The Second Circuit Makes Sophisticated Insider Trading the Perfect Crime

By William K. Black
Bloomington, MN: December 10, 2014

We know that insider trading is an activity in which cheaters prosper. We know that Wall Street and the City of London are dominated by a fraudulent culture and we know that firm culture is set by the officers that control the firm. We know that the Department of Justice (DOJ) has allowed that to occur by refusing to prosecute any of the thousands of senior bank officers who became wealthy by leading the three most destructive financial fraud epidemics (appraisals, “liar’s” loans, and fraudulent sales of these fraudulently originated mortgages to the secondary market) in history. No one is surprised that Wall Street’s elites have also engaged in widespread efforts to rig the stock markets so that they can shoot fish in the barrel through insider trading. Unlike the three fraud epidemics, one DOJ office, the Southern District of New York, has brought a series of criminal prosecutions against these officers.

Wall Street’s court of appeals (the Second Circuit) has just issued an opinion not simply overturning guilty verdicts but making it impossible to retry the elite Wall Street defendants that grew wealthy through trading on insider information. Indeed, the opinion reads like a roadmap (or a script) that every corrupt Wall Street elite can follow to create a cynical system of cutouts (ala SAC) that will allow the most senior elites to profit by trading on insider information as a matter of routine with total impunity. The Second Circuit decision makes any moderately sophisticated insider trading scheme that uses cutouts to protect the elite traders a perfect crime. It is a perfect crime because (1) it is guaranteed to make the elite traders who trades on the basis of what he knows is secret, insider information wealthy absent successful prosecutions and (2) using the Second Circuit’s decision as a fraud roadmap, an elite trader can arrange the scheme with total impunity from the criminal laws. The Second Circuit ruling appears to make the financial version of “don’t ask; don’t tell” a complete defense to insider trading prosecutions. The Second Circuit does not simply make it harder to prosecute – they make it impossible to prosecute sophisticated insider fraud schemes in which the elites use junior cutouts to create (totally implausible) deniability.

The New York Times article on the decision was entitled “Two Insider Trading Convictions Are Overturned in Blow to Prosecutors.” The title is partially correct. The real blows, however, were to investors, the already crippled integrity of Wall Street, and every honest trader on Wall Street who cannot possibly compete with his rivals who cheat through the “sure thing” of insider trading now that the Second Circuit has written an opinion explaining how to corrupt the entire system with impunity from the criminal laws.

Wall Street’s most recent effort to rig the markets through insider trading is far larger and more audacious than any prior effort, including those by Michael Milken and Boesky. Wall Street elites sought to institutionalize the corruption of officers of a wide range of publicly traded corporations.  The goal was to gain a corrupt advantage over honest investors in trillions of dollars in securities trades.

The Second Circuit decision admits that the prosecutors presented evidence established a massive conspiracy designed to allow Wall Street elites to profit by engaging in insider trading, a conspiracy that greatly enriched the defendants that were convicted in the case under appeal.

“At trial, the Government presented evidence that a group of financial analysts exchanged information they obtained from company insiders, both directly and more often indirectly. Specifically, the Government alleged that these analysts received information from insiders at Dell and NVIDIA disclosing those companies’ earnings numbers before they were publicly released in Dell’s May 2008 and August 2008 earnings announcements and NVIDIA’s May 2008 earnings announcement. These analysts then passed the inside information to their portfolio managers, including Newman and Chiasson, who, in turn, executed trades in Dell and NVIDIA stock, earning approximately $4 million and $68 million, respectively, in profits for their respective funds.”

The Second Circuit was not distressed that senior Wall Street officials received information that was clearly insider information that they knew they should not have access to. The insider information they were provided was the crown jewels – two major corporations’ soon to be announced “numbers” – at least one of which was sure to be a major surprise to the markets. A senior trader that knows “the number” in advance, particularly when he knows that the number will be a surprise, can shoot fish in a small barrel with a large shotgun. The insider information allows the senior trader to reduce the risk of loss to trivial levels while increasing the probability of gain to near certainty. The trader makes a fortune by cheating, not through any unusual skill. The senior trader knows that no employee of any publicly traded corporation is permitted to release such secret and proprietary insider information to investors.

The Second Circuit was not distressed that the senior Wall Street officials did not react to being provided what was clearly insider information by demanding to know how their analysts got the information and instructing them that their actions violated the firms’ ethical standards and would lead to their termination if it were ever repeated. The firm’s ethics manuals banned the senior traders from trading on the basis of insider information. Instead, of serving as ethical leaders in training the analysts not to engage in such behavior and instead of following their firm’s ban on trading on the basis of insider information, the senior officers engaged in a cynical financial version of “don’t ask; don’t tell.” The analysts and the senior officials that traded on the inside information understood the wisdom of the old line “ask me no questions and I’ll tell you know lies.” The senior officers proceeded to profit by exploiting this advantage over honest investors while minimizing the risk of a successful prosecution not by being ethical, but by consciously maintaining (not remotely) “plausible deniability.”

I recently wrote a column responding to an article in which a prominent criminal justice scholar was quoted as complaining, in response to the protests of the police killing of Eric Garner during their attempt to arrest him for selling “broken packs” of cigarettes on a NYC street, that politicians had a “responsibility” to explain to the public the necessity of “broken windows” policing strategies. The concept of “broken windows” is that is essential to take formal, aggressive enforcement actions against even minor transgressions in order to prevent a “criminogenic environment” from developing that will produce large numbers of major crime. The SEC is formally claiming to have adopted “broken windows” as its enforcement standards. Confusingly, “broken windows” has been rebranded by some academics as “quality-of-life enforcement.”

“‘Everyone is just demonizing the police,’ said Maki Haberfeld, a professor of police studies at John Jay College of criminal justice. ‘But police follow orders and laws. Nobody talks about the responsibility of the politicians to explain to the community why quality-of-life enforcement is necessary.’”

Garner’s profits from violating an obscure law on the sale of cigarettes in any given week probably amounted under $70. A few days of the defendants’ trades based on insider information produced a $72 million profit – a million time larger. Garner died. The Wall Street guys were able to hire elite criminal defense lawyers. They will walk. Wall Street’s culture is so corrupt that it will treat the now officially “innocent” defendants like heroes and even victims of a rapacious prosecutor. “Broken windows” is a discredited theory when it comes to offenses like that of Garner, but it is vitally and urgently needed as a corrective to Wall Street’s corrupt culture.

But worse will soon come. The Second Circuit’s decision is a “how to” manual on how elites Wall Streeters can become wealthy through insider trading with impunity from the criminal laws. The Second Circuit opinion shows that using a “cutout” is the key to achieve the “sure thing” of enormous wealth through insider trading without financial or legal risk. The Second Circuit lays out the game plan. The little folks in the organization develop the contacts with insiders in publicly traded firms. The analysts function initially like any good intelligence agent recruiting an asset. These assets have insider information of their employers, the publicly traded corporations. The analyst develops a rapport with the employee or exploits an existing tie. The analyst shows the employee a very good time – a taste of how good his life can be if he plays ball. But the analyst doesn’t make any explicit promises or deals. (In the case decided by the Second Circuit others cutouts earlier in the insider trading chain made the corrupt payments to the employees.) The Wall Street senior officers who grow wealthy by trading the insider information will make sure that the analysts are well cared for – discretely and at a later date.

The analyst then has to do one thing and avoid doing a second. Both are simple. The analyst needs to signal to his superior that the information is reliable. The government complaint against SAC show one the innumerable means of sending that signal. The government’s appellate brief contains the text of an email in which an analyst explicitly conveyed the reliable track record of the leakers of the inside information to the senior traders so that they could be sure they had a “sure thing” by investing on the basis of the inside information.

The analyst needs not to explicitly tell the senior officer conducting the trade that the insider information was the product of a deal in which the employee who leaks the insider information was explicitly promised a quid pro quo to the leaker. Again, the government complaint against SAC and the government appellate brief in the case reversed by the Second Circuit show in detail how simple it is to design systems of not making these matters explicit. That is why the Second Circuit ruling imperils prosecutions in every case in which the insider trading scheme was done with even modest cleverness.

The Second Circuit did not treat the elite traders’ use of a series of junior cutouts as what it really is – a cynical abuse of power sure to corrupt the firm, Wall Street professionals the financial industry, and financial markets. Ending the rule of law by making sophisticated insider trading schemes the perfect crime corrupts the industry by generating a “Gresham’s” dynamic in which “bad ethics drive good ethics out of the markets and professions.” The capacity for corruption makes the Second Circuit’s creation of a perfect crime all the more perverse. The sophisticated insider trading schemes using cutouts that the Second Circuit opinion immunizes from prosecution represent a far more dangerous and sophisticated conspiracy that should be subject to far more severe sanctions than simpler forms of insider trading.

The elites’ “don’t ask; don’t tell” insider trading scheme was designed solely to make already exceptionally wealthy elites even richer through corrupt “sure things.” The “don’t ask; don’t tell” scheme worked by coercing junior members of the firm (through perverse compensation and promotion or firing pressures) to corrupt employees of publicly traded corporations. The Second Circuit opinion treats the “don’t ask; don’t tell” tactic, the large power differentials between the participants of the scheme, and the elite traders’ use of multiple cutouts as if these factors were exculpatory. The more sophisticated and destructive the insider trading scheme, the more the Second Circuit opinion shields the elite traders made wealthy by the scheme from prosecution. The Second Circuit adopts, celebrates, and shields from accountability Wall Street’s corrupt culture by making sophisticated insider trading the perfect crime.

“[The defendant senior traders] Newman and Chiasson were several steps removed from the corporate insiders and there was no evidence that either was aware of the source of the inside information. With respect to the Dell tipping chain, the evidence established that Rob Ray of Dell’s investor relations department tipped information regarding Dell’s consolidated earnings numbers to Sandy Goyal, an analyst at Neuberger Berman. Goyal in turn gave the information to Diamondback analyst Jesse Tortora. Tortora in turn relayed the information to his manager Newman as well as to other analysts including Level Global analyst Spyridon “Sam” Adondakis. Adondakis then passed along the Dell information to Chiasson, making Newman and Chiasson three and four levels removed from the inside tipper, respectively.”

The Second Circuit’s reasoning has the perverse effect that the more corrupt individuals engaged in the insider trading scheme the more likely the scheme is to be declared lawful as long as the traders use their corrupt colleagues as cutouts. Note that the Second Circuit reasoning does not simply make it harder to prosecute sophisticated insider trading schemes – it holds that the actions of the elite traders who know that they are achieving the “sure thing” of immense insider trading profits on the basis of deliberate leaks of that information are not unlawful and cannot be prosecuted. The Second Circuit has created the perfect crime and publicized how to shape the scheme to insure wealth and impunity through creating widespread chains designed to corrupt the markets, employees of the publicly traded corporations, and the Wall Street firms.

The tone of the opinion is particularly galling. The Second Circuit is not even mildly distressed by the result. It expresses disdain for the idea that Wall Street elites should not be able to enrich themselves with complete impunity from the laws through corrupt arrangements such as those proven at the trial. The opinion consciously deliberately creates a straw man argument designed to hide the fact that insider trading schemes of this make it impossible for honest competitors to prevail through skill and hard work.

“Although the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets.”

Wall Street’s pet Court of Appeals sneers at the concept that there might be reasons to wish that the law did not (under its holding) create a perfect crime that is inherently corrupting. The three judges on the panel were appointed by Presidents Reagan and Bush II. The opinion does not contain even a perfunctory statement of regret that it creates a path to the perfect crime and the further corruption of Wall Street at the expense of honest traders and investors.

There was a real conspiracy to corrupt employees at publicly traded firms and to profit from the resultant insider information that was proven at the trial. The conspiracy produced the desired result, until the government brought it to a halt by prosecuting. The Second Circuit took the exceptional step of not reversing the conviction based on an erroneous jury instruction and allowing the prosecutors to retry the case and present again at the new trial the powerful evidence of conscious disregard by the elite traders made wealthy through trading on insider information. The government’s appellate brief demonstrates that the government presented what I would consider as a white-collar criminologist detailed and compelling evidence that the elite traders knew that they were trading on insider information that was improperly leaked for corrupt purposes. The Second Circuit forbade any retrial. Worse, the Second Circuit appears to be declaring that even a modestly sophisticated use of cutouts by elite traders using insider information creates the perfect crime. They will be made wealthy by the “sure thing” of insider trading and no future prosecutor will be permitted to even prosecute such a perfect crime.

Whatever one thinks of the Second Circuit’s legal reasoning, anyone who cares about the integrity of financial markets should be appalled by the result of their decision that announces a template of how to make insider trading a perfect crime for elites. Republicans and Democrats both purport to care about the integrity of Wall Street firms and the markets and proclaim that they are dedicated to the protection of investors from such forms of cheating. We are about to run a real world test of whether they believe what they say and are willing to take on the powerful Wall Street elites that crafted the corrupt culture of Wall Street. I call on the members of both parties to co-sponsor on an urgent basis a bill to clarify that Congress does intend to make the type of insider trading schemes that were the subject of the Second Circuit’s decision criminal violations of the securities laws.

I also call on members of both parties to double the number of FBI agents and federal prosecutors dedicated to elite white-collar crime investigations and prosecutions. Yes, I know it over 13 years late, but we can all see the costs – over $20 trillion in GDP and 10 million jobs – of ending the rule of law when it comes to bankers. The Second Circuit decision will make Wall Street even more corrupt – and that is saying a great deal. Only through prosecuting the corrupt can we block the “Gresham’s” dynamic and make it possible for honest bankers to take control of Wall Street.