Charles W. Murdock
Volume 70, Issue 6, 1547-1612
In large part due to two poorly reasoned decisions by Justice Powell in the early 1980s, Chiarella v. U. S. and Dirks v. SEC, the development of insider trading law has been constrained, enforcement has been hampered, and insider-trading has grown to the point where hundreds of millions of dollars are at stake. Moreover, Chiarella and Dirkswere inconsistent with the Congressional policy that the purpose of the securities laws is to ensure a level playing field where one participant does not have an undue advantage over another participant.
A Second Circuit decision, U.S. v. Newman unnecessarily extended Dirks, notwithstanding Congress’s caution to constrain the Dirks decision to its unique set of facts. Newman reversed the conviction of hedge fund portfolio managers who made millions of dollars by trading on inside information on the basis that they did not know the benefit that the tippers who provided that information had received in connection with their tips. Newman further cast doubt on whether a benefit can be relational, rather than pecuniary.
Recent insider trading prosecutions reflect the fact that insider trading today is big business. Hedge funds are under intense pressure to get an “edge” to enhance their returns, even if it means resorting to a “black edge.” As Sheelah Kolhatkar, the author of Black Edge, a three-year study of the skulduggery that inheres in much of the hedge fund industry, noted the basic problem with Newman “is that it completely misunderstood the way the world actually works.” For the Newman court, defendants’ lack of culpability stemmed from the fact that “Newman and Chiasson were several steps removed from the corporate insiders and there was no evidence that either was aware of the source of the inside information.”
The Newman court failed to realize that this is the way the game is played. The portfolio manager orders trades, which make millions for the organization and indirectly for the analysts and others who feed information to the portfolio manager. All of these people are aware of the risks of insider trading and, when a dark edge is employed, want to obfuscate insider trading as much as possible. The key for the portfolio manager is to inform the analysts that he wants the best possible information, but does not want to know how they get it.
Shortly after Newman, the Supreme Court decided Salman v. U.S., which involved a fairly pedestrian situation in which one family member tipped another. However, the Supreme Court declined to adopt the requirement in Newman that there must be something of a “pecuniary or valuable nature” in a gift to family or friends in order for the gift rationale in insider trading to apply.
Salman was then followed by U.S. v. Martoma, where SAC Capital Advisors realized $80.3 million in gains and avoided $194.6 million in losses by obtaining advance notice that the Alzheimer study was flawed. The portfolio manager who obtained the information from a participant in the study received a $9 million bonus. Martoma, in first analyzing Salman, opined that Salman in effect also rejected Newman’s requirement of a “meaningfully close personal relationship” in order to use the gift approach. The Martoma court later amended its opinion and looked at the basis for requiring a “meaningfully close personal relationship,” namely, that there must be evidence of “a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the latter.”
This Article provides an extensive analysis of the history of insider trading, and the policies underlying the law, and demonstrates that the pre-Chiarella/Dirkslaw was much more consistent with the Congressional policy of a level playing field. Hopefully, Salman and Martoma reflect a more realistic approach to the law of insider trading. It is critical for courts to understand the pressures to receive illegal information, the chain through which it travels, where it must end in order to be operational, and the devices employed to disguise the illegal sources that are often used. Courts also need to understand that much of the world operates on networking and relationships, and that people are motivated by factors other than immediate pecuniary gain.