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On Tuesday, the Insider Trading Prohibition Act passed the house by a pretty big bipartisan majority—350 to 75. Currently, there is no explicit statutory prohibition on insider trading and prosecutors have relied on general fraud statutes to pursue charges. The bill would add to the Exchange Act a new Section 16A that would define insider trading and make it illegal. In an interview with Reuters, the bill’s sponsor, Jim Himes, said that “the legislation does not expand insider trading law but simpli?es and codi?es the law as articulated by courts through decades of opinions.” A version of the bill passed the House in 2019 by an even stronger vote, but never made it through the Republican-led Senate.  No,w with Democrats in charge, will the bill be passed and signed into law?

Generally, the bill prohibits trading in securities, as well as related communications to others, by a person aware of material, nonpublic information that was wrongfully obtained. More specifically, the bill would make it unlawful for any person, directly or indirectly, to trade in any security while aware of material, nonpublic information relating to that security (or any nonpublic information, from any source, that would reasonably be expected to have a material effect on the market price of the security) (MNPI) if the person knows, or recklessly disregards, that the information has been obtained wrongfully, or that the purchase or sale would constitute a wrongful use of the information.

The bill also makes it unlawful for any person whose own trade in a security would violate the prohibition above to wrongfully communicate MNPI relating to the security to any other person if that other person trades in that security or tips the information to another person who trades in that security, provided that the trade (while aware of the MNPI) is reasonably foreseeable. 

The bill also prescribes when the conduct is to be considered “wrongful.”  Trading while aware of MNPI or tipping MNPI under these prohibitions is

“wrongful only if the information has been obtained by, or its communication or use would constitute, directly or indirectly—

(A) theft, bribery, misrepresentation, or espionage (through electronic or other means);

(B) a violation of any Federal law protecting computer data or the intellectual property or privacy of computer users;

(C) conversion, misappropriation, or other unauthorized and deceptive taking of such information; or

(D) a breach of any fiduciary duty, a breach of a confidentiality agreement, a breach of contract, a breach of any code of conduct or ethics policy, or a breach of any other personal or other relationship of trust and confidence for a direct or indirect personal benefit (including pecuniary gain, reputational benefit, or a gift of confidential information to a trading relative or friend).”

Notably, the statute would retain a personal benefit requirement. However, it is not necessary that the person trading or making the communication know “the specific means by which the information was obtained or communicated, or whether any personal benefit was paid or promised by or to any person in the chain of communication, so long as the person trading while aware of such information or making the communication, as the case may be, was aware, consciously avoided being aware, or recklessly disregarded that such information was wrongfully obtained, improperly used, or wrongfully communicated.”

Reuters reported that Columbia Law School Professor John Coffee “said on Tuesday that the language limits the bill’s value by allowing Wall Street traders to exchange information on the expectation of future favors and viewed it as unlikely to gain traction in a Democratic-controlled Senate.”

There is no control person liability (unless the control person participates), and there are several affirmative defenses, including for directed trading or trades that satisfy Rule 10b5-1 (which the SEC is required to review and modify as necessary).

SideBar

In February 2020, 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, issued a report and recommendations intended to address the ambiguity and uncertainty inherent in insider trading law.  According to the report, that state of affairs exists 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.” 

The report contended 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 continued, 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? 

Commenting on the 2019 version of the insider trading bill (that had just passed the House), the Task Force lauded the bill for “sensibly shift[ing] the focus to information that is ‘wrongfully’ obtained as opposed to having to rely entirely on concepts of fraud or deception.” Nevertheless, the Task Force considered 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), to undermine “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.”

Although prior attempts at legislation were not successful, the Task Force nevertheless concluded that legislation was still the best approach to addressing the problem.  The Task Force recommended that 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.”

(See this PubCo post.)

It’s worth noting that the failure to establish personal benefit also undermined a couple of Bharara’s high-profile insider trading cases as U.S. Attorney. As described by Bharara to the FT, “‘If you have a broad personal benefit requirement, it lets off the hook a rich insider who steals information from his company and benefits a crony or a family member to the tunes of tens of millions of dollars….That’s classic unfairness and it has to be clear that such a thing violates the law.’”

Posted by Cydney Posner

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