The “Don’t Ask, Don’t Tell” Model of Insider Trading

In 2014, a landmark insider trading case (U.S. v. Newman) redefined the nature of insider trading.

According to the ruling, a person who had profited off of tips from an insider was not insider trading unless there was something given in exchange for the tips.

In other words, a corporate heavyweight could simply let his golf buddies in on a piece of inside information, but because of a casual friendship and a lack of quid pro quo, this wouldn’t be considered criminal insider trading. And this is the exact sort of legal loophole that helped Phil Mickelson avoid insider trading charges in a recent case.

Deans Double Down

Four years ago, Mickelson got a call from William Walters, a professional gambler who is well known in Las Vegas for his aggressive and successful sports bets. Walters urged Mickelson to put his money into a company called Dean Foods.

It just so happens that Dean Foods was soon going to announce a spinoff of its organic foods department. The spin off wasn’t yet announced to the public, but the board of directors knew that the information would make the stock pop. One of the board member told Walters, who accumulated shares in the company worth more than $50 million.

Phil Mickelson wasn’t exactly up for such high stakes though. Some estimates suggest he’d made over $80 million over his long professional golf career. Record show that he’d never bought any shares in Dean Foods before the phone call.

A few days after the phone call, however, he’d dropped $2.4 million to buy 200,240 shares in the company, and some of these shares were even bought on margin. When the announcement was made a week later, Mickelson had pocketed $931,000 in profits as the stock soared 40%.

Don’t Ask, Don’t Tell

The story of rich people calling each other up and making risky trades on inside information like this probably sound like a crime. And for the most part, it is. Thomas Davis, the board member who leaked the information to Walters, pleaded guilty. And William Walters was arrested shortly after as well. The men had taken advantage of their access to tomorrow’s headlines and made a huge amount of money. But things get interesting when you consider Mickelson.

The golf pro wasn’t charged at all and the reason was that 2014 U.S. v. Newman court ruling, which is considered a major victory for Wall Street. It effectively legalized the “don’t ask, don’t tell” model of insider trading.

Before the ruling, it was considered a crime if someone got insider information, (anything that was not known to the public and had the potential to move markets) and acted on this information. But what if this person had no idea where the information came from?

Acting on vague information that came from someone who isn’t an insider is not insider trading, as per this law. So, as long as you get the information secondhand and don’t know much about where it came from, it’s fair game.

Murky Waters

Of course, this raises a lot of questions about the effects on the integrity of the markets. Insider trading remains a murky financial crime given that it’s a challenge to define, and with recent rulings, is even harder to prosecute. And this case demonstrates those challenges perfectly.

Preet Bharara, a US prosecutor who’s earned a bit of a reputation on Wall Street, seemed to deflect questions from the media about Mickelson.  Mickelson’s lawyers, meanwhile, have portrayed the golf champion as “an innocent bystander.”

It’s now known that Mickelson owed Walters money on a gambling debt, and used some of the proceeds from the million-dollar profit to pay him back. When you take a step back and look at the bigger picture, it seems like this is a pretty straightforward case of insider trading, and yet a main player involved appears to have gotten away with it scott-free.

Of course, the two other men were prosecuted, but that was mainly because they were directly involved and used unsophisticated methods like prepaid dumbphones and simple code words. The whole timeline of events leaves no doubt that Walters and Davis executed a get-money-quick trade based on their so-called “edge.” And the only one who’s not charged with a wrongdoing is the pro-golfer with limited stock investing experience. The implication seems to be: Maybe he didn’t know better.

While Mikelson may not be as culpable as the finance pros involved, this case brings up many important questions about what constitutes wrongdoing when it comes to privileged information. And these questions must be answered definitively as we cannot simply rely on a, “When I see it, I know it” approach, which leaves plenty of wiggle room for those who see ambiguity as an opportunity.

About the Author:  Andrew May is a hedge fund attorney and the founding member of May Law, a commercial and financial law firm that specializes in startup businesses and FINRA arbitration.  He is also an avid blogger who enjoys sharing his advice and expertise on a variety of business sites.  Click here to learn more.

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