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
James A. Kidney, Former SEC Trial Attorney
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.
