By Pam Martens: December 15, 2014
Today we welcome former SEC attorney, James A. Kidney, as a guest columnist to our front page. Mr. Kidney brings 25 years of SEC experience and wisdom to the conversation. Here’s the backdrop:
The U.S. Department of Justice has been burning through millions of dollars of taxpayer money chasing down suspected insider traders who are four and five times removed from the person leaking inside information; convening grand juries to indict the traders; convincing trial courts to send them off to prison. The Securities and Exchange Commission has gone after the same individuals, banning them for life from the industry. That’s the same DOJ and SEC that have failed to bring charges against one CEO of a major Wall Street firm for the crash of 2008 — the greatest and most corrupt financial collapse since the Great Depression.
Last week, in a wide-reaching decision, the U.S. Court of Appeals for the Second Circuit, in United States of America v Todd Newman, Anthony Chiasson effectively advised Americans that the Department of Justice has grossly misapplied insider trading laws. And since the SEC has targeted the same individuals using the same legal principle, the decision means the SEC also doesn’t understand the laws it is supposed to be carrying out.
In a nutshell, the Court found that to be guilty of a crime the person trading on inside information has to have knowledge that the inside tipster breached a duty of trust to the corporation in exchange for a personal benefit. That knowledge was missing in many of these traders who were four and five times removed from the tipster. In fact, the court found that there may not have even been a tangible personal benefit to the tipster.
In simple terms, if a corporate insider gives material non-public information to a trader in exchange for cash or something of value, and the same trader then trades on that information, that’s a classic case of insider trading. But when the traders have no knowledge of any personal benefit given to the tipster, there is no insider trading crime.
Whether this is good law or bad can be debated. For example, corporate insiders might leak information for no current personal benefit on the hope or expectation that in the future they’ll be rewarded with a plum job and fat compensation at the trader’s firm. (That form of quid pro quo is a staple on Wall Street.)
The message the Appeals Court might have been subtly sending to the DOJ and SEC is to stop casting their wide net at people four times removed from a crime scene and go after the real criminals on Wall Street whose past and current actions pose a real and pressing danger to the entire financial system.
We turn the discussion over to James A. Kidney, who caused quite a stir earlier this year in a speech at his retirement party criticizing SEC management for policing “the broken windows on the street level” while ignoring the “penthouse floors”.
Finding the Courage to Go After the Big Fish
By James A. Kidney: December 15, 2014
Most of the highlights of my 25-year career as a trial attorney at the Securities and Exchange Commission involve the half dozen or more insider trading cases I tried before juries. I was lead counsel in the very first jury trial the SEC ever brought – an insider trading case in Seattle in 1989. I prevailed on behalf of the SEC in every one of my insider trading trials.
I wish I could say these victories achieved something important for securities enforcement. I doubt that they did. Those cases tried against other than true corporate insiders were largely a waste of government (and my) time. As were the far more numerous such cases which settled without trial, sometimes for substantial sums by any standard, and sometimes by such small sums they were substantial only to the middle class sap who acted on a stock tip and had the misfortune to be persecuted by the SEC.
Investigating and litigating insider trading cases are probably the most fun the SEC Enforcement staff has as it muddles around the oft-amended, often confusing statutes and rules embedded in 70 year old basic securities laws that are long past their sell-by date. Of all the common securities law claims brought by the SEC as civil cases (and, sometimes, by the Department of Justice as civil or criminal matters), insider trading requires investigations that are the most like Sam Spade detective work as seen on film and television. Insider trading is often like finding out who killed Colonel Mustard in the library with a candlestick. I know I enjoyed them, even as I doubted their utility.
The investigation team at the SEC (and the U.S. attorneys’ offices) first have to figure out if information was leaked from a corporate source. Maybe the trading on good or bad news was a corporate source using a beard, such as a friend or neighbor. Maybe the corporate source was getting paid, in cash, favors, future employment, or some other benefit, for passing on material nonpublic information to a stock trader. It is fun trying to track down the inside source, usually working backwards from someone who made a timely purchase or sale in advance of good or bad corporate news. Finding the key telephone call or other communication and then springing the evidence on the defendant in a deposition or courtroom is a thrill rare in the annals of securities litigation. A little like Perry Mason, if I may date myself.
In addition to working backwards to the source, the staff usually will also work forward, finding persons who traded at several levels removed from the insider. I have tried cases, and prevailed in front of juries, in which the defendant was several levels removed from the insider. In my most extreme case, the defendant was five levels removed from the original source of the information. The source was supposedly the brother of a guy who worked for the company and received information from his brother. The brother called his broker – but didn’t trade himself when the broker told him doing so would be illegal. But the broker couldn’t keep his mouth shut and told some of his customers, who told their friends, who told their friends. The SEC sued about a dozen people in this chain (but not the original insider). All but the fifth level guy settled. We tried the case against him, a high school dropout who operated a scaffolding company and who was his own lawyer. After a four-day trial in front of a senior federal judge, the SEC prevailed with the jury. Whooo Hoo! Markets saved.
In my view, as a recently retired SEC trial lawyer, the Commission spends far too many resources on pursuing low level “insider traders” who are far removed from the corporate suite. Most of these cases have zero impact on market prices or practices. So-called “remote tippee” cases employ legal fictions that are fuzzy at best and often outright unfair and unrealistic. Insider trading cases rely on “legal fictions” of transferred duties from the insider to one tippee, to another tippee, to a third tippee, who might have been tipped on the golf course by a friend who vaguely says he got it from a guy who knew a guy at the subject public company. These actions put the emphasis on “fiction” in legal fiction.
Such cases are not by any means the only waste of enforcement resources. The Commission staff typically spends much time near the end of the fiscal year (September 30) boosting its enforcement numbers with window dressing cases, such as administrative follow-ons to criminal convictions, some years old, filing actions to deregister defunct corporations and bringing minor administrative actions against corporate officers who fail to report stock transactions as required by law. The press and Congress, as well as the Commissioners themselves, want the enforcement numbers pumped up. And the press uncritically considers the raw enforcement numbers a measure of the success or failure of the Division of Enforcement. No matter if large numbers of cases are the equivalent of jaywalking tickets while banks are being robbed (or, rather, doing the robbing). The numbers are up! Again, Whooo Hoo!
This practice is defended by the current SEC chair and the current director of the Division of Enforcement as the “broken windows” theory of “law enforcement,” as if big Wall Street firms gave a dam whether a smalltime Joe got nailed by the Big Bad SEC. As is well-known, much of the SEC docket is devoted to enforcement against such small timers.
“Broken windows” might be tolerable, if the SEC staff did not also shy away from the big picture windows on the upper floors of Wall Street. I know from personal experience at the SEC that the Division of Enforcement has been loath to bring perfectly colorable fraud actions against more senior insiders at the big banks that brought us the 2008 financial crisis and their large customers. Division of Enforcement senior management, presumably at the behest of the chairman at the time, actually had a virtual template for the SEC staying its hand in other cases involving other large Wall Street institutions – grab a big fine from the institution and sue a very small fry. After all, a firm like Goldman Sachs will let a junior vice president peddle a billion dollar product with no supervision, right?
I often pictured some banking fat cat reading a headline about the SEC or DOJ nailing some “broken windows” defendant and thinking, “Keep it up. Leave me alone.”
All of which brings us to the good news about last week’s decision by a panel of the U.S. Court of Appeals for the Second Circuit in U.S. v. Newman. In that criminal case brought by the Office of the U.S. Attorney for the Southern District of New York, the court unanimously held that the prosecutor must prove that remote tippees knew that the original insider who provided material nonpublic information did so in return for a personal benefit. This was a straightforward reading of a 30-year-old Supreme Court decision which the SEC and the Justice Department over the years had turned into a practical nullity in remote tippee cases such as Newman.
The press reaction has been all about how damaging this decision will be to insider trading enforcement. Yes, it will serve as a major deterrent to bringing enforcement actions, civil or criminal, against remote tippees who had no personal contact with the corporate insider and often do not even know his or her name or corporate position. Until now, as a practical matter, the prosecution had only to persuade a jury that a remote tippee defendant had sufficient facts to know, or, in an SEC civil case, was reckless in not knowing, that the information on which the defendant traded likely came from an insider corporate source, that it was material and that at the time the defendant made the trade it was still nonpublic. In other words, that the defendant knew he was acting on what he thought was a “hot stock tip.”
Of course, the defendants in U.S. v. Newman were not small fry. They were traders employed by crème de la crème hedge funds, which is why the reversal and dismissal of their criminal convictions and long white collar prison sentences causes such consternation. But acting on a hot tip, even knowing that it probably came from a corporate insider (and thus was more reliable than mere gossip) stretches notions of securities fraud far beyond safe boundaries for society. The rules of proper behavior are too ill-defined when information is received far from its source, even if the defendants or their employers are among the One Percent, as in Newman. Most important, remote tippee insider trading does little economic damage to the markets — certainly far less damage than the billion dollar deals put together by Wall Street and sold as relatively safe when they are in fact built on soft mud – but it’s an easy win and fun to work on, at least at the SEC.
I don’t go along with those who say insider trading should be legal because it adds information to the market through trading. I am very skeptical of the whole efficient markets theory, and there are concrete reasons to bar insiders from benefitting from corporate information. Insiders are paid a salary and often bonuses – sometimes quite large – and should not be taking advantage of their position for additional personal gain, especially at the expense of shareholders lacking the inside information and, therefore, willing to trade their shares. Nor should they be permitted to advantage their friends and relations by tipping them to inside information as a gift. The court’s decision in U.S. v. Newman does not change the existing law in this regard.
The really good news about U.S. v. Newman, should it not be reversed on appeal or circumvented by clever SEC and DOJ lawyers, is that all those resources spent in going after remote tippee defendants such as those I made a career of prosecuting (at the direction of my bosses) can now be used to ferret out conduct far more damaging to the markets and, sometimes, the economy. That is, if the aforementioned SEC and DOJ ever find the courage to do so.