INSIDER TRADING LAW AND THE AMBIGUOUS QUEST FOR EDGE.

• Author: Pritchard, A.C.
• Position: Book review

Black Edge. By Sheelah Kolhatkar. New York: Random House. 2017. Pp. xx, 344. $28.

The quest for information in the securities markets bears more than passing similarity to sex: much desired, okay to get it for free, but illegal--and morally condemned--if you are paying for it. Marking the dividing line between getting info gratis and paying for it can be rather murky. Just paying for dinner probably does not count; the bag of cash does. But you have to know that you are paying for it to make it illegal; if you don't know how you happened to get lucky, you are on the right side of the line.

The line between paying and getting something for nothing lurks in the background of Black Edge. Black Edge is Sheelah Kolhatkar's (1) journalistic account of the investigation by the SEC, FBI, and DOJ into SAC Capital Advisors, the hedge fund managed by Steven A. Cohen, one of Wall Street's most successful traders. Knowing more than others--"edge"--is smart business unless you got the information the wrong way (and you know it), in which case, your edge is the product of criminal fraud, the "Black Edge" of the book's title. The book, although nonfiction, is written in the style of a Grishamesque thriller, minus the dramatic finish. (And, sorry, dear reader, there is no sex.) Indeed, the anticlimactic conclusion is the book's key takeaway from a legal perspective. Cohen, the white whale of the government's investigation, evades criminal prosecution, despite the conviction of a number of lower-level individuals caught up in the government's pursuit of Cohen (p. 294). Cohen's firm, SAC Capital, ultimately pleaded guilty to criminal indictment, paying out $1.8 billion in criminal fines and civil penalties (pp. 258-59). The SEC barred the firm from managing investors' money for a period of two years, but the firm continues to manage Cohen's multibillion-dollar private fortune under the name Point72 Asset Management (pp. 288, 292). Cohen faced no personal sanction, but as the owner of SAC Capital, he took a financial hit from the fine paid by his company, although he remains comfortably a multibillionaire (p. 258). Point72 is poised to return to managing other people's money in 2018. (2)

Kolhatkar is a journalist, not a lawyer, but her book highlights the tension between populism and the rule of law that bedevils the regulation of insider trading. The widely held moral condemnation of insider trading views the crime in black-and-white terms: greed leading to abuse of trust. That moral judgment is animated by a strong populist impulse. In the public mind, insider trading is the signature crime of the wealthy and powerful. The resentment is no doubt exacerbated by the fact that insider trading is associated with speculators. The average person sees the work of professional traders as largely pointless--a zero-sum game. Traders are not producing anything, good or service, but they nonetheless earn enormous sums of money. As a society, we are devoting a lot of resources to promoting liquidity and share-price accuracy--real economic benefits to be sure, but amorphous ones not readily apparent to the public at large. The public's suspicion of the trading class is further fueled by ambitious prosecutors hustling for headlines, who do not miss an opportunity to feature insider trading in well-publicized news conferences.

Despite the politicians' definitive condemnation, the legal prohibition against insider dealing is beset by murky lines, the product of its essentially common law origins. Courts have made it up as they go along because Congress and the SEC have refused to define insider trading by statute or rule. The murkiness of the law, however, also betrays a certain ambivalence in our moral view of insider trading. From an economic perspective, using nonpublic information for trading undermines the liquidity of securities markets. Information asymmetries among traders discourage participation in trading markets, regardless of their source, because the uninformed--"dumb money"--seek to avoid trading with those who know more--"smart money." Our moral intuitions, however, differ sharply based on the source of the information. Few question the use of information found through good fortune (talk of an impending deal overheard in the elevator), while most condemn the use of information divulged in breach of trust--"tipping" in the parlance of insider trading doctrine. But what if the good fortune was promoted by a lot of hard digging? What if the disclosure was "encouraged"? When do investments in digging veer into the prohibited area of paying for information? The law endeavors to distinguish good fortune, even enhanced by honest effort, from the corruption represented by breach of trust. The fluidity with which information passes among participants in the securities markets, however, makes drawing that line treacherous in any given case.

Kolhatkar's account of the pursuit of Cohen and SAC Capital illustrates the fuzzy border defining when use of nonpublic information constitutes insider trading. She also shows the evidentiary challenges that the law poses for prosecutors and the SEC in making their cases. The ambiguity of insider-trading law lurks in the background of how SAC Capital operated. Information can be translated into profit in the securities markets, and SAC Capital invested enormous sums and effort in getting information relevant to its trading decisions. The line between legally and illegally obtained information is a fine one; Kolhatkar never squarely pins down which side of the line Cohen and SAC Capital were on.

In this Review, I will use Black Edge to highlight how the law's ambiguities limit the government's reach in pursuing insider trading. In particular, I will focus on how the knowledge requirement for securities fraud casts a shadow over the government's campaign against the hedge fund industry's never-ceasing quest for an informational advantage--"edge," be it white, gray, or black. After setting forth the blurred lines of insider-trading law's approach to the hunt for nonpublic information in Part I, I explore its implications for the government's investigation of Cohen and SAC Capital in Part II. The Review concludes with some thoughts on how insider-trading law may develop going forward.

1. BLURRED LINES

   The offense of insider trading is based nominally on the prohibition against fraud found in Rule 10b-5 of the Securities Exchange Act, (3) but neither Rule 10b-5 nor its authorizing statute, section 10(b) of the Exchange Act, say anything about insider trading. It is closer to the truth to call the insider trading prohibition a species of common law, albeit one given teeth by the enforcement resources of the federal government. Beginning in the 1960s, the SEC pushed the courts to recognize insider trading as fraud within the broad language of Rule 10b-5. (4) The agency enjoyed considerable success with its agenda in the lower courts, most notably the Second Circuit, the leading intermediate court for the securities law. (5) The government got pushback, however, when the Justice Department deployed the prohibition in a criminal case. That expansion brought the topic of insider trading to the attention of the Supreme Court in Chiarella v. United States. (6) Chiarella began the process by which the Supreme Court, under the guidance of Justice Lewis F. Powell, Jr. narrowed the scope of insider trading under Rule 10b-5 from the broad prohibition endorsed by the SEC and validated by the Second Circuit to one that more closely tied to common law understandings of fraud. (7) That process culminated in a complex doctrinal thicket, in contrast to the relatively clear prohibitions found in jurisdictions that have prohibited insider trading explicitly by statute. The law of insider trading as it stands now incorporates two principal theories:

   1. the classical theory, first recognized by the Supreme Court in Chiarella, which holds that a corporate insider (or temporary insider, such as a lawyer or an accountant) commits fraud when he trades with a shareholder without disclosing material, nonpublic information to that shareholder; and

   2. the misappropriation theory, which...