Congress May Have to Define Insider Trading : Wall Street: A conviction overturned earlier this week may force lawmakers to spell out where a trader crosses the line to become a lawbreaker.


A federal appeals court decision this week may force Congress to deal with an issue that it ducked two years ago: coming up with a definition of illegal insider trading.

The U.S. 2nd Circuit Court of Appeals in New York on Wednesday overturned the criminal conviction of a former stockbroker, Robert Chestman. It was a decision that some legal experts said could sharply undercut the recent government crackdown on insider trading.

Chestman was convicted in 1989 on 31 counts related to insider trading. He allegedly had received information from a customer about the pending sale of an East Coast supermarket chain, Waldbaum’s, to another chain. He then bought Waldbaum’s stock for himself and customers in advance of the public announcement. But the appeals court ruled that Chestman had gotten the information fourth-hand and was so far removed from the original source of the tip that he wasn’t under any obligation not to trade on the information.

Securities law experts said Thursday that they are almost certain that the government will appeal the ruling by the three-judge panel, probably by asking for a rehearing by the full appeals court.


But they said that if the decision is upheld, there will be an urgent need for Congress to draw a clear dividing line between which types of securities trading are legal and which aren’t.

“I do believe it underscores the enormous need for a definition,” said Harvey Pitt, a Washington securities lawyer. He said the ruling “will have a significant deleterious effect on the (Securities and Exchange) Commission’s enforcement activities.” Pitt represented former stock speculator Ivan F. Boesky on insider trading charges and also served on a committee appointed by Congress that had proposed a definition of insider trading in 1987. Congress never acted on the proposal.

Current insider trading law refers only to “material, non-public information.” It doesn’t spell out what precisely is meant by “non-public” or who is bound by the prohibition. The absence of specific guidelines has given the SEC and federal prosecutors wide discretion to bring charges when the authorities believe that improper trading has occurred. Some SEC commissioners have opposed fixing a definition, arguing that a precise definition would only invite violators to find a way to sidestep it.

But many securities lawyers and law professors say Congress may need to set specific legal guidelines or else the courts may continue to throw cases out. Alan Bromberg, a securities law professor at Southern Methodist University, referred to this week’s Chestman ruling and said: “Here’s a case that the government took all the way through the courts. Somebody should have known at the beginning of the case whether this was a violation.”

Some types of insider trading seem black-and-white cases. Few dispute, for example, that Boesky was guilty when he used deliberate tips from investment bankers about secret pending takeover deals to make a killing in the market. But is a securities analyst who is told by an insider that a company’s earnings are likely to go down and who then advises clients to sell the stock guilty of insider trading? And--to draw from an actual pending case--what about a psychiatrist who allegedly buys stock after learning information from a patient about a major change at her husband’s company?

The appeals court decision this week involved Chestman, a former stockbroker at Gruntal & Co. He had as a client Keith Loeb, the husband of a niece of Ira Waldbaum, then the president of Waldbaum’s. Word of the pending purchase of Waldbaum’s by Great Atlantic & Pacific Tea Co. filtered down through members of the Waldbaum family to Loeb and then, allegedly, on to Chestman. But the appeals court ruled that there was no evidence showing that Chestman had been told that the information was secret or that he had any fiduciary obligation to keep the information confidential.

The ruling specifically attacked an SEC regulation, known as 14e-3, which states that people who trade on advance knowledge of tender offers can be prosecuted even if they don’t have any specific fiduciary obligation to keep the information secret.

While his appeal was pending, Chestman had voluntarily begun serving a two-year prison sentence last June at the Allenwood Federal Prison Camp in Pennsylvania. He was released almost immediately after the appeals court ruling Wednesday. His lawyer, Elkan Abramowitz, said: “He’s home. I spoke to him. He’s reunited with his wife and family and sounds like a very happy man.”

Other legal experts, however, such as Joel Seligman, a professor at the University of Michigan Law School, noted that the three judges on the appeals panel were split. Seligman said he thinks that there is a good chance the appeals court decision itself could be overturned.

As it stands now, the ruling would only have effect in New York, the territory covered by the 2nd Circuit. But because the territory encompasses Wall Street, federal courts in New York have been the most important forum for bringing insider trading cases. The U.S. Attorney’s Office in Manhattan said a decision on an appeal may not be made for a month.

Officials at the SEC in Washington said the agency and Congress will probably wait to see what happens in court before proposing any new legislation on insider trading. Meanwhile, lawyers in other cases that may be affected by the ruling were scrutinizing it closely on Thursday.

Until now, Congress has been content to leave prosecutors and SEC enforcement officials in a position analogous to the possibly apocryphal story about the judge in a pornography case who supposedly said that “while obscenity may be hard to define, I know it when I see it.” For the moment, at least, prosecutors who think that they know insider trading when they see it may have to think again.