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Deconstructing the Galleon Insider Trading Case—A Commentary by Jonathan Macey ’82

The following commentary was published in The Wall Street Journal on April 19, 2011.

Deconstructing the Galleon Insider Trading Case
By Jonathan Macey ’82

According to government prosecutors, Raj Rajaratnam, co-founder of the hedge fund Galleon Group, made millions of dollars in illegal profits by trading on tips about companies like Intel Corp., Goldman Sachs and Clearwire Corp. But the Supreme Court has long made it clear that getting tips from sources inside companies and trading on those tips is not necessarily illegal.

Some of the government's accusations in U.S. v. Rajaratnam appear well-grounded in the law. For example, on Feb. 8, 2010, former Intel executive Rajiv Goel pleaded guilty to leaking information to Mr. Rajaratnam about Clearwire that he learned at Intel. The government alleges that Mr. Rajaratnam made about $579,000 trading on this information, and that he "paid" for the tips by placing profitable trades for Mr. Goel's benefit in a private brokerage account. Paying for confidential corporate information is and should be illegal because it is improper to bribe an executive to betray his duty of confidence to his employer.

However, some of the government's other allegations accuse Mr. Rajaratnam of simply talking to people and then trading. But if the information did not come from an insider, or if it was being relayed for a legitimate corporate purpose such as to set the record straight about the company, then it is not illegal.

The prosecution of Mr. Rajaratnam is not an isolated fight but rather part of an ongoing doctrinal war pitting the rather extreme views of the Securities and Exchange Commission against the carefully considered law of insider trading articulated by the Supreme Court. The SEC does not draw a distinction between trading on the basis of legitimate albeit unorthodox research and illegal trading on the basis of improperly acquired proprietary information. But it should.

Despite the court's rejection of the view that all trading on the basis of material nonpublic information is illegal, the SEC persistently litigates this issue. In landmark cases like U.S. v. Chiarella (1980), Dirks v. SEC (1983), and U.S. v. O'Hagan (1997), the court has distinguished trading on the basis of information that was legitimately ferreted out from trading on the basis of information that has been wrongfully obtained through fraud or theft.

The SEC long has contended in litigation and in regulation that trading on the basis of any information advantage, no matter how obtained, is illegal. It takes the view that even if a trader does legitimate research to get information about a company, then that person should have to disclose that information before trading. Such a rule would destroy the incentives of analysts and traders to do research.

Decades ago, Justice Lewis Powell, speaking for the court in Dirks v. SEC, made clear that traders should be free to collect information and trade on it. Imposing a duty to abstain from trading in a stock "solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market." The court added that it is "commonplace for analysts to ferret out and analyze information and this often is done by meeting with and questioning corporate officers and others who are insiders."

The Supreme Court recognizes that if a person acquires information in the course of legitimate business activities, like research or mining sources appropriately, then he has a right to that information and should be able to trade without disclosing it. The government, on the other hand, espouses a socialist philosophy that valuable information belongs to the people—regardless of how it was obtained.

The line between legitimate research and illegitimate insider trading isn't always unclear. In the first criminal prosecution for insider trading in the 1970s, Vincent Chiarella was accused of stealing the identities of takeover targets from the disclosure documents he saw as an employee of Pandick Press, which was printing them for would-be acquirers. There is little doubt his actions were objectionable, though he made only $30,000 on his trades.

The same holds true for disbarred attorney James O'Hagan, partner in a big Minneapolis firm, who made $4.3 million trading in Pillsbury stock and stock options in the late 1980s after learning that his firm's client, London-based Grand-Metropolitan P.L.C., was planning a hostile takeover bid of Pillsbury. Mr. O'Hagan rightfully was convicted of stealing this information from his law firm's files and trading on it.

Every day, thousands of hedge-fund managers, private investors, mutual-fund advisers, stock-market analysts and others compete fiercely, using a variety of tactics to obtain new information about the companies they cover. These tactics range from analyzing public disclosures, which are increasingly useless as sources of information, to staking out the courtrooms in which the companies they follow are litigating. They cultivate friendships with employees and analyze everything about them, down to the makes and models of the cars in company parking lots.

This research is rarely glamorous. Rooting around in a company's discarded garbage in order to ferret out information is undignified. And it might well be trespassing. But it is not a crime to trade on the basis of information gotten this way. If the company has voluntarily discarded the information in such a haphazard way, then the information is up for grabs.

For decades, the SEC has kept the insider-trading rules vague and undefined. This ambiguity increases the SEC's power and allows government lawyers to pick and choose among prosecution targets.

Some, though by no means all, trading on the basis of informational advantage is and should be illegal. But the government should be compelled to provide clear guidance as to what constitutes illegal insider trading and what constitutes legitimate, albeit aggressive, research.

Mr. Macey is a professor at Yale Law School and a member of the Hoover Institution Task Force on Property Rights.