It is not often that the Supreme Court’s denial of certiorari represents a major legal development. It is significant, however, when that denial provides finality in a much-watched insider trading case certain to have reverberations in the years to come.
On October 5, 2015, the US Supreme Court denied certiorari in United States v. Newman.1 In doing so, the US Supreme Court rejected the government’s invitation to wade into the murky waters of insider trading law and left intact the US Court of Appeals for the Second Circuit’s decision below. The Second Circuit had held that that: (1) unlawful insider trading requires proof that the remote tippee of inside information knew he was trading on inside information that had been improperly disclosed in exchange for a personal benefit; and (2) a personal benefit can only be inferred from a personal relationship between tipper and tippee when there is evidence of a “meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”2
While the Supreme Court gave no explanation for its denial, the denial could represent an invitation from the Court for Congressional action, or could reflect the Court’s preference for resolving issues on which there is a significant split between the circuit courts (at most, there was a split between the Second and Ninth Circuits here). Whatever the Court’s reasoning, its denial means that any further development in insider trading law in the years ahead will likely be in Congress, the lower courts, SEC administrative law judge opinions, or in SEC opinions and rulemaking.
There has been longstanding debate about the scope of insider trading laws and whether Congressional action is needed to provide greater clarity. Currently, no statute or regulation expressly prohibits insider trading. Instead, prosecutors rely on a judicially-created framework that stems from the general fraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5.
The judiciary itself has criticized this lack of a specific insider trading law regime. Southern District of New York (SDNY) District Court Judge Jed Rakoff wrote in an opinion earlier this year that Congress is the “appropriate body” to “adequately define” insider trading.3 According to Judge Rakoff, the lack of Congressional action “has created difficulties” as courts can only shape the contours of insider trading law in response to the specific cases that come before them.4
In the wake of the Second Circuit’s decision, three bills were proposed in Congress to create a statutory scheme for insider trading. The bills have yet to be taken up by a committee.
First, Senators Jack Reed (D-RI) and Robert Menendez (D-NJ) proposed a bill that would prohibit the sale or purchase of a security based on material inside information.5 The bill would also prohibit “knowingly or recklessly” communicating material inside information when it is reasonably foreseeable that a person would trade on the information.
Second, Representative Stephen Lynch (D-MA) proposed a bill that would go a step further and prohibit the purchase or sale of a security based on information that the trader knew or should have known was material and insider information.6 The proposed factors for whether a trader should have known that they were trading on inside information are “financial sophistication, knowledge of and experience in financial matters, position in a company, and amount of assets under management.”7
Finally, Representative James Himes (D-CT) proposed a bill that would prohibit the sale or purchase of a security while in possession of insider information (or the communication of the information to the person who makes the purchase or sale) when the sale is reasonably foreseeable.8
While continued gridlock in Congress makes it unlikely that Congress will address this issue, action in this arena is not unprecedented. In 2012, Congress passed the STOCK Act, which prohibits insider trading by members of Congress and other government employees.9 And, with the 2016 Presidential election fast approaching, the regulation of the financial sector will continue to be a subject of considerable debate. For example, Presidential candidate Hillary Clinton recently proposed financial regulation reforms that would specifically include legislation clarifying: (1) that insider trading prosecutions do not require knowledge of a personal benefit; and (2) what “personal benefit” means.
The Lower Courts
In the absence of Congressional action, lower federal courts are likely to continue to grapple with insider trading law in the years ahead.
In the Second Circuit, another closely followed case – United States v. Steinberg10 – was stayed pending resolution of the government’s certiorari petition in Newman. With that petition denied, the Circuit will now hear the Steinberg case, which involves similar issues as Newman. And Second Circuit district courts have already heard, and will continue to hear, challenges to criminal prosecutions and SEC enforcement actions based on Newman.
In the Ninth Circuit, SDNY District Court Judge Rakoff authored an opinion while sitting by designation – United States v. Salman11 – criticizing the rigor of the Second Circuit’s personal benefit test to the extent that test can be read to require a tangible benefit to the tipper. It may take time before the remaining circuits have the opportunity to address Newman, as the New York courts have historically been the dominant forum for both the Department of Justice (DOJ) and SEC insider trading actions. Whether that will remain the case post-Newman is unclear. The DOJ and SEC could react to Newman by filing actions outside the Second Circuit to avoid Newman.
Finally, additional SEC rulemaking on this issue is also a possibility though it appears unlikely. It is more likely that the issue will continue to be developed through SEC administrative proceedings, which are ultimately reviewable by the federal courts.
Key enforcement authorities have voiced significant criticism of Newman. SEC Chairwoman Mary Jo White called the decision “overly narrow” and a cause for “concern”12 while SDNY US Attorney Preet Bharara said the decision would create “a potential bonanza for friends and family of rich people with access to material non-public information.”13
Notwithstanding this criticism, there have been no rumblings from the SEC concerning any steps it would take to independently address the Newman decision through rulemaking. This is so even in the face of a letter from Senators Jack Reed (D-RI) and Mike Rounds (R-SD) pointedly asking Chairwoman White whether the SEC had any such plans.14 In light of this, and the fact that the SEC has generally been content to allow insider trading law to develop primarily through the courts, it appears unlikely presently that the SEC will propose additional rules specifically focused on insider trading or to address Newman.
In contrast, the Newman decision is already making an impact in SEC administrative proceedings. On September 14, 2015, an SEC administrative law judge expressly relied on Newman to conclude that the SEC had failed to demonstrate that the tipper had received a personal benefit.15 On October 5, 2015, the SEC filed a petition for review of that decision.16 If the SEC ultimately rules inconsistently with Newman, it could tee up the issue of whether that decision, as the product of an executive agency, is entitled to any deference by the courts. Justice Scalia recently raised this very question in denying certiorari of another insider trading case – United States v. Whitman.17
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Newman is now final and no rule or lawmaking by the SEC or Congress is likely in the immediate future. In these circumstances, while SEC rulemaking and Congressional proposals should be carefully monitored, focus is appropriately placed on the courts and SEC administrative actions. These proceedings have no choice but to confront the issues raised by Newman if they are presented. Their presentation is only a matter of time as regulators are likely to continue to aggressively pursue insider trading cases.
In the interim, public companies and other entities regularly engaged in trading cannot overlook their compliance and regulatory obligations and the many related risks to their businesses. While Newman represents a significant protection against insider trading prosecutions, it is narrow. Maintaining appropriate controls – policies and codes of conduct and, perhaps most important, monitoring their effectiveness – is still imperative to prevent the improper dissemination of material, non-public information and improper trading based on that information. While the government lost these rounds of the fight, we feel certain that it will continue to pursue public companies, hedge funds and others with great vigilance as it looks to recapture the allowances made by Newman.18