Last December, in a separate case, a New York appeals court overturned the convictions of two other hedge-fund traders and issued an opinion that dramatically narrowed the definition of insider trading, by requiring that prosecutors prove both that the tipper received some sort of compensation for sharing the information and that the individual who traded on that information knew it was an illegal tip. Bharara’s office challenged the ruling, but, earlier this month, the Supreme Court declined to hear the case.
But the truth is that if you operate a hedge fund and care to structure your business around the gaping loopholes that the Supreme Court has implicitly endorsed, insider trading is now effectively legal in the United States.
because there are so many hedge funds, each with its own army of analysts, the trick is to find some nugget of information that the rest of the market doesn’t know. This is where the culture of insider trading took hold.
Is it fair to convict someone of engaging in insider trading if he didn’t know he was doing so at the time?
In overturning the convictions of the two other traders, Todd Newman and Anthony Chiasson, the court derided the “doctrinal novelty” of Bharara’s approach, and held that it is not enough to prove that someone traded on a tip that she should have known constituted material nonpublic information; instead, prosecutors need to prove that she was affirmatively aware of the dodgy provenance of the tip. The court also held that prosecutors must demonstrate that the original tipper was somehow compensated for offering the tip.
But to anyone who is at all acquainted with the anthropology of the contemporary hedge fund it also represented, unmistakably, a license to cheat. Company insiders share tips for many reasons, not just financial compensation: the person they share the information with may be a friend or a family member, someone they want to impress, someone they owe a favor. And once they pass the tip along it often circulates through a network of people in the investment community. At a large hedge fund, the senior investors are generally not out shaking the trees and doing primary market research themselves—they are relying on their analysts and portfolio managers to feed them data and hypotheses. These intermediaries were always a buffer against legal exposure, and the existence of that buffer may offer one explanation for why Bharara was never able to personally charge Cohen with criminal wrongdoing.
Richard Holwell, a former federal judge who presided over several high-profile securities-fraud cases, told me that when an illegal tip is passed up the chain at a hedge fund, senior traders often know better than to inquire about its origins. Instead, some firms have an unspoken policy that Holwell characterized as “don’t ask, don’t tell.” This was the case in the old legal landscape, at the height of Bharara’s crackdown. But in the new legal climate “don’t ask, don’t tell” will amount to much more than a mere precaution—it will be an ironclad bar to prosecution.
But in a textbook instance of perverse incentives the ruling by the Second Circuit will discourage due diligence, because the less management knows about the sourcing employed by analysts and traders to generate investment ideas, the fewer people will face legal exposure. It’s not that it will be impossible to bring insider-trading cases from now on; it’s that at a hedge fund, all of the legal liability will now rest with the analysts and traders on the front lines of information gathering—with the initial knowing recipients of a tip. (Incidentally, if you’re a junior portfolio manager, this might be a good time to ask your boss for a raise.)
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