OSEC Policy Paper: Insider Trading Gets a Free Pass – The Relaxation of Liability Under U.S. v. Newman

U.S. v Newman, a recent decision by the Second Circuit Court of Appeals, is a deeply troubling dilution of insider trading law.  The attached policy paper explains OSEC’s position on the case in further detail.  The following is an executive summary of the paper:

A Brief History

Newman involved two hedge fund managers who were originally tried and convicted for their roles in an insider-trading scheme involving the trading of Dell and NVIDIA securities based on significant nonpublic information.  The managers appealed their conviction and the decision was overturned. Occupy the SEC firmly believes that the Court of Appeals has made a grave error in overturning its Newman decision.

Insider trading is considered the buying or selling of a security by an individual who has access to material nonpublic information about the security. Insider trading can be illegal or legal, but is only illegal when the material information forming the basis for a trade is still nonpublic. Thus, illegal insider trading can include tipping others when one has any kind of nonpublic information.

Current insider trading law was established under the Securities Act of 1934 (“Act”).  The Act was created to provide governance of securities transactions, and to control exchanges and broker dealers in order to protect the public. Sections of the Act are devoted to combating fraudulent or deceptive activity that would harm the general public.

Current Relevance

Numerous entities were engaged in insider trading activities during the financial crisis of 2008, notably banks and other financial institutions. Bankers traded on their own stocks because they foresaw the underperformance of their own institutions that contributed partially to the housing market’s burst bubble and ultimately broke the public’s trust. While a corporation’s officers and other insiders are meant to act in the shareholder’s best interests, many such individuals violated that trusting relationship by engaging in insider trading.  Profiting from non-public information (at the expense of individual investors) indicates the lack of a fair or equitable market and severely damages the operation of thriving capital markets.

The Real Effect of U.S. v Newman

Newman adopted an extremely narrow interpretation of the “knowledge” requirement applicable to insider trading cases.  Under this standard, professionals will be able to easily evade liability despite their participation in insider trading schemes.  Professionals will be able to either go to great lengths in order to remain blind to any information of personal benefit or flat out deny any knowledge of these benefits in order to get off scot-free. Supporters of the Newman decision claim it clarified a previously ambiguous understanding of insider trading regulation. However, despite claims that they are overbroad, the pre-Newman interpretations of insider trading law are the most effective when it comes to policing insider-trading activity because those decisions held professionals involved in insider-trading schemes accountable for their actions. The Newman decision loses sight of an important policy consideration: that it is unfair to grant those with greater access to information an advantage over those who are not business experts. The Newman decision will indisputably have an adverse impact on future insider-trading rulings.

Solutions

In order to reverse the Newman’s unquestionably adverse impact on insider trading liability, overturning the decision completely would be the best and most important thing to be done in solving this problem. Furthermore, the judiciary should adopt an enterprise liability standard, whereby constructive knowledge (and not just actual knowledge) if sufficient to meet the knowledge requirement under insider trading law.  Finally, in order to ensure that such an unsound decision does not occur again, Congress must intervene and execute legislation that clarifies any ambiguities in insider trading law.

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