14. White Collar Week: A retrospective on the SAC Capital insider trading case

An interview with Richard Lee, the 8th person targeted by the Preet Bharara SDNY in ‘Perfect Hedge’. Notable is that Lee implies Bharara not only ‘discovered’ he was innocent as soon as a month after his rushed (coerced) guilty plea, but that the SDNY refused to exonerate him until he moved to successfully vacate the plea, nearly seven years later. Seven years.

Notably, in the Government’s own (publicly available) opposition to Lee’s motion to vacate his plea, they admit receipt of exculpatory evidence a month after his rushed plea: “Further, based on a review of the Government’s file, it appears the Government did not receive the Instant Messages between Lee and the Trader until August 15, 2013, i.e., almost a month after Lee’s guilty plea…“

The interview begs a number of questions about the SDNY’s conduct as well as the underlying narrative about the SAC Capital prosecution.

13. The fourth substantial revision of US insider trading law in five years – US v Martoma

Once more into the fray

Yesterday, the 2^nd Circuit Court of Appeals withdrew its prior ruling in US v Martoma.  Issuing an amended ruling in its place, now authored by Chief Judge Robert Katzmann, this marks the 4^th significant revision in US insider trading law in the past five years:

2013: US v Newman, restoring the knowledge of personal benefit requirement of Dirks & narrowing the definition of what qualifies as personal benefit

2015: Salman v US, striking down parts of Newman and redefining personal benefit

2017: US v Martoma, radically redefining personal benefit as ‘expectation that the recipient will trade’, and declaring Newman no longer ‘good law’

2018: US v Martoma, withdrawing the prior ruling, reinstating Newman and again, redefining the personal benefit standard

The amended Martoma ruling parses this specific sentence from Dirks:

“For example, there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient.”

Is the “intention to benefit” cabined within the context of the relationship?  Can intent to benefit be exclusive of any relationship whatsoever?

The majority opinion argues the comma separates the two, such that “intention to benefit” is not linked to the relationship:

Katzmann: “The comma separating the “intention to benefit” and “relationship . . . suggesting a quid pro quo” phrases can be read to sever any connection between them.”

But in doing so, the majority opinion again reaches a conclusion which fundamentally contradicts Dirks:

Katzmann: “The tipper’s intention to benefit the tippee proves a breach of fiduciary duty because it demonstrates that the tipper improperly used inside information for personal ends and thus lacked a legitimate corporate purpose.”

Again, we return to underlying context of Dirks:

“In the Court’s words, “[Secrist] uncovered . . . startling information that required no analysis or exercise of judgment as to its market relevance.” In disclosing that information to Dirks, Secrist intended that Dirks would disseminate the information to his clients, those clients would unload their Equity Funding securities on the market, and the price would fall precipitously…”

Ronald Secrist had no legitimate corporate purpose in disclosing the Equity Funding fraud that he uncovered as an employee.  Indeed, while a motivation was that of a whistleblower, the method he chose for disclosure was one he felt would be most effective principally because the information itself represented a benefit to the equity analyst he tipped, Ray Dirks, and in turn, his clients, who promptly dumped the shares of Equity Funding forcing the outcome Secrist had predicted… an investigation and uncovering of the fraud.

The facts of Dirks are clear: Secrist intended to benefit Dirks, but because it was not in the context of a relationship, Secrist had no criminal liability.

 

Newman’s Knowledge of Personal Benefit Requirement

The revised Martoma ruling re-emphasizes one of the central aspects of Newman:

Katzmann: “whether a tippee must be aware, not only that the tipper breached a fiduciary duty in disclosing inside information, but also that the tipper received a personal benefit. Newman, 773 F.3d at 447–51. The Court persuasively explained that both were required. This important teaching of Newman is not before us.”

I highlight this because, semantically, it has been argued that receipt of personal benefit was, by definition, included in a breach of fiduciary duty.  Katzmann makes clear that they are separate, and as such, individually distinct requirements.

 

The Dissent

Judge Rosemary Pooler’s dissent focuses on the foundational underpinnings of Dirks: that ambiguity around a subjective test for personal benefit (and thus criminal liability) left market participants exposed to “the whims of prosecutorial enforcement priorities.” (Dirks).

Pooler: “Absent objective evidence, a slip of the tongue might be presented to a jury as a purposeful tip with a good cover story… The difference between guilty and innocent conduct would be a matter of speculation into what a tippee knew or should have known about the tipper’s intent.”

Pooler ultimately distills to the fundamental issue with analysis of “intention to benefit” in isolation (emphasis added):

“Nearly as difficult to understand is why the Dirks court would have provided an intention to benefit a tippee as an  example of a benefit to the tipper. Intending to benefit somebody is not in itself a benefit. That is, not unless one has reason to believe that the person with the intention to benefit benefits from the beneficiary’s benefit or one adopts the trivializing view of human psychology wherein everything any individual does is to benefit herself.”

Continuing:

“This theory fails to deal with the fact that an intention to benefit is not itself an “objective fact or circumstance,” as Dirks requires, but rather an inference drawn from objective facts or circumstances. Additionally, this theory makes it difficult to understand why the Dirks court would have adopted the personal benefit test in the first place. If a jury can conclude that a tipper breached his duty so long as it concludes that she intended to benefit the tippee, why should it have to go through the tortuous process of concluding that the tipper received a personal benefit based on its conclusion that the tipper intended to benefit the tippee? Why should we care about the tipper’s benefit at all?”

 

Conclusion

Pooler’s dissent includes the intriguing remark:

“Today’s opinion must be interpreted consistently with the rule that, as a three‐judge panel, we are unable to abrogate prior circuit decisions.”

It is unclear what guidance this leaves lower courts with respect to following Newman or the amended Martoma ruling as guidance for determination of personal benefit, and thus, criminal liability.

To this writer, it appears painfully evident that under Martoma, Ray Dirks would himself be criminally liable.  Again, the ruling intended to clarify the ruling that exonerated Dirks would instead find Dirks had committed a crime.

It is painfully evident after five years of repeated attempts from courts to clarify and redefine insider trading law that it is hopelessly mired in confusing and vague semantics.  This vagueness has been abused and exploited by prosecutors (Preet Bharara) for personal political purposes.  It’s high time a federal judge declared insider trading law as unconstitutionally vague and that Congress writes a cogent, clear law that all market participants can understand as easily as traffic signals.

 

12. A federal judge should void insider trading law as unconstitutionally vague. Martoma contradicts Dirks.

Perhaps the most confusing element of the recent (split) Martoma ruling by the 2^nd Circuit Court of Appeals, authored by the widely respected Judge Denny Chin, is how the revised definition of personal benefit explicitly conflicts with the foundation of modern US insider trading law, Dirks v SEC (1982).

In Dirks, Ron Secrist, the former controller of Equity Funding (EFCA), an insurance company, leaked to Ray Dirks ‘inside information’ about EFCA revealing that it was fabricating insurance policies out of thin air.  At the time (1973), Ray Dirks was a well-regarded sell-side Analyst covering insurance companies.  Importantly, while Secrist’s primary motivation was to expose the EFCA fraud, his expectation was that this information would induce EFCA’s shareholders to dump their stock, forcing an investigation.  Indeed, that is exactly what happened.

“After a meeting with Ronald Secrist, a former Equity Funding employee, on March 7, 1973, App. 226, petitioner Raymond Dirks found himself in possession of material nonpublic information of massive fraud within the company.^[2] In the Court’s words, “[h]e uncovered . . . startling information that required no analysis or exercise of judgment as to 669*669 its market relevance.” Ibid. In disclosing that information to Dirks, Secrist intended that Dirks would disseminate the information to his clients, those clients would unload their Equity Funding securities on the market, and the price would fall precipitously, thereby triggering a reaction from the authorities. App. 16, 25, 27.”

In Martoma, the majority opinion redefines personal benefit (and thus criminal liability):

“However, the straightforward logic of the gift‐giving analysis in Dirks, strongly reaffirmed in Salman, is that a corporate insider personally benefits whenever he ”disclos[es] inside information as a gift . . . with the expectation that [the recipient] would trade” on the basis of such information or otherwise exploit it for his pecuniary gain.”

Later in Martoma, the majority opinion attempts to hedge their new radical redefinition of personal benefit:

“For example, disclosures for whistleblowing purposes to reveal a fraud, see Dirks, 463 U.S. at 649–50, 667, and inadvertent disclosures, see id. at 663 & n.23, are not disclosures made “with the expectation that [the recipient] would trade on” them and thus involve no personal benefit to the insider.”

This is wrong and makes little sense.  People are complex and the reasons they do something may be multiple, not singular.  While Ron Secrist was driven by an ‘altruistic’ purpose of exposing the EFCA fraud, he clearly also intended to give information to Ray Dirks with expectation the final recipient of the information, the shareholders of EFCA, would trade on it.  That is, Ray Dirks would be criminally liable for insider trading under Martoma, the very ruling intended to clarify the Supreme Court ruling which exonerated him.

Perhaps what is confusing is that in Dirks, the Supreme Court ruled that Secrist did not give a valuable ‘gift’ to Dirks.  I would think any sell-side Analyst (or reporter, for that matter), would love to get a scoop on a large-scale corporate fraud that would confer a prestige or “reputational benefit that will translate into future earnings.”

The only limiting factor articulated in Martoma that could reconcile its blatant contradiction of Dirks would be the concurrent requirement that “the disclosure “resemble[s] trading by the insider followed by a gift of the profits to the recipient.”  While Secrist clearly tipped Dirks with an “expectation that the recipient will trade”, it is also clear that Secrist did not do so with the intent to give the functional equivalent of cash to Dirks.

And yet, should insider trading prosecutions be limited by the rule that the tip must resemble the functional equivalent of giving the tippee cash, it is this author’s opinion that 90%+ of historical prosecutions over the past decade would fail that requirement.

For example, this one:

Since Dirks v SEC (1982), insider trading law has endured several radical revisions:

• US v O’Hagan (1997), establishing misappropriation theory
• US v Newman (2013), reinstating the personal benefit requirement and knowledge of personal benefit requirement
• Salman v US (2016), striking down parts of Newman and re-redefining personal benefit
• US v Martoma (2017), again re-defining personal benefit

In light of a lengthy and vociferous dissent in Martoma, it seems clear that personal benefit as “expectation that the recipient will trade” will be contested once more (likely in a future case, not through an en banc appeal).

When will a federal judge do what seems rather obvious, and strike down insider trading as unconstitutionally vague?  It’s high time this ball passes to Congress for a statute instead of a judge-made law.

11. Implications of US v Martoma and why the media may be getting it entirely wrong

Most ‘Big Law’ commentary on US v Martoma has been limited to the observation that US Circuit Judge Denny Chin has effectively nullified the ‘meaningfully close personal relationship’ language of US v Newman and  replaced it with a much broader ‘expectation that the recipient will trade’ rule.  The Opinion showcases this new definition of insider trading liability with the example of a tipper giving his/her doorman inside information with instructions to trade instead of an annual cash bonus.

1. Wither Tippee-Only Liability?

The Bharara-era insider trading prosecutions were remarkable in the sheer number of cases that were brought against tippees and remote tippees where the tipper was never prosecuted.  What seems rather obvious to me is that the SDNY under Bharara advanced a misappropriation theory of insider trading liability which has been clearly rejected by Newman, Salman and now Martoma.  That is, his interpretation (or willful breach) of the law has been resoundingly refuted.

The tippee cannot be liable for insider trading unless the tipper is also liable.  Put simply, you cannot put the cart before the horse.

The Martoma decision may have cemented this:

“However, the straightforward logic of the gift‐giving analysis in Dirks, strongly reaffirmed in Salman, is that a corporate insider personally benefits whenever he ”disclos[es] inside information as a gift . . . with the expectation that [the recipient] would trade” on the basis of such information or otherwise exploit it for his pecuniary gain. Salman, 137 S. Ct. at 428. That is because such a disclosure is the functional equivalent of trading on the information himself and giving a cash gift to the recipient.”

The only person who can testify as to whether they expected a tippee to trade is the tipper himself/herself.

In her dissent, Judge Pooler raises relevant questions:  How can jurors (or even the Appellate Court) know that information was disclosed with the expectation that the recipient would trade on it (unless the tipper testifies as a cooperator)?  And to the extent the government is allowed to show “circumstantial evidence of intent”, does this new rule then serve as a limitation at all, since the government would not be required to show “objective facts”?

2. An Old Rule Revived: Does the tip “resemble trading by the insider followed by a gift of profits to the recipient?”

From Dirks v SEC:

“The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.”

I have argued that this version of insider trading (a tip which is the “functional equivalent” of a cash gift) is a much smaller subset of historical insider trading prosecutions.  It is unclear, for example, the classic case of golf buddies sharing inside information fits into this framework.  When is sharing material nonpublic information trading gossip, albeit gossip one might trade on, and when is it the functional equivalent of intending to and giving your friend cash?

Once more, while a jury can make an inference about the nature of the insider trading tip, and the prosecution can rely upon circumstantial evidence in a relationship to build a theory that the tip was intended as a functional equivalent to cash, the only person who can definitively testify to the purpose of the tip is the tipper.

It stands to reason this long-ignored clause in Dirks, reiterated and revived in Martoma, will limit prosecutions, particularly those of a casual or one-off nature.

Conclusion

Contrary to mainstream media spin, prosecutors may very well regret the day Martoma became controlling law in the Second Circuit.  The decision complicates their job in two ways: First, they must show that a tipper tipped with an expectation the recipient of the information would trade on it.  Second, they must show the tip was the functional equivalent of a cash gift.  Up until now, juries may have well made an unconscious inference regarding these two, but to the extent these become incorporated into explicit jury instructions as specific evidentiary hurdles, the burden of proof to surpass reasonable doubt may increase substantially.  Only time will tell.

10. Why Fed President Lacker’s resignation highlights the hypocrisy in the DoJ’s narrative of insider trading

The resignation of Richmond Fed President Jeffrey Lacker, begs more questions than it answers.

What do we know?

• We know that in Oct 2012, Mr. Lacker spoke with Regina Schleiger, a senior managing director at Medley Global Advisors, which bills itself as a macro-policy intelligence service.  Those of us who’ve worked at hedge funds know that not only do the major broker-dealers all have a macro-policy strategist blasting Congressional ‘scuttlebutt’ to clients, but a substantial industry of boutique firms exist that focus on this general area – healthcare policy (Marwood Group), global macro-political development (Ian Bremmer of Eurasia Group), and many others.  I personally have used a number of the more cottage industry ‘political intelligence’ groups to give insight into FTC issues the few times I had been involved in cable & telecommunications investments as well as investments where a Committee on Foreign Investment in the US (CFIUS) review were key risks.
• Medley Global Advisors has claimed First Amendment privileges as a ‘journalistic organization’ in refusing to cooperate with a DoJ probe into insider trading:

“the firm at the center of the probe, Medley Global Advisors, has thrown up a roadblock by claiming a novel defense: It says it is a media organization entitled to special protections under the law, the people said.

• We also know Mr. Lacker will not be charged, presumably criminally nor civilly, as per his attorney.
• Lastly, we know that the Inspector General for the Federal Reserve Board, has indicated it considers this matter now to be closed.  I suspect we will see nothing further here from the CFTC, SEC or DoJ.

Why is this critical to the false narrative of insider trading that has been manipulated by the SDNY to the willing public and complicit journalists?

I have stated before that to whatever extent anyone can be upset about insider trading in the stock market, one must express similar outrage at perfectly legal trading on material, nonpublic information that happens every single day in the bond market, commodities market and real estate market.  Consider that this single ‘tip’ given by Mr. Lacker to Ms. Schleiger, who in essence is a sell-side Research Analyst, probably in sum resulted in profits and losses avoided well in excess of the cumulative profits of all insider trading prosecutions in history.  What could affect market integrity more than advance knowledge of critical Fed decisions affecting the largest, most liquid and most important market in the world – U.S. interest rate futures?

And yet, Mr. Lacker, Ms. Schleiger and the clients of Medley, who must be well aware her source was a direct, voting member of the Fed, will avoid criminal and civil sanctions.

And for good reason!  It is unclear that Dirks v SEC  applies in this case!  Yet the media refuses to highlight this disparity.  Let me be clear: were Mathew Martoma or Ivan Boesky paying a ‘consultant’ for material, nonpublic information on interest rate futures, they would be lauded today as preternatural investment gurus, instead of white collar felons.

Prior prosecutions in light of the ‘special treatment’ of Medley Global?

That the case of Mr. Lacker involves, what is in essence, a sell-side research firm, either being paid directly or in soft dollar commissions from hedge funds and other investment firms, begs the question not only as to what is a media organization, but when is information that it distributes to a limited client list considered ‘nonpublic’?  It is a near certainty that clients of Medley Global, and specifically Ms. Schleiger, were clients precisely because of the nature of the ‘access’ the Medley Global offered.  To be clear: clients paid Medley because Medley told them they spoke directly with sitting Fed Presidents.

There is at least one case, US v Sandeep Aggarwal, which was part of the indictment of SAC Capital yet which received little or no media coverage (likely because the DoJ did not want excessive scrutiny).  The case centers on a sell-side Analyst who receives allegedly nonpublic information from a contact at Microsoft about a pending and well-rumored Microsoft-Yahoo search engine partnership.  He then circulates this information broadly to the client base of the sell-side firm (rendering the information public in the process), and later specifically to the SAC Capital Analyst.  Curiously, the Microsoft contact (the tipper, as it were) was never prosecuted.  Similar to the overturned Chiasson & Newman cases, it is unclear why – one can only conclude the legal case against the tipper was insufficient.  (Arguably a series of cases coincident to and predating the overturn of Newman relied on a now discarded theory of misappropriation advanced by Preet Bharara under which a number of guilty pleas were coerced procured but which now cannot be withdrawn under post-conviction relief.)

This is a scenario which is broadly analogous to Medley Global Advisors.  Substitute Fed President Lacker for Mr. Aggarwal’s Microsoft contact.  Substitute Ms. Schleiger for Mr. Aggarwal.  Substitute Medley Global’s clients for Collins Stewart’s clients.  Both Collins Stewart, the sell-side firm where Aggarwal worked, and Medley Global Advisors, where Ms. Schleiger is still employed, are in essence sell-side organizations catering to the same client base – hedge funds.  Both cultivate ‘sources’, employ ‘Analysts’ for research, and publish and disseminate their ‘research product’ to hedge funds, via email, phone calls and in-person meetings.  To wit: If Medley Global Advisors qualifies as a ‘journalistic media organization’, then all sell-side research firms do.

The comparison of Ms. Schleiger and Mr. Aggarwal begs the question as to why Mr. Aggarwal and his client were prosecuted, and yet Ms. Schleiger today remains gainfully employed by Medley Global and there have been no accusations of insider trading by the clients of Ms. Schleiger and Medley Global.

I suspect the prominence of Mr. Lacker and ‘too important to jail’ figures prominently in this calculus.  Alternatively, Mr. Aggarwal is innocent and was railroaded into a guilty plea (along with his client). Either conclusion raises more questions than it answers.

9. The failure of Sheelah Kolhatkar’s ‘Black Edge’

Sheelah Kolhatkar, a recent addition as a staff writer for the New Yorker (though most associate her with Bloomberg where she recently left after 6 years), finally published her first novel about the Wall Street ‘Perfect Hedge’ insider trading investigation, focusing on Mathew Martoma and SAC Capital.  She was interviewed about her book on NPR’s Fresh Air, in addition to having a series of favorable reviews appear on behalf of her journalist friends in the business (notably, this one by Andrew Ross Sorkin).

I had known for years this book was under development and had been skeptical for a variety of reasons, but withheld my judgment and with as open a mind as possible trotted over to a bookstore to check it out.

This is a critical review which I wanted to put out immediately, for purposes of relevance but also to counter what I consider a concerted effort by vested interests to control a false narrative that Kolhatkar is partly the messenger of.  This post will be revised as I gather additional thoughts and request feedback from others.

1. Similar to recent critiques of the editorial process at the New York Times, it is imperative to note Kolhatkar struck while the iron was red hot – ‘Black Edge’ began as a proposal which was auctioned to publishing houses in 2013, ultimately selling for an advance of $500,000.  Why this is relevant is that the initial narrative was decided at the peak of the insider trading hysteria, in the wake of the indictment of SAC Capital and before: the successful Newman/Chiasson appeals which have highlighted the vast ambiguity of insider trading law itself, the civil suit by David Ganek against the SDNY which raises critical questions of DoJ ethics, and the most recent revelation of FBI leaks of confidential grand jury proceedings designed to illegally influence the outcome of pending cases.
2. What this suggests is that the narrative was preset, and facts were selectively chosen or ignored to fit the preset narrative, instead of a proper investigative approach which should have been the reverse.
3. The substantial majority of ‘Black Edge’ appears to be the patchwork synthesis of a other pieces by different journalists that have appeared the prior years.  While Kolhatkar adds interesting tidbits of Steve Cohen’s life or illustrative anecdotes from SAC Capital that haven’t appeared elsewhere, she doesn’t uncover anything new that is substantive.  Notwithstanding that, ‘Black Edge’ could have value to future generations who haven’t lived through the ‘Perfect Hedge’ cases, if only it were actually objective and balanced.
4. I have serious reservations about the actual level of research and interviews that Kolhatkar conducted.  Tracking down Steve Cohen in a luxury department store and being turned down for an interview is not evidence of tenacity in research.  And interviewing 200+ people doesn’t reflect much, given that it appears dozens were interviews with fellow journalists.  The real question is – how many Wall Street professionals directly related to the insider trading cases were interviewed?  First, a number of relevant people I know who were directly involved in the SAC Capital, Diamondback/Level Global and Galleon cases claim they were never contacted by Kolhatkar.  Secondly, Kolhatkar puts forward simple narratives (for example, regarding Jason Karp’s role within SAC Capital and whitewashing his overall moral compass) that I happen to know are just not true.  These are narratives that had a useful trial function to highlight black and white for a jury, but are not representative of the objective truth.  Nearly anyone who had worked in the CR Intrinsic unit of SAC Capital would attest to this.  Given the nature of her writing and attribution to other journalists, I wouldn’t be surprised if she directly spoke with less than a dozen actual Wall Street professionals directly or one-step removed from the insider trading cases.
5. Lastly, Kolhatkar places an altruistic halo around the crown of the government prosecutors doggedly trying to ‘catch the bad guy’.  For the government prosecutors, Steve Cohen represents their brass ring to personal career advancement, be it the ground level AUSAs looking to move into cushy white collar defense roles, or Preet Bharara himself (widely believed within certain inner circles in NYC to have coveted a path to becoming the junior Senator next to his patron, Chuck Schumer.)  Nowhere does Kolhatkar question the overall prerogative of why the SDNY had decided to focus on insider trading, especially given its irrelevance to the actual root causes of the 2008 financial crisis.  (The answer?  Because it is best for individual career ambitions.)  Curiously, the Todd Newman case sat on Reed Brodsky’s desk for over six months after the raid of Diamondback Capital and Level Global.  Brodsky had already earned his chops prosecuting Raj Rajaratnam and for whatever reason (perhaps because there was no case), was disinclined to arrest Newman.  Only when the case transitioned to Antonia Apps was she able to (arguably dubiously) form a case to arrest and convict Todd Newman, on a legal basis that was eventually overturned by the 2nd Circuit Court of Appeals.  That win, and her associated role in the SAC Capital indictment (to be discussed in a later post), earned her her own chops for a cushy white collar defense role at Milbank.  Kolhatkar can’t get this level of insight from her investigations, because it appears she is captive to her sources who are the very same current and former prosecutors with a vested interest in selling the public a false narrative.
6. Here’s the critical moral point that is missing and that Kolhatkar herself acknowledges in her Fresh Air interview: for many of those on Wall Street, and even for the government itself, people just don’t know if they are breaking the law.  A number of these prosecutions consisted of the FBI showing up, an AUSA claiming you broke the law and committed insider trading and threatening years of incarceration unless you plead guilty and cooperated.  Consider how frightening this is – for several folks, the FBI and SDNY’s ‘Perfect Hedge’ created an unbearable Sophie’s Choice – a lose-lose of staggering proportions.
7. When asked about her early Wall Street career (as a risk arbitrage analyst, no less – those with Wall Street experience know that risk arbitrage is probably the strategy on Wall Street with the most historical insider trading), Kolhatkar denies she ever crossed into ‘black edge’ territory while inconsistently qualifying that she and most wouldn’t even know when that line was crossed.  I hold her to a higher standard, and if there’s anyone who should understand the nuances of legal and illegal information gathering, and of knowledge of criminal intent in doing so, it should be the one business journalist with actual hedge fund Analyst experience.

In this critic’s opinion, therein lies the lesson that could have real social value, to the public and to business school students, and yet Kolhatkar punts to a simplistic ‘good prosecutor/FBI’ / ‘bad Wall Street insider trader’ narrative.

My two cents?  Save your money, save your time.  ‘Black Edge’ is compelling in the way Zero Dark Thirty is.  You know you’re being fed a piece of propaganda and that it’s untrue, but it still might be an enjoyable afternoon fiction read nonetheless.  Fiction.

8. The Unbearable Lightness of the DoJ’s Duplicity

In the recent US v Salman oral arguments, Michael Dreeben, the Deputy US Solicitor General, attempts to rewrite history.  He outlines for Justice Ruth Bader Ginsburg purported DoJ standards for criminal liability when a ‘tip’ is passed from one tippee to another down a chain:

DREEBEN: Well, tipping chains can – can go quite a ways when the information is passed, and the limitation on when the government can charge these cases is a limitation of proof. We need to be able to show that the tippee, perhaps at the end of the chain will be more difficult than the ones earlier in the chain, had knowledge that the information originated in a circumstance in which there was a breach of fiduciary duty for personal benefit.

JUSTICE GINSBURG: Had knowledge or should — should have known.

DREEBEN: No, with — in a criminal case we have to show knowledge. Now, we can rely on conscious avoidance. That’s a very classic instruction that the Court clarified in Global-Tech about how knowledge can be inferred when someone deliberately  avoids confirming facts of which they — or should be aware, but that involves a personal culpability that takes care of I think the concern that criminal liability will extend forever. It won’t.

It’s as if the Deputy US Solictor General had conveniently forgotten three decades of insider trading prosecution. I nearly fell out of my chair, half-expecting a SCOTUS clerk acting as a fact checker to stand up, point a finger at Mr Dreeben and shout “You lie!”

The US is at best, being disingenuously deceptive and at worst, outright lying.

As discussed previously, the Newman/Chiasson/Steinberg prosecutions were four, five and five steps removed from the original source of the insider trading ‘tip’.  In none of those prosecutions did the DoJ hold itself to the standard of showing knowledge that the remote tippee (Newman, Chiasson, or Steinberg) knew the information originated in a scenario where there was a breach of fiduciary duty for a personal benefit.  One reason is because the tippers in these cases were never prosecuted!

In fact, in numerous coerced guilty pleas (remember, five individuals in the tipping chain all plead guilty and testified in trials against Newman/Chiasson/Steinberg), the requirement of knowledge was absent.  It was not even a consideration as a requirement in prosecution or acceptance of criminal liability.  These five guilty pleas were later withdrawn by DoJ because the 2nd Circuit Court of Appeals deemed there was no breach of fiduciary duty for personal benefit in the original tip.

How, then, can the Deputy US Solicitor General rewrite history and claim otherwise?

Assuming the Supreme Court is aware of the DoJ’s prosecutorial history in insider trading, particularly when it comes to guilty pleas, the Deputy US Solicitor General’s comment highlights not only the DoJ’s hypocrisy but the obvious necessity in light of it to re-write and narrowly proscribe the boundaries of insider trading law.

Think about it: the DoJ is arguing one thing to the Supreme Court, to make it appear it has a cogent and universally consistent framework for insider trading prosecutions, when the very case history of the DoJ shows precisely otherwise.

I’ve already discussed the legally unsound emphasis the DoJ has placed on prosecuting tippees but not tippers.  The next post will discuss resolved and pending cases, and apply the rigor of the Deputy US Solicitor General’s proclaimed acid test for criminal prosecution to determine whether those cases were, in fact, overreaches of the law. (hint: they were)

7. The wrongful death of Ephraim Karpel and insider trading

The insider trading investigations have left a wreckage of human lives in its wake.  Perhaps it is justified; certainly the consequences of breaking the law must be a deterrent to future bad actors.  What if you don’t know what the law is, or whether you’ve broken it?  The persistent problem with insider trading is that we don’t know if these devastated lives are the result of an actual crime, or a perversion of the law as applied by federal prosecutors and the FBI.

Ephraim Karpel was an experienced, veteran Wall Street trader when he was approached by the FBI.  From the NYTimes:

“I’ve got the trade for the month of January for you,” Mr. Karpel said, according to a transcript of the call. “It’s coming from a banker.”

On the call, recorded on Dec. 31, 2007, Mr. Karpel told Mr. Goffer that the drugstore chain Walgreens had made an offer to acquire Matria Healthcare.

Ephraim Karpel was later compelled to wiretap relationships he had in the investment management business to advance the DoJ’s investigations into insider trading.  Notably, he was never charged nor plead guilty.  In 2011, when news of his involvement became public, he hung himself in his office.

Karpel’s suicide, along with a number of others, including James Fan and Sanjay Valvani are directly linked to the aftermath of the government’s insider trading investigation.

The exact facts of the government’s case in each of the suicides are unclear.  But what we do know of the DoJ’s tactics in the Karpel case are disturbing:

• The Walgreens-Matria deal that Ephraim Karpel alluded to never happened. In fact, Matria was later acquired by Inverness Medical, and when the transaction was publicly announced, Matria’s shares closed lower on the day.  This is very important, especially as it relates to Dirks and Justice Ruth Bader Ginsburg’s equation that the gift of inside information is no different than the gift of cold, hard cash:
  • There is always risk. At first glance, Karpel’s ‘tip’ carries the appearance of certain, material, nonpublic information. And yet, it did not transpire and had you traded on it, you would have lost money.  The ‘gift of inside information’ is not the equivalent of trading on the information and giving the gift of cold, hard cash.
  • Karpel’s gift of information cost him nothing, whereas trading on the information himself to create profits with which to pay the tipee costs him something.  And Karpel’s tippee, Zvi Goffer, at least at face value, does not know through how many intermediaries Karpel’s information passed through, how credible Karpel and those intermediaries have been, etc.  Had Karpel intended to repay a debt owed to Goffer through the ‘gift of inside information’, and instead chose to trade on the information himself and repay the debt with cash – he would not have generated any profits and in fact would have lost money on the trade.  But conveying a tip – this cost Karpel nothing.
• It’s not clear that Karpel ever did anything wrong*, and that instead the FBI coerced cooperation through threats and subterfuge. Again, he was never charged nor plead guilty (under seal or otherwise).  To be clear: this did not just destroy Karpel’s life, it led to his suicide.  It would be akin, for example, to coercing cooperation or a guilty plea by threatening to expose a trader’s marital infidelities, or his sexual orientation.  Karpel may (like many others) have just been confused as to what insider trading was and felt guilty that he was playing in a gray area.  The same might have applied to his defense attorney (assuming he had one).  But the DoJ ought to be held to a higher standard.  The next post will explore this further – whether the DoJ has actually been applying the law as they stated to SCOTUS or whether they’ve been exploiting misunderstanding of the law to coerce guilty pleas.  In Karpel’s case, it certainly looks like exploitation, and unfortunately, it seems the primary factor in his suicide.

 

* Specifically, it is not clear that Ephraim Karpel was aware that the tip was generated from an insider (yes, a banker, but a banker connected to Walgreens and Matria), in exchange for a personal benefit in breach of a fiduciary duty. Given Matria’s shares closed lower upon actual announcement, there is a weak argument against materiality, as well.

6. Why the Supreme Court must reign in insider trading law (but probably won’t)

[Note: This post won’t make much sense unless you’ve read this one first and then this second.]

33 years ago, Supreme Court Justice Lewis Powell inked Dirks, which created insider trading tippee liability, in a way to try to circumscribe insider trading within Rule 10b-5 of the Securities Exchange Act of 1934 prohibiting the use of any “device, scheme, or artifice to defraud… in connection with” a securities transaction.

Justice Powell did so with great intent to narrowly define insider trading.  “In Justice Powell’s view, a breach of a duty of confidentiality was insufficient to allege an insider trading violation; breach required exploitation of information.”  It is, ultimately, a metaphysical question as to why we share information and the nature of the personal benefit we receive for doing so.  The line of demarcation, as Justice Powell intended, was to demonstrate clear, bad faith reasons for doing so – to prove an “exploitation of information” commensurate with financial gain, or intent to give a valuable gift (akin to cold, hard cash).

In 1983, Wall Street played a far smaller role in the economy than today.  For example, in 1981, 14.4% of the population owned shares either directly or through a mutual fund.  In 2014, that figure was 54% percent.  I believe robust, rigorous thinking regarding how information is transmitted through the market and into securities prices just hadn’t developed yet.  Our collective understanding was sophomoric.

Only in later years were insider trading prosecutions found to become a highly effective tool for the personal careers of the prosecutor (beginning with Rudy Giuliani).  But because prosecutions were few and far between, rigorous examination of the legal precepts underlying those prosecutions were never thoroughly examined.  The prosecutor, be it the DoJ or SEC, was able to convince juries and the broader public that the insider trading violation was about fairness in the equality of information.  It was easy to point to a privileged Wall Street person and say “he traded on something he knew that others did not.  That’s wrong!”  Most judges acquiesced to this definition.

And Congress has largely been content to leave insider trading a judge-made law.  Again, Justice Kagan expounds on this in the oral arguments for US v Salman:

JUSTICE KAGAN: Ms. Shapiro, here is not a question of expanding [insider trading law] further. You’re asking us to cut back significantly from something that we said several decades ago [in Dirks], something that Congress has shown no indication that it’s unhappy with, and in a context in which, I mean, obviously the integrity of the markets are a very important thing for this country. And you’re asking us essentially to change the rules in a way that threatens that integrity.

Justice Kagan confuses that Congressional reluctance to legislatively define insider trading is not the same as Congressional approval of the existing interpretation of insider trading laws.  I’d suggest that Congress has refused to define insider trading because

• Congress itself has been immune from insider trading laws.
• Defining insider trading would be an elective legislative task that would inevitably result in political re-election risk.  (Imagine political ads claiming a sitting legislator was “soft on Wall Street crime”.)

Insider trading legislation is a political minefield, a Pandora’s box most would rather not open.  I, as a Congressperson, could take deep objection to the current state of insider trading law.  But it would be political suicide to make it part of my agenda to fix or clarify.  Don’t confuse reluctance to address an problematic law with approval of how that law is currently being applied.

This is a legislative ‘dead zone’ similar to political bribery, an area politicians would soon enough leave alone.  From the Atlantic: “The silence from politicians is telling, if understandable. Like [former Virginia Governor] McDonnell, many of those who have been accused of bribery or corruption attack overzealous prosecutors for “criminalizing” the normal give-and-take of politics.”

Salman is a terrible vehicle to examine and challenge the myriad of issues in insider trading law, from its inconsistency across different markets to the lack of clarity in differentiating an exploitation of information from a breach of duty of confidentiality.  But, unfortunately, it is the only vehicle we have.  The Supreme Court has only heard four insider trading cases since 1980.  It’s now or never.

Should the Supreme Court effectively reiterate Dirks’ “intent to benefit a trading relative or friend is sufficient to establish the breach of fiduciary duty element of insider trading,” they will have made little progress in clarifying what academics and practicioners widely view to be an inconsistent, vague law that is open to prosecutorial misinterpretation and abuse.

I don’t have the answers.  But a more natural path might be to limit insider trading law to violations that explicitly demonstrate an “exploitation of information” by proving the intent in sharing information is to give a financial gift to the recipient.

The result might then be a temporary outrage expressed in media that the Supreme Court has ‘legalized insider trading’, followed by a potential public outcry to force a rigorous debate in Congress over what constitutes insider trading (and with it, why Congress itself has effectively exempted itself from rules applying to others).

I doubt this will happen.  For one, a majority of the Court is itself too invested in the confusing logic of insider trading they themselves have contributed to, notably Justices Ginsberg, Breyer and Kennedy, who constituted part of the majority opinion in US v O’Hagan.  To acknowledge the inconsistencies in insider trading law I’ve attempted to point out would be to explicitly acknowledge their decision in O’Hagan was partially flawed.

I fear, it is an ask too far to expect a Supreme Court Justice to admit error.

5. SEC v Stefes and Griffiths (2010)

This is a case where two employees of a railroad – a mechanical engineer and a trainman – began to notice “there were an unusual number of daytime tours of [the railroad yard] involving a tour bus and people dressed in business attire”.  They suspected their company was for sale and purchased stock, as did four family members.  Six defendants total.

This particular case was egregious enough to draw criticism from the NYTimes, but other publications mustered courage to question the SEC prerogative only in hindsight after the defendants were cleared by a jury.  [Cynically, I’d argue the media ‘permits itself’ to criticize the DoJ & SEC only after a trial loss or successful appeal. Don’t bite the hand that feeds!]

What is very notable here is that two of the defendants, Gary Griffiths and Robert Steffes, settled with the SEC before trial and paid cumulative fines and disgorgement of $240,000.  This settlement was not disqualified by the SEC’s trial loss against the remaining four defendants who chose not to settle.

This is a perfect example of the confusion of insider trading laws.  Of six defendants charged, two, in essence, chose to settle and four went to trial, highlighting

• That a split between defendants in a civil trial with no risk of incarceration highlights the general confusion regarding what insider trading actually is, and
• That the settlements were not automatically overturned by the courts and/or voluntarily returned by the SEC again highlights an institutional acceptance of this vagueness.  It is akin to acceptance of a false guilty plea that is proven so at trial.