The NYT, the SEC and Insider Trading

The NYT published a piece over the weekend on insider trading (Is Insider Trading Part of the Fabric?).  The article examines allegations of insider trading based on analyst reports produced at Lehman Brothers.  The reports were produced by analysts at the firm then allegedly used by Lehman in connection with proprietary trading and tipped to select clients.  As the article stated:

What exactly happened at Lehman? Mr. Parmigiani says traders there were routinely advised of changes in analysts’ company ratings before those changes were made public. That way, Lehman could profit on subsequent market moves. Here is how he describes it: First, research officials tipped off the traders; then Lehman’s proprietary trading desk, which cast bets with the firm’s own money, positioned itself accordingly. Lehman salespeople also alerted favored hedge funds. Only later, he says, were ratings changes made public.

Information on these trades were given to the SEC and, while an investigation was conducted, the implication was that the SEC simply lost interest.  Id.  ("But then, as the financial crisis flared that summer, the S.E.C.’s interest waned. After Lehman failed, Mr. Parmigiani got a call from two of the lawyers, signaling that the S.E.C. was probably not going to pursue the matter."). 

Moreover, the article quoted a reaction by Senator Grassley, a frequent critic of the SEC.  According to Senator Grassley:

This case emphasizes serious questions about the S.E.C.’s culture of deference to Wall Street and big players going back a long time. The S.E.C. obtained what appears to be clear evidence of, at a minimum, disregard for regulations designed to ensure that Wall Street firms can’t leak inside information to preferred clients prior to public announcements. Yet there appears to have been no consequences.

The article, however, completely sidestepped the most significant problem confronted by the SEC in bringing insider trading cases.  The law of insider trading has been so mangled by the Supreme Court that most of the behavior mentioned in the NYT piece probably does not even constitute insider trading.  It may violate other provisions of the securities laws but not those governing insider trading.  How could that be the case? 

It all started with Dirks v. SEC, 463 US 646 (1983), a piece of judicial activism designed to limit the reach of the prohibitions on insider trading.  The opinion for the most part contained faulty analysis that confined insider trading to circumstances involving a breach of a fiduciary "duty" by an insider.  To fill the gaps created by Dirks, the SEC had to develop an alternative theory of insider trading, misappropriation.  The theory posited that insider trading occurred when persons traded in violation of a "duty" of trust and confidence, an approach eventually affirmed in US v. O'Hagan, 521 U.S. 642 (1997).  

For the most part, a duty of trust and confidence is imposed on employees by the employer.  If an employee uses confidential information when trading, he or she engages in insider trading.  But the theory has a flaw.  When the employer uses the same information, it is not insider trading.  An employer that sets the obligation of confidentiality can set it aside.  To the extent, therefore, that analysts at Lehman Brothers produced reports that were used by the Lehman trading desk for proprietary trades, it is probably not insider trading.  Lehman, rather than the trading employees, benefited from the trades. In other words, employees did not violate a duty of trust and confidence by engaging in behavior that benefited Lehman. 

What about tipping the information to favored clients?  In Dirks v. SEC, an insider "tipped" information to an analyst.  The Court held that this was not insider trading.  In other words, selective disclosure of inside information is not necessarily insider trading.  To the extent that Lehman employees gave the information to favored clients in order to personally benefit, they may have violated the prohibitions on insider trading.  To the extent, however, that they gave the information to favored clients to benefit Lehman, it may not be insider trading. 

It may be the case that this sort of behavior ought to be insider trading.  But the reality is a great deal more complicated.  And, contrary to the suggestions in the NYT article, the problem is not the SEC's unwillingness to bring a case.  The problem is the complexity and irrationality of the law on insider trading. 

If the NYT wants to point the finger of blame for failing to bring an insider trading case under the alleged facts mentioned in the article, the finger should be pointed not at the SEC but at the US Supreme Court. 

J Robert Brown Jr.