US v. Newman and the Rewriting of the Law of Insider Trading (Part 2)
Lets start at the beginning, with Dirks.
Dirks involved allegations that an insider (actually a former insider) tipped information to Dirks, an analyst. The information related to possible fraud at an insurance company. Dirks attempted to expose the fraud by going to media outlets (the WSJ) but to no avail. Ultimately, he informed five investment advisers of the information. The advisers liquidated their positions in the relevant company and ultimately avoided the rout that occurred in share prices once the fraud was exposed.
It was not a very sympathetic set of facts for an insider trading claim against Dirks but the SEC brought it nonetheless (in the form of an administrative proceeding). See In re Dirks, Exchange Act Release No. 17480 (admin proc Jan. 22, 1981) (“On the basis of the Commission's opinion issued this day, it is ORDERED that Raymond L. Dirks be, and he hereby is, censured.”). The Commission’s opinion acknowledged the concern that the action would interfere with disclosure that was important to investors and actually reduced the sanction imposed by the administrative law judge. As the Commission noted:
- We fully appreciate the importance of the analyst's work in providing public investors with an accurate and complete factual basis upon which to make their investment decisions. Accordingly, we do not seek in any way to chill the investigation of rumors concerning a particular company. Nonetheless, the analyst's role, like that of any other person, is constrained by the well-established proscriptions of the antifraud provisions of the federal securities laws, and we cannot condone the unfairness inherent in the selective dissemination of material, inside information prior to its public disclosure. Neither the analysis set forth above, nor the sanction we impose, should hamper legitimate, investigative securities analysis.
21 S.E.C. Docket 1401 (1981). For the SEC, however, it was enough to show that the tippee provided information from an insider knowing that the recipient would trade on the information. Id. (“Such a tippee breaches the fiduciary duty which he assumes from the insider when the tippee knowingly transmits the information to someone who will probably trade on the basis thereof.”).
Light though the sanction was, the SEC nonetheless penalized an analyst who had tried to get the information to news outlets and ultimately contributed to the exposure of a major fraud. Under the logic of the decision, future analysts in the same position would have an incentive to remain silent out of fear of liability, depriving the market of important information.
Even broader, any analyst who received nonpublic information as a result of doing his or her job (meeting with management for example) would be open to claims of insider trading if taking advantage of the information. Moreover, given the uncertainty of any materiality analysts, analysts receiving nonpublic information could rationally conclude that it was better not to use the information even if likely immaterial. Thus, a standard that allowed insider trading claims to be brought whenever insiders “tipped” information that would then be used to make trading decisions had the potential to “chill” the flow of information to the market. See SEC v. Dirks, 463 US 636 (1983) (“Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market”).
With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site. The amicus filed by a small group of law professors that supports the decision is here.