Pomerantz LLP

Judge Rakoff Challenges The Securities Bar


On July 3, 2016, the European Union implemented Market Abuse Regulation (“MAR”), a rulebook that governs, in part, enforcement of insider trading violations. MAR differs sharply from the American approach to insider trading law in that it does not require the government to link the trade to a known breach of fiduciary duty.

In a speech earlier this month to the New York City Bar Association, U.S. District Judge Jed S. Rakoff challenged the securities bar to draft a statute that would provide needed clarity to U.S. courts trying to make sense of the confusing tangle of judge-made insider trading law and
pointed to MAR as a potential model.

Judge Rakoff suggested that most of the headaches created by U.S. insider trading law arise from judgemade requirements, such as that trading on inside information can be a crime only if the tippee knew that the tipper breached a fiduciary duty. Not only that, but that breach must involve betraying confidences of an employer, and also receiving some kind of personal benefit in exchange.

Judge Rakoff knows these difficulties well. He gave his speech three months after the Supreme Court ruled in the insider trading case Salman v. United States. As we reported in the last issue of the Monitor, Salman held that someone who trades on inside information can be found guilty even if the source of the information was a friend or family member of the tippee, and did not receive a financial quid pro quo. Salman affirmed a 2015 ruling that Judge Rakoff had authored while sitting by designation on the Ninth Circuit Court of Appeals. In a further twist, Rakoff’s Ninth Circuit opinion in Salman relied on his reasoning in a 2013 insider trading decision, which the Second Circuit had reversed on appeal in 2014 in U.S. v. Newman. In effect, Judge Rakoff single-handedly created the circuit split that led the Supreme Court to validate his overturned district court ruling.

But Salman resolved just one of a myriad of issues surrounding insider trading: whether a tip to a friend or relative, without a financial quid pro quo, supports a claim of insider trading. As Rakoff noted in his speech, U.S. insider trading law is a judicial creation based on generalized
antifraud provisions of the federal securities laws. There is no statutory definition of what constitutes inside information, or when a tippee violates the law by trading on it. The result has been that decades of often inconsistent judicial decisions have congealed into a common law morass that erodes investor confidence in the U.S. capital markets.

Some of the difficulties of insider trading law are illustrated by the prosecutions brought by Preet Bharara, the former U.S. Attorney for the Southern District of New York. Notably, he secured a conviction in 2011 of Raj Rajaratnam, the founder of hedge fund Galleon
Group. But when Bharara decided to take on Steven A. Cohen, the hedge fund billionaire who founded S.A.C. Capital Advisors (“SAC”), he ran into a wall created by the requirement that a tippee, to be liable, has to be aware that the source of the inside information violated a fiduciary duty by disclosing it. Bharara decided not to go after Cohen.

As recounted in a recent New Yorker article, Bharara’s decision rested in part on the difficulty
in making the necessary evidentiary showing. The government’s best evidence against Cohen
was an email from one of his traders that conveyed inside information. To win, the government
had to convince a jury that Cohen not only read the email—one of a thousand or so he received
every day—but also that he read to the end of the email chain and realized that the trader’s source had breached a fiduciary duty. Even Bharara, not known for timidity, blinked when faced with an opponent with billions to spend on his defense and a burden of proof that becomes more difficult to carry the more remote the tipper is from the tippee. Instead, Bharara settled for convictions of two of Cohen’s top traders and a $1.8 billion penalty paid by Cohen’s company, SAC. Cohen skated. After shuttering SAC, he set up shop under a new company, and went on trading as if nothing had happened.

Just as telling, even the narrow ruling in Salman, which criminalizes trading on uncompensated tips from friends and relatives, is subject to nitpicking. One of the former SAC traders that Bharaha managed to convict, Mathew Martoma, has appealed his conviction to the Second Circuit on the grounds that the friendship by which the information was passed to him was not a “meaningfully close” friendship.

By contrast, under MAR, the EU treats insider trading as a threat to the proper functioning of the capital markets, in that it impedes transparency. Article 7 of MAR defines “inside information” as non-public information which, if revealed, would significantly affect the price of a security. Regarding tippee liability, Article 8 says that it is “insider dealing” where a tippee uses the tip and “knows or ought to know” that the tip is “based upon inside information.” This approach eliminates the fiduciary duty element of U.S. law, which Judge Rakoff has characterized as a “pretty complicated formulation.” Moreover, in cases against top executives like Steven Cohen, who are often several degrees of separation distant from the source of the tip, it increases the prosecutor’s ability to discern whether the law has been violated. While MAR is a new and relatively untested template, it has the potential to create a clear set of guidelines for traders, regulators, prosecutors and courts to follow, and a regime that the
market can trust.

Pomerantz is familiar with the proof issues in SAC, having recently settled a civil suit for insider trading against Cohen and SAC for $135 million, on claims not pursued by the government.