Court Ruling Backs SEC : Where to Draw the Line Is Still a Tough Call

So your big-deal brother-in-law--the one who works for that fancy Wall Street law firm--gets to bragging about his latest project, a takeover so huge it’ll make MCI-British Telecom look dinky.

Now you know you really shouldn’t, but where’s the harm in calling your discount broker and picking up, say, 5,000 call options on the target company? You’ll impress the hell out of the broker, not to mention clearing a quick few million.

Better think twice before you pull the trigger on that deal.

The Supreme Court on Wednesday upheld the government’s right to prosecute people for insider trading even if they have no direct connection to the companies involved.

The key is whether the people traded on information that they knew was misappropriated from its rightful “owner”--in our example, the brother-in-law’s law firm.

Of course, the Securities and Exchange Commission and other market watchdogs have been using the “misappropriation theory” to go after such “outsiders” for more than 15 years, but a couple of setbacks in appellate courts in recent years had cast a cloud over the approach.

While the high court’s solid-majority decision clarified the government’s position on this crucial theory, it doesn’t mean that there is suddenly a broad consensus on what constitutes insider trading.

Far from it.

Let’s try another scenario: You’re in a Hollywood bar favored by movie bigwigs, and you overhear a conversation between two designer-sunglasses types. It seems the new action blockbuster is a complete turkey and the studio’s $250-million investment is toast.

Naturally, you sell the studio’s stock short--betting that it will plummet--and you make a bundle when the movie bombs at the box office.

Questionable? Sure. Illegal? Not necessarily.

Even William McLucas, the SEC’s enforcement chief and one of the lead dogs in the fight against insider trading, acknowledged in an interview Wednesday that “eavesdropper” cases probably can’t be prosecuted.

The reason is that it would be hard to prove that the eavesdropper knew both that he was getting real inside dope as opposed to an after-hours rumor and that the information was being aired in violation of the chatty executives’ duty to their employer.

Until federal prosecutors developed the misappropriation theory in the early 1980s, securities-law experts say, the government had a hard time with many insider-trading cases.

Statutes and court precedents seemed to imply that insider trading could be conducted only by executives of the company that was the subject of a takeover bid or other major development.

The misappropriation theory let the government extend culpability to people who knew of such market-moving developments because they worked for law firms, investment banks, financial-printing companies or other service providers entrusted with information about deals.

Prosecutors used the new approach in sometimes creative ways, once going after a psychiatrist who traded on information he heard from a patient--the wife of a Fortune 500 executive.

In that case, the government argued successfully that the psychiatrist’s breaching of patient confidentiality constituted misappropriation of secret information.

On similar grounds, the SEC prosecuted former Wall Street Journal reporter R. Foster Winans for passing along tips on the contents of upcoming “Heard on the Street” columns.

While the Supreme Court blessed the government’s use of the misappropriation theory in Wednesday’s decision, it has previously reined in regulators over the same issue.

In a famous 1983 decision, the court exonerated a securities analyst named Raymond L. Dirks, who learned from an insider at Equity Funding Corp. that the firm had massively defrauded investors and was about to collapse.

Although Dirks notified the SEC--and the Wall Street Journal, for good measure--he first told his own clients to get out of the stock.

The SEC censured the analyst for insider trading, but the court ruled that analysts do not have the same responsibility for public disclosure that corporate executives do.

Mary Jo White, U.S. attorney for the Southern District of New York, which includes Wall Street, said in an interview Wednesday that over the last 15 years, her office has seen insider-trading jump the gap “from Wall Street to Main Street.”

For example, in a still-pending case that provides a twist on the “friends and family” phone plan, 17 people were charged with illegally trading on information funneled to them over a period of years by a then-executive of AT&T; Corp.

Sure, several of the defendants were executives of the telephone giant, but the bulk were hometown relatives and neighbors who allegedly couldn’t resist a good tip.

Although the government now has court-approved enforcement tools, few on Wall Street think the courts can do more than capture a token few violators, given the huge volume of trading, the burgeoning number of players and the multitude of corporate mergers and acquisitions.

Gary Lynch, a former SEC enforcement chief now in private law practice, said Wednesday that regardless of regulatory zeal, “people will still make the basic cost-benefit analysis and sometimes decide it’s worth the risk.”