As reported on Columbia Law School’s Blog on Corporations and the Capital Markets, the Bharara Task Force on Insider Trading, chaired by former U.S. Attorney for the SDNY, Preet Bharara, and comprising former U.S. Attorneys and staff, academics and judges, has now issued its report and recommendations. The objective of the Task Force was to address the problem that insider trading law “has suffered—and continues to suffer—from uncertainty and ambiguity to a degree not seen in other areas of law, with elements of the offense defined by—and at times, evolving with—court opinions applying particular fact patterns.” Why is that? Because insider trading law is not defined by statute and has instead “developed through a series of fact-specific court decisions applying the general anti-fraud provisions of our securities laws across a broadening set of conduct.” The result has been a lack of clarity that “has left market participants without sufficient guidance” on how to avoid, or defend against, insider trading, made it more difficult for prosecutors to establish their cases and given the public “reason to question the fairness and integrity of our securities markets.”
Although there have been prior attempts at legislation, they have not succeeded. Nevertheless, according to the Task Force, legislation is still the best approach to addressing the problem, The Task Force has summarized its conclusions as follows:
- “Reform that simplifies, clarifies, and modernizes insider trading law is necessary and long overdue.
- A legislative solution, in the form of a new statute expressly setting out the elements of an insider trading offense, would be the best vehicle for such reform. While other measures, including regulatory rule-making, could provide incremental benefits, any steps short of a new statute will continue to be burdened by the uncertainty that accompanies existing common law.
- To improve upon the current insider trading regime and to confront its most significant problems, the Task Force believes any new legislation should seek to apply the following key principles:
- The language and structure of any statute should aim for clarity and simplicity.
- The law should focus on material nonpublic information that is “wrongfully” obtained or communicated, as opposed to focusing exclusively on concepts of “deception” or “fraud,” as the current case law does.
- The “personal benefit” requirement should be eliminated.
- The law should clearly and explicitly define the knowledge requirement for criminal and civil insider trading enforcement, as well as the knowledge requirement for downstream tippees who receive material nonpublic information and trade on it.”
The report contends that, although the gravamen of insider trading is “unfairness,” the law on insider trading that has developed is not based on the idea of fairness in trading or harm to market participants, but rather on the idea of “fraud or deception committed against the holder of the information.” In general, the report continues, courts have viewed insider trading law to be based on “information ownership,” but have added a number of “quirks,” including requirements to show breach of a duty of trust and confidence owed to the shareholders (classical theory) or to the source of the information (misappropriation theory) or to show personal benefit (however that has been defined over time). But these quirks have generated many questions, often related to unique circumstances, that have challenged the courts. How should information be treated that was obtained illegally but without breach of a duty? When should “tippees” be held liable for insider trading? Do any of these requirements apply to prosecutions of insider trading under wire fraud and securities fraud statutes? The report observes that “the elements and theories of insider trading have shifted and evolved over time, often in unpredictable and confusing ways. Theories of insider trading have come and gone, and elements of the offense that once seemed well-settled (like the ‘personal benefit’ test) have at times been thrown into doubt by unexpected or unclear language in court decisions.” Similarly, the “focus on deception and the breach of a duty for Section 10(b) insider trading liability has also led to confusion in other areas, particularly in the rapidly-changing world of technology and cybercrime.” (The report has a terrific summary of insider trading law.)
Historically, although Congress has imposed civil and criminal penalties for insider trading (e.g., the Insider Trading Sanctions Act of 1983, the Insider Trading and Securities Fraud Enforcement Act of 1988), “[l]egislative efforts to codify insider trading or otherwise change or clarify the substantive elements of the offense [have] failed.” There have been some efforts at regulation, including Rule 14e-3(a), Reg FD, and Rules 10b5-1 and 10b5-2. However, one bill introduced in 2019 by Representative Jim Himes, “The Insider Trading Prohibition Act” (H.R. 2534), was passed in the House in December by an overwhelming bipartisan vote (410 – 13) and, therefore, may stand a chance in the Senate. According to the report, the Himes bill “sensibly shifts the focus to information that is ‘wrongfully’ obtained as opposed to having to rely entirely on concepts of fraud or deception.” However, the Task Force views its inclusion of a “personal benefit” requirement (added in by amendment by the Committee’s ranking Republican to help protect “good-faith traders,” according to the Financial Times), “undermines much of the [bill’s] improvement and simplification,” leaving “alternative statutes like Title 18 securities fraud or wire fraud… an even more attractive vehicle for prosecutors.”
The authors interpret the passage of the bill in the House as signifying a “broad consensus that has developed over the need to clarify and modernize our insider trading laws.” (Note that another bill related to insider trading that was passed by an overwhelming vote in the House is the “8-K Trading Gap Act.” See this PubCo post.)
As noted above, the report concludes that reform is long overdue and should come in the form of legislation, which would be “freed from any of the long-accumulated baggage of existing common law. It also carries with it the imprimatur of democratic legitimacy.” The Task Force has developed four principles that it believes should guide the effort to develop legislation:
- “Aim for clarity and simplicity.” The current uncertainties and ambiguities are driving the need for reform, so plain language, minimal exceptions and well-defined terms should be the standard.
- “Focus on ‘wrongful’ use of material nonpublic information, not exclusively on ‘deception’ or ‘fraud.’” Much of the current uncertainty has its origin in interpretations of the term “manipulative or deceptive device” in Rule 10b-5. Obtaining information wrongfully can be just as blameworthy, and a shift to “wrongful” would offer a number of benefits: addressing the different ways that information can be misappropriated in light of technological advances; capturing the distinction between inside information used for illegitimate or self-serving purposes as opposed to permissible purposes; eliminating the distinction between “classical” and “misappropriation” cases; and more clearly distinguishing the culpability of the tippee from the tipper.
- “Eliminate the ‘personal benefit’ requirement.” In the view of the Task Force, this requirement has created a lot of confusion, especially with regard to whether a showing of pecuniary gain is necessary, and “unduly narrows the way in which wrongful dissemination of inside information can be actionable.”
- “Clearly and explicitly define the state of mind requirement for criminal and civil insider trading, as well as the knowledge requirement for tippees.” These differing standards (“willfulness” v. “recklessness”) have led to much uncertainty. Establishing state of mind is especially difficult in “cases involving tipping chains (a common insider trading fact pattern), because it requires proving that a tippee had knowledge of the tipper’s breach of duty.”
The Task Force has produced the following model statutory language for consideration:
“It shall be unlawful for any person, (a) directly or indirectly, to purchase or sell any security, while in possession of material, nonpublic information relating to such security, knowing that such information had been obtained or communicated wrongfully, or (b) to wrongfully communicate or communicate wrongfully-obtained material, nonpublic information knowing that such information will be used in the purchase or sale of any security.”
Definition of ‘wrongfully’
“Wrongfully shall mean obtained or communicated in a manner that involves (a) deception, fraud, or misrepresentation, (b) breaches of duties of trust or confidence or breach of an agreement to keep information confidential, express or implied,69 (c) theft, misappropriation, or embezzlement, or (d) unauthorized access to electronic devices, documents, or information.”
“Any person who willfully violates this statute shall be sentenced to a fine not to exceed $5,000,000 or imprisonment of not more than 20 years, or both, except that when such person is a person other than a natural person, a fine shall not exceed $25,000,000. The Securities and Exchange Commission shall be authorized to enforce violations of this statute involving the reckless disregard of the fact that material nonpublic information was wrongfully obtained or communicated.”