Emily Pataki | Bloomberg Law Stop Trading on Congressional Knowledge Act, S. 2038, 112 Cong. (2012) This week, the Senate took up a bill intended to prohibit Members of Congress and their employees from trading on nonpublic information derived from their official positions. Since the bill's introduction on the Senate floor, Majority Leader Eric Cantor (R-VA) has indicated support for a similar bill in the House of Representatives. The timing is significant—in his State of the Union Address on January 25, 2012, President Obama implored his bicameral audience: "send me a bill that bans insider trading by Members of Congress, and I will sign it tomorrow." Although insider trading laws have been interpreted to apply to both "insiders" and "outsiders" of publicly traded corporations and the general public, there is no express language in the law nor any case dealing with Congressional insider trading. As a result, there is now a public perception that Members of Congress and their staff can knowingly conduct financial transactions using the material nonpublic information they gain during the course of their jobs. Several new bills in the House and Senate aim to address this concern by removing any ambiguity in new statutory language.
Insider Trading and CongressInsider trading is often prosecuted as a violation of Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5 thereunder. Rule 10b-5 prohibits fraud "in connection with the purchase or sale of any security." Grounds for prosecution are also available to the Justice Department under the federal statutes prohibiting mail fraud and wire fraud. Federal judicial opinions interpreting Rule 10b-5 and these mail and wire fraud prohibitions have played a large role in shaping the elements necessary to prove a modern-day insider trading case. Two common insider trading theories exist within the parameters of these laws and Rule 10b-5: the classical theory and the misappropriation theory. The classical theory is used to prosecute "insiders" such as officers, directors, and employees of corporations.1 The U.S. Supreme Court established the misappropriation theory in 1997 in United States v. O'Hagan,2 and under this theory, a fraud in violation of Rule 10b-5 occurs when a person owing a fiduciary-like duty to the source of material nonpublic information misappropriates that information by secretly using it to personally profit. Unlike the classical theory, the misappropriation theory is used in the prosecution of "outsiders" who do not have any explicit duty or connection to an issuer's shareholders. The Court inO'Hagan explained that the misappropriation theory "premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information."3 To provide further clarity in this area, in 2000 the Securities and Exchange Commission (SEC) promulgated Rule 10b5-2, which provides a list of situations in which individuals are generally deemed to have a "duty of trust or confidence" under the misappropriation theory.4 Members of Congress would arguably fall under misappropriation theory parameters since they work for the federal government and are not corporate "insiders" reporting or bound to a corporation. Although there is no language in these laws exempting Members of Congress, or their staff, from insider trading liability, there are currently no cases or histories of prosecution either. Since there is no judicial precedent contemplating this scenario, experts have disagreed on how to define Members' "duty of trust or confidence" in this context.
Four Elements of the Misappropriation TheoryAs explained by the SEC's Director of Enforcement, Robert Khuzami, on December 6, 2011 in testimony before the Committee on Financial Services of the U.S. House of Representatives, the misappropriation theory has four elements which must be met: the (1) the existence of a duty of trust or confidence owed to the source of information; (2) the materiality of the information; (3) the nonpublic nature of the information; and finally (4) the presence of scienter. Rule 10b5-2 sets forth the non-exclusive circumstances when a duty of trust or confidence exists. The Supreme Court defined "materiality" in Basic, Inc. v. Levinson,5 as when there is "a substantial likelihood" that a reasonable investor "would consider it important" in making an investment decision. The SEC has defined "nonpublic" information as information that "has not been disseminated in a manner making it available to investors generally."6 In an effort to understand how Members of Congress are impacted by current law, senators and representatives have recently asked experts whether Congress is clearly covered by the law as it is currently interpreted by the courts. Director Khuzami stated in his testimony that there "is no reason why trading by Members of Congress or their staff members would be considered 'exempt' from the federal securities laws, including the insider trading prohibitions, though," he explains, "the applications of these principles to such trading, particularly in the case of Members of Congress, is without direct precedent."7
Congressional Ethics Rules and the Public's TrustOn November 29, 2011, the U.S. House of Representatives Committee on Ethics released guidance on the use of nonpublic information in personal financial transactions.8 Prior to the release of this guidance, personally profiting from circumstances relating to service in Congress was addressed in well-established ethical guidelines that cover fraud and bribery (with no mention of insider trading). In the recent guidance, the Committee on Ethics returned to familiar securities law to lay out clearly the insider trading prohibitions for Members. Although ethical guidelines are a constant reality of serving in public office, the circulation of a memorandum is not enough to close the door on this topic. As mentioned above, within the elements of the misappropriation theory, one threshold question in insider trading analysis is whether Members of Congress owe a duty of trust or confidence to the source of information. In 1978, the Second Circuit recognized a fiduciary duty owed by a Member of Congress to the federal government in United States v. Podell.9 Furthermore, the fiduciary responsibility that Members of the Senate owe to the federal government is set forth in Senate Standing Orders, which read, "the officer holds this power in trust to be used only for [the people's] benefit and never for the benefit of himself."10There are also express prohibitions in other government ethics rules prohibiting the use of one's government access to profit personally. Such a prohibition is set forth in House Rules which state that Members "may not use their official positions for personal gain."11 The Code of Ethics of Government Service states that any federal official may "never use any information coming to him confidentially in the performance of governmental duties as a means for making profit."12 Despite these numerous directives, Congress in recent months has expressed the need for more clear laws, and has been in the process of re-writing legislation that would explicitly and permanently prohibit Members from insider trading. S. 2038, the Stop Trading on Congressional Knowledge Act (STOCK), is one re-worked version of the STOCK Act now being debated on the Senate floor. In his December 14, 2011 press release discussing it, sponsor Sen. Joseph Lieberman (I-CT) stated that "a public perception has developed that Congress is not covered by insider trading laws, and worse, has exempted itself from them."13
A Brief History of the STOCK ActsCongressional insider trading was brought to light by former Congressman Brian Baird (D-WA) in 2006, with the introduction of the original STOCK Act. Rep. Baird's version of the STOCK Act would have amended the Exchange Act and the Commodities Exchange Act (CEA) to direct both the SEC and the Commodity Futures Trading Commission to prohibit a person from buying or selling securities while in possession of related material nonpublic information regarding legislative action if the information was obtained (1) knowingly from a Member or employee of Congress, or (2) by reason of being a Member or employee of Congress. The bill also would have amended the Ethics in Government Act to require Members' formal disclosure of certain securities transactions to the Clerk of the House and the Secretary of the Senate. Finally, the bill would have amended the Lobbying Disclosure Act of 1995 to require "political intelligence" activities to be disclosed in the same manner as lobbying activities. This bill had 14 cosponsors and never made it to the House floor. A hearing held by Rep. Baird to discuss the bill was very poorly attended. A similar bill resurfaced in 2007 under the same name, with 10 cosponsors, and again in 2009, also with 10 cosponsors. Rep. Baird had retired by the time various versions of the bill—this time at least four of them—were introduced in the current Congress. In 2011, Rep. Timothy Walz (D-MN) introduced H.R. 1148, while Senators Scott Brown (R-MA) and Kirsten Gillibrand (D-NY) introduced S. 1871 and S. 1903, respectively. In its current form, H.R. 1148 lays out many of the changes initially introduced by Rep. Baird in 2006, namely, the amendments to the Exchange Act and the CEA, and the added disclosure requirements for "political intelligence" activities. In addition, H.R. 1148 considers the fact that more than simply equities can be traded, and directs the Committees on Agriculture and Financial Services to hold hearings on the bill's financial transaction prohibitions that affect commodities and other non-equity securities. H.R. 1148 currently has 258 cosponsors. Recently, House Majority Leader Eric Cantor has indicated that any House bill will have to be comprehensive and perhaps should include restrictions on unethical real estate transactions in addition to securities trades.
Sen. Lieberman's Version of the STOCK ActIn the Senate on December 14, 2011, the Homeland Security and Governmental Affairs Committee, led by Sen. Joseph Lieberman, (I-CT) adopted the revised version of the STOCK Act that is currently being debated, on a bipartisan vote of 7-2. S. 2038 is a direct result of in-depth hearings and discussion held in December of 2011 between leading experts in securities law and the Senators who, by virtue of their Committee membership, have jurisdiction over drafting insider trading laws that will affect government employees. The new bill demonstrates both an effort to make insider trading laws unambiguous in their application to Congress and federal employees, but also to protect and keep intact all insider trading doctrine that has preceded this STOCK Act. S. 2038 does the following:
ConclusionIn the coming weeks and months, both the Senate and the House will likely debate and amend the Stop Trading on Congressional Knowledge Act. New language may be suggested to address unethical real estate transactions as well as trading by executive branch employees. Some securities experts have cautioned that, as the bills are potentially amended, legislators should be mindful that new prohibitions do not confuse or corrode authority already existing under current law. The feedback that the Senate and House have received from outside experts will play a role in shaping the final text, as will further inquiry into the role and reach of political intelligence firms. Although Sen. Lieberman's new bill no longer contains language impacting political intelligence firms directly, the bill does call for a review of the industry by the Comptroller General. DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.
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