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White Collar Watch

U.S. Weighs Whether to Act or Wait on Insider Trading

Preet Bharara, the United States attorney for Manhattan, had secured dozens of insider trading convictions and guilty pleas over the years.Credit...Fred R. Conrad/The New York Times

Last week’s decision by the United States Court of Appeals for the Second Circuit to reject the Justice Department’s request to reconsider its ruling in United States v. Newman, which makes insider trading harder to prove, leaves the government with three choices. It can ask the Supreme Court to review the decision, push Congress to adopt a law to define insider trading or live with the outcome and figure out how to minimize its effect.

The first two options might be tempting because they provide the potential for a quick fix. But the more likely course for prosecutors and the Securities and Exchange Commission will be to deal with the limitations that the Newman opinion imposes by making sure future cases do not stray too far from the core of the prohibition on insider trading.

It is uncommon that a single opinion from an intermediate appeals court can have so much influence. But the Second Circuit is the pre-eminent court for insider trading cases, once described by Justice Harry A. Blackmun as the “Mother Court” of securities law. And Preet Bharara, the United States attorney in Manhattan, poured significant resources into pursuing insider trading, so any limitation on the law will have an outsize effect on future cases.

The Justice Department’s objection to the Newman opinion, issued in December, centered on the notion of what constitutes a benefit that the recipient of inside information provides to the source, qualifying the exchange as a violation of the law.

The Second Circuit held that mere friendship was not enough to show a benefit and that the government must offer “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature.” Figuring out what constitutes a benefit that is both “consequential” and “valuable” remains open because the appeals court did not explain what those terms mean.

Under the Supreme Court’s rules, the Justice Department has 90 days from the denial of its rehearing request to ask for further review. But doing so would be risky because the court is not constrained to consider only the issue of what proof is required to show an improper benefit.

Of late, the justices have been unwilling to let federal prosecutors try to broaden the law in white-collar criminal cases. The court’s recent decision in Yates v. United States, which found that an obstruction of justice provision did not apply to throwing undersize fish overboard to avoid a penalty under federal conservation regulations, even though the statute prohibits destruction of any “tangible object,” highlights the hostility to expansive views of the law.

The Second Circuit’s pointed statement in the Newman opinion criticizing the “doctrinal novelty” of Mr. Bharara’s recent insider trading prosecutions signals that courts could impose even greater restrictions on what types of trading are illegal. The Justice Department would be playing with fire if it decided to ask the Supreme Court to take the case.

And Congress could be an unpredictable ally in expanding the law. Democrats have introduced three bills to significantly broaden the prohibition on insider trading by making trading while in possession of confidential information illegal. The legislative proposals would discard the requirement to show a benefit provided to a tipper and could cover trading based on confidential information about large stock orders and other data that can move markets.

At a congressional hearing last month, Mary Jo White, the S.E.C. chairwoman, was coy about whether the agency would support legislation to describe explicitly what constitutes insider trading. “I think it’s challenging to codify it clearly in a way that is both not too broad and retains the strength of common law,” she said.

One bill has a Republican co-sponsor, but the push to expand the insider trading law has come mainly from the minority party, limiting the chances of success in passing legislation. The S.E.C. has not been winning any popularity contests with Republicans on Capitol Hill lately, so the agency may not want to push for a legislative fix when it is unclear whether enough support exists to get a bill through Congress.

The third option is the wait-and-see approach. The Newman decision will most likely affect some current cases involving so-called remote tippees who never dealt directly with the source of the information, but whether it spreads to other situations remains to be seen.

For example, the insider trading conviction of Michael Steinberg, a former hedge fund manager at SAC Capital Advisors who was close to the firm’s founder, Steven A. Cohen, will most likely be overturned. His case involved the same issues as those decided in Newman, and the Second Circuit delayed his appeal until the government’s rehearing request was decided.

Other prominent defendants pursued by Mr. Bharara’s office have argued that the Newman opinion requires that their convictions be overturned as well. Mathew Martoma, another hedge fund manager at SAC Capital, received confidential information directly from a doctor about a failed drug trial that resulted in gains and losses avoided of more than $260 million for the firm. Mr. Martoma contends that the only evidence of a benefit was an “illusory friendship that consisted of a cup of coffee and some pleasantries over email.”

Rajat K. Gupta, convicted of providing information to the hedge fund founder Raj Rajaratnam about developments at Goldman Sachs while he was a director of the firm, asked to have his conviction set aside because the jury was instructed that only a “modest benefit” was sufficient to prove a violation. He argues the standard used by the jury was far short of the “consequential” benefit requirement of the Newman decision.

If one of these prominent defendants is able to persuade a court to overturn his conviction, the pressure may grow for Congress to adopt a legislative fix. The public mistrust of Wall Street is so great that letting a hedge fund trader off on what looks like a technicality can help fuel demand for a clearer prohibition — and a broader one — on insider trading.

But if most convictions from Mr. Bharara’s crackdown remain undisturbed, then the Justice Department and S.E.C. may be willing to see how the law develops. Terms like “consequential” and “valuable” are the type of malleable language that could allow a wide range of cases to move forward despite the higher hurdle.

The Justice Department dismissed charges against five defendants who traded ahead of the acquisition of SPSS Inc. by IBM because there was insufficient evidence of a benefit being conferred on the source. But in an interesting twist, the S.E.C. is continuing to pursue civil insider trading charges against two defendants after amending its complaint to contend that a “consequential” and “valuable” benefit was provided, as required by the Newman opinion. Judge Jed S. Rakoff of the Federal District Court in Manhattan rejected a request by the defendants to dismiss the case, finding that the S.E.C. had put enough into its complaint to meet the heightened benefit requirement. Judge Rakoff’s decision shows that the Newman opinion may not be quite as problematic as the government argued when it asked for reconsideration.

The government may have to take a step back by skipping cases when the relationship between the recipient and source is only a casual friendship. That may mean golfing buddies will be largely immune from insider trading charges, but most cases involving significant trading are likely to involve the type of benefits that can pass the Newman test.

This approach will be frustrating for hard-charging prosecutors and S.E.C. enforcement lawyers who now have to ease up a bit, but letting the law develop may turn out to be the best approach.

A correction was made on 
April 8, 2015

An earlier version of this column misspelled the given name of a manager at SAC Capital who was convicted of insider trading. He is Mathew Martoma, not Matthew.

How we handle corrections

Peter J. Henning, a professor at Wayne State University Law School, is a co-author of “Securities Crimes (2nd edition).” Twitter: @peterjhenning

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