Influential U.S. judge calls on Congress to define insider trading

April 7, 2015

(Reuters) – On Monday, U.S. District Judge Jed Rakoff of Manhattan got up onto his well-worn soapbox to suggest that if Congress wants to protect U.S. markets from inside traders, lawmakers ought to specify when it is illegal to trade on confidential information.

Rakoff – a judicial celebrity known for demanding more transparency from the Securities and Exchange Commission and for asking whether the Justice Department has let corporate criminals off the hook – issued an opinion permitting the SEC to move forward with its civil case against two stockbrokers, Daryl Payton and Benjamin Durant, accused of illegal trading in advance of a 2009 IBM deal. As my Reuters colleague Nate Raymond wrote Monday, federal prosecutors in Manhattan dropped criminal charges against the two men after the 2nd U.S. Circuit Court of Appeals issued its decision last December in U.S. v. Newman, which made it harder to bring a criminal case against defendants who received second- or third-hand tips. Rakoff found the SEC met the looser standards for civil cases.

The judge also said, however, that when courts are forced to develop insider trading law on a case-by-case basis, “difficulties” ensue. If defendants are facing prison, judges are obliged to define insider trading narrowly, he said, yet in SEC cases, judges give more leeway because it’s important to deter cheaters. “The tensions thereby created cannot always be resolved in satisfactory fashion – thus reinforcing the need for Congressional action,” Rakoff wrote.

The judge is not alone in that sentiment. As he said at the beginning of Monday’s opinion, there is nothing complicated about the idea that securities markets should be fair to all investors. But there is no specific prohibition against trading on insider information in U.S. securities laws. The SEC, federal prosecutors and courts have inferred the boundaries of illegal trading from anti-fraud provisions.

The problem is that without statutory language to define the crime of insider trading or to distinguish between criminal and civil violations, judges don’t always agree with the SEC and prosecutors (or, for that matter, with one another). Look, for example, at the 2nd Circuit’s Newman decision, widely considered the most important insider trading opinion in recent years. The three judges on the 2nd Circuit panel said that the office of Manhattan U.S. Attorney Preet Bharara had stretched the boundaries of the crime too far. Prosecutors resorted to “doctrinal novelty,” the 2nd Circuit said, to bring cases targeting traders far removed from tipsters.

By refusing last week to review the panel’s decision — despite prosecutors’ claims that the ruling would “dramatically limit the government’s ability to prosecute some of the most common, culpable and market-threatening forms of insider trading” – the entire 2nd Circuit showed that it is not willing to permit prosecutors unilaterally to reshape the law.

Two justices of the U.S. Supreme Court, meanwhile, are uneasy about deferring to the SEC to define criminal insider trading. Last November, Justices Antonin Scalia and Clarence Thomas said in an unusual statement accompanying the court’s order list that it is up to Congress, not executive branch agencies, to decide what constitutes a federal crime. The Supreme Court decided not to review the case that prompted the statement by Scalia and Thomas, hedge fund executive Douglas Whitman’s appeal of his 2012 insider trading conviction, and has since declined to hear another appeal that raised questions about the SEC’s authority to define insider trading. Nevertheless, the statement by Scalia and Thomas, like the 2nd Circuit’s Newman decision and Rakoff’s opinion Monday, reflects dissatisfaction with the statutory vacuum at the core of insider trading prosecution.

There is actually a tiny bit of momentum behind a law banning insider trading. Since the 2nd Circuit’s Newman decision, two bills have been introduced in the House, one by Massachusetts Democrat Stephen Lynch and another by Connecticut Democrat Jim Himes and several co-sponsors. Two Senate Democrats, Bob Menendez of New Jersey and Jack Reed of Rhode Island, introduced similar proposed legislation last month.

A bill is a long way from a law (thank you, Schoolhouse Rock), and Rakoff, for one, seems skeptical that Congress intends to legislate a definition of insider trading. SEC Chair Mary Jo White has said that she cannot comment on specific proposals but told a House oversight committee that it will be difficult to draft an insider trading law. “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 last month.

The odds are certainly against Congressional action on insider trading. But if judges and enforcers continue to disagree about the boundaries, lawmakers may have to do something about it.

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