A New Guide to Trading on Inside Tips Without Going to Prison After Second Circuit Case

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By David Glovin and Patricia Hurtado

Dec. 12 — A casual tip on the back nine seems safe. A hot steer from someone who knows someone might be iffy.

And a profitable, you-scratch-mine-I'll-scratch-yours exchange is—well, get a lawyer.

After the biggest insider trading crackdown since the days of Ivan Boesky, Wall Street is getting more wiggle room, not less, to trade on confidential information.

No one is being handed a free pass. People who knowingly trade on nonpublic information can still end up in prison.

But after a federal appeals court last week overturned two prominent insider trading convictions, new legal questions have sprung up about the chain of information that winds through the financial markets. For some participants, avoiding prosecution just got easier.

Fund managers who trade on advice from analysts are now more protected if the analysts feed them inside tips, legal experts say. Analysts who swap information casually among themselves can breathe easier too.

The same goes for traders who are steps removed from sources of information. Trading day banter—a call from a friend who got a call from a friend—will be harder to hang a case on.

“I don't know that it gives traders carte blanche to break the law, but it certainly makes it easier to get away with it,” said Richard Holwell, who was the federal judge who presided over the insider trading trial of Galleon Group co-founder Raj Rajaratnam, said of the U.S. Court of Appeals for the Second Circuit's Dec. 10 decision.

Newman, Chiasson

The ruling by the Second Circuit did more than toss out the convictions of fund traders Todd Newman and Anthony Chiasson, who faced years behind bars. For the first time, the court said traders must know that insiders who leak information are doing so in return for “personal benefit.”

That's good news for traders several links down the information chain. Now, in addition to showing a trader knew a potentially market-moving leak originated from an insider obligated to keep it secret, prosecutors must prove the trader knew the source got something in return.

“You can sleep easier,” said Peter Henning, a law professor at Wayne State University and a former Securities and Exchange Commission attorney.

Quid Pro Quo

The court handed a second victory to Wall Street in its 28-page ruling. For years, prosecutors have argued that tipsters broke the law if they leaked information in return for friendship or job advice. Now, “that's not enough” said Holwell. The court said tipsters must receive something “of some consequence” to prove an illegal quid-pro-quo. A friendly exchange about a pending merger or earnings report won't be enough.

Prosecutors “are going to have to show more than they were just friends,” said Henning. “There will need to be something consequential.”

None of this would have helped Rajaratnam, who is serving 11 years in prison for orchestrating an elaborate insider trading network. He paid for secrets he subsequently used to earn millions of dollars trading.

“Raj knew all about the benefit because he was the guy bestowing them upon his tippers,” said Anthony Sabino, a business law professor at St. John's University in New York. “He's giving his pal, Anil Kumar who worked at McKinsey, hundreds of thousands of dollars to put in a Swiss bank account in exchange for information. And then there were the wiretaps of Raj getting tips. This is very direct contact between the tipper and the tippee with an obvious benefit.”

SAC's Martoma

Nor would the decision have helped ex-SAC Capital Advisors portfolio manager Mathew Martoma, who received a $9.4 million bonus for trades based on tips from a corporate insider who was paid for information about a drug's clinical test results. SAC made $275 million on those trades.

“People shouldn't take comfort that they can now go out and indiscriminately engage insiders to divulge material information about their companies that they know is confidential,” said Marc Powers, a former enforcement lawyer at the SEC who is in private practice at BakerHostetler in New York. “This decision isn't about opening up the floodgates for people to engage in illegal insider trading.” 

To contact the reporters on this story: David Glovin in New York at dglovin@bloomberg.net; Patricia Hurtado in Manhattan at pathurtado@bloomberg.net

To contact the editor responsible for this story: Michael Hytha at mhytha@bloomberg.net

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