to granting it.”

It is not clear where that case will come from, at least based on current appeals working through the system. In arguments last week before the federal Court of Appeals for the Second Circuit on the issue of granting bail pending appeal, Mathew Martoma’s lawyer focused on the question of whether the trial judge should have admitted testimony by Steven A. Cohen about the decision to sell a $700 million position that his hedge fund, called SAC Capital Advisors at the time, had amassed in two pharmaceutical companies. That issue has nothing to do with the S.E.C.’s interpretation of what constitutes insider trading and so it is an unlikely candidate to heed Justice Scalia’s invitation.

The conviction of Michael Steinberg, another portfolio manager at SAC, could be the case to raise this issue on appeal. One challenge filed to the conviction concerned whether his possession of inside information was enough to establish a violation, which the trial judge rejected. His appeal is on hold, however, until the appeals court decides another case about whether the government has to prove a recipient of inside information knew that a benefit was provided to the tipper. A favorable ruling for the defendants in that case is likely to result in a new trial for Mr. Steinberg, rendering the issue of the S.E.C.’s interpretation of the law irrelevant.

Justice Scalia has put defense lawyers on notice to raise the issue of whether a criminal prosecution should be based on the S.E.C.’s broad interpretation of the insider trading law. Federal prosecutors may well try to steer clear of the issue by hewing to a narrower approach of what constitutes insider trading in the hope of avoiding future review of the issue of who gets to decide the law.