The Rothschild legend’s legacy on insider trading

The convictions of two former hedge fund managers on insider trading charges were unanimously dismissed last month by the three-judge panel of the influential Second Circuit U.S. Court of Appeals. The ruling makes the charge tougher to prove, and illustrates why Congress needs to provide a clear definition of insider trading.

The court held that two Wall Street traders could not be convicted of insider trading by merely possessing and trading on privileged information leaked by corporate insiders and passed along to them through several levels of intermediaries. Instead, it found that the traders must have known the source of the inside information and that the person who provided material, nonpublic information must personally benefit from the leak.

This tougher standard puts pressure on the Securities and Exchange Commission (SEC) to better define what actually constitutes insider trading. Both the SEC and the Department of Justice prefer a broad rule against insider trading because they believe that it seriously erodes the public’s confidence in financial and capital markets, thereby reducing liquidity and investment.

The Second Circuit ruling marks a significant setback to U.S. Attorney for the Southern District of New York Preet Bharara, whose office patrols Wall Street. Until now, Bhahara had a near-perfect track record, gaining convictions or guilty pleas from about 90 people for insider trading since he became U.S. attorney in 2009.

SEC chairwoman Mary Jo White predictably complained that the ruling was “overly narrow.” Bharara said he fears it “interprets the securities laws in a way that will limit the ability to prosecute people who trade on leaked inside information.” A key objective of the aggressive prosecutions was to leverage the ambiguity of what constitutes insider trading to deter illegal behavior, especially on Wall Street.

In the United States, insider trading is one of the most common offenses that usually falls under the general purview of securities fraud. Most insider trading cases are covered by Rule 1Ob-5 of the Securities Act of 1934, which prohibits fraudulent or manipulative conduct in connection with the purchase or sale of securities. While it is regarded as a serious crime, no statute specifically defines it.

The ultimate insider trade was when Nathan Rothschild learned that Napoleon had been defeated at the Battle of Waterloo in 1815 a full day before anyone else, allegedly thanks to carrier pigeons that made their way across the English Channel to London. This advance knowledge enabled him to make a killing by buying up the British bond market before the news of the British victory was more widely known.

The Rothschild legend identifies the value of inside information when it is applied to securities trading. For years, judges, prosecutors and the SEC have worked to expand what constitutes insider trading, yet there is little agreement as to exactly when trading on material nonpublic information should be prohibited. This lack of clear guidance on the parameters of the prohibition creates immense difficulties for prosecutors.

So an ever-changing cast of prosecutors, judges and SEC officials have interpreted the general law against “securities fraud” differently as it applies to insider trading, struggling to measure what conduct constitutes improper trading on material non-public information with the precision of a crystal meth cook.

Since insider trading is a crime punishable by harsh penalties, Congress needs to define it, perhaps by prohibiting any trading on material nonpublic information. It should be made clear that those possessing inside information must either make it public or forego trading. The Second Circuit’s recent ruling makes it clear that such an approach would be preferable to the current murky, fuzzy rules.

Until Congress unambiguously defines insider trading, we will continue to rely on the ability of present­ day Solomons to make the most delicate of judgments about what constitutes improper trading on material nonpublic information. 

originally published: January 10, 2015