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

Dancing on the edge of absurdity

There can be little doubt that one of the causes of the 2008 financial crisis was diminished regulatory control , the seeds of which were sown during the three preceding decades.

Recent legislation re-regulates financial markets, but attracting the best and brightest to regulatory jobs is proving to be a major challenge. The congressionally authorized Financial Industry Regulatory Authority, a not-for-profit self-regulator,,  may offer a solution to the problem.

Beginning with the Carter administration and accelerating during Reagan’s presidency, the banking industry,  among others, was steadily deregulated. Not only were leveraging requirements continually lowered but watchdog organizations such as the Securities and Exchange Commission were weakened both by legislation and the appointment of free-market advocates.

Successive administrations were enthusiastic advocates of deregulation. The dominant economic paradigm was that markets are efficient and inherently maximize welfare and work best when managed least. Moreover, with free-market advocates in charge of regulatory agencies such as the SEC, many existing laws were ignored or rarely enforced.

For example, observers repeatedly warned the Securities and Exchange Commission about suspected irregularities at Bernard Madoff’s investment firm, which was later revealed to be a multi-billion dollar Ponzi scheme. In spite of several warnings, no serious investigation was undertaken until after the firm’s spectacular collapse.

One reason offered for poor financial regulation is that government agencies are seriously disadvantaged when it comes to attracting the best and the brightest. The salaries of elected officials tend to impose an artificial ceiling on how much public employees can be paid. Even though these ceilings ignore marketplace realities, elected officials are reluctant to raise them by advocating higher salaries for themselves because it looks bad to voters.

Consequently,   Americans are told that many government regulatory agencies lack the talent to regulate financial markets because they can’t pay the going rate for good people. Thus, the regulatory agencies best and the brightest flock to higher-paying jobs with firms they regulate. This leaves the public to complain that our regulatory agencies are less effective than they need to be.

But not all regulators are underpaid. According to the Bond Buyer ‘s annual salary survey of 21 industry regulatory groups, compensation for the chairman and CEO of Financial Industry Regulatory Authority , which oversees the 4,100 securities firms and over 636,000 stockbrokers in the United States, was $2.63 million in 2013.

The perks aren’t bad either, he receives $20,000 annually for admission fees, dues, and house charges to one club each in the Big Apple and Washington, and up to $20,000 annually for personal finance and tax counseling, as well as spousal travel for certain business-related events. Financial Industry Regulatory Authority also paid four of its top executives more than $1 million in 2013. These folks can spend more for one dinner than the average American -whose wages have been flat for decades – spends on a vacation.

Let’s put these salaries in perspective: The President earns $400,000 annually. Janet Yellen, the chair of the Federal Reserve who has sway over the entire world economy as opposed to just American stockbrokers, earns $201,700. Securities and Exchange Commission Chair Mary Jo White makes $165,300. White’s predecessor at the SEC, Mary Shapiro, was fresh from running Financial Industry Regulatory Authority, which gave her a $9 million severance to ease the pain of a low government salary.

These are clearly difficult times for national financial regulators. They are challenged with implementing hideously complicated Dodd-Frank legislation that is supposed to safeguard and stabilize the financial system to avoid another financial crisis.

At 2,319 pages, the Dodd-Frank Act is the most far-reaching financial regulatory undertaking since the 1930s, requiring regulatory agencies that had been withering to enact 447 rules and complete 63 reports and 59 studies within tight congressional deadlines.

It may be at the edge of absurdity, but just maybe the best way to attract the best and the brightest would be to expand the number of one-percenters by outsourcing all regulation to not-for-profit entities such as Financial Industry Regulatory Authority.

originally published: October 25, 2014