Research Versus Cheating: Insider Trading and the High Court

By Tanner Bowen

Tanner Bowen is a junior at the University of Pennsylvania studying business.

In popular culture, insider trading is a very prevalent topic with which we are all familiar. We’ve all seen movies or TV shows where a character is accused of insider trading, or you’ve used it as a punchline to a joke about your friend going to business school. The ironic fact of this all is that even though insider trading seems to be clear-cut in the minds of Americans, it is still a legally murky area.  

Going back to the Securities and Exchange Act of 1934, it made sense to put prohibitions against fraudulent and deceptive trading practices after the Great Depression. In fact, capital markets work best whenever they are built upon the principles of trust and transparency. That is why Section 10(b) of the Exchange Act put in a rule (Rule 10b5-1) which outlawed the use of “any manipulative or deceptive device or contrivance” in trading securities. Okay –so far, still no mention of “insider trading.”

What resulted next was a long set of court cases that attempted to define when insider trading was illegal while keeping Rule 10b5-1 in mind.  In 1983, the Supreme Court concluded on a breach of duty test in Dirks v. SEC, which stated: “The test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders.” [1]

And so for a few decades, prosecutors used this “personal benefit” test to put traders and hedge fund managers behind bars. That was, until the Newman decision reinvigorated the debate. United States v. Newman put a limit on this “personal benefit” test. In fact, the old adage of the time was that disclosing some sort of confidential information to a friend or through some “casual or social nature” was enough for a conviction. However, the Second Circuit ruled that “in order to form the basis for a fraudulent breach, the personal benefit received in exchange for confidential information must be of some consequence.” [2] In layman’s terms, if you tip someone information in exchange for a vacation home or a large check, that’s illegal. But if you give someone information and you happen to get a slight warm-glow effect, that’s fine.

This all leads us to the current case before the Supreme Court: United States v. Salman. The Ninth Circuit upheld the conviction of Bassam Salman, a onetime Chicago grocery wholesaler.  The story essentially goes that Salman’s brother-in-law, Michael Kara, got insider information from his brother Maher Kara, an investment banker at Citigroup. In the light of Newman, there was no evidence that Maher got any monetary personal benefit from giving his brother information, aside from getting Michael off of his back in terms of asking for a “favor.”

Yet if we use intuition, we see how silly of a situation this is: to think that it’s okay to tell your brother information about an upcoming acquisition just because he’s been annoying you, and then your brother goes around and tells his brother-in-law, who proceeds to trade on this information.  Everyone can agree that that is cheating. But the issue that is more important in relation to Salman is that not every one of these cases is a straightforward good guy/bad guy scenario. In fact, over the last few years, there seems to have been an ambiguous line between doing research and benefiting from this research in the markets, as opposed to plain cheating.   

I don’t think anyone believes that cheating or insider trading should have no repercussions. But often times, the government will bring administrative proceedings against those individuals who have done research on a company and hope to trade off of that information (in other words, doing their job). The most common example of this issue would be prosecutors wanting to send a person to jail for talking to an investor-relations person at a company, or employing an analyst who was talking to other investment-relations people. This would defeat the purpose of people talking to their investors and investors subsequently talking to the company while also ignoring the fact that managers talk to their shareholders in private all the time. Absent a more perfect world where all private conversations were illegal between companies and investors and public information was considered research, considering the personal-benefit test could come in handy in this situation, however imperfect it might be.

But then again, the personal benefit test might not be extensive enough. Sure, exchanging information for a bribe seems to qualify for insider trading, but an insider-trading tip can be cheating even if there is no obvious quid pro quo. A CEO and hedge fund manager playing a round of golf might be good for market efficiency if the conversation is about improving the company, but if the CEO plays a round of golf with his brother and then tips his brother off in order to assist the brother in making money on a proposed merger, then there is no efficiency: it’s just cheating. [3]

However, the issue with all of this is that we’re making judgments about insider trading using intuition, or what seems right and wrong. After reading this article, you might still be confused about insider trading law - and that is because there is not much original legal precedence to insider trading. The courts have turned insider trading into a new-age version of Jacobellis v. Ohio, where you might not be able to describe perfectly what insider trading is, but you “know it when you see it.”

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[1]. Dirks v. SEC 463 U.S. 6646 (1983).
[2]. Jon Eisenberg, K & L Gates LLP. “How United States v. Newman Changes The Law.” The Harvard Law School Forum on Corporate Governance and Financial Regulation. May 3, 2015. Accessed October 14, 2016.
https://corpgov.law.harvard.edu/2015/05/03/how-united-states-v-newman-changes-the-law/
[3]. Levine, Matt. “Justices Will Know Insider trading When They See It.” Bloomberg.com. January 9, 2016. Accessed October 14, 2016.
https://www.bloomberg.com/view/articles/2016-01-19/justices-will-know-insider-trading-when-they-see-it


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