Someone on the Inside: The Chaos of Insider Trading Laws

Written by Nicholas Ronk

Edited by Ritvik Mahendra, Saanya Pherwani, and Juliette Draper

In American political discourse, it’s commonplace to see the vast majority of issues manifest into two dominant schools of thought. Typically, these fall along party lines. Perhaps the biggest exception to this, however, is the subject of insider trading. For decades, there has been massive bipartisan support for the regulation of what and how corporate elites are allowed to trade on their portfolios in light of the non-public information they tend to possess. In fact, Americans have been unified on the front for so long that the Securities and Exchange Commission (SEC) started sanctioning people for such behavior over 50 years ago. Albeit, it didn’t become a top priority until closer to 30 years ago. [1] In any case, one thing is clear for most Americans: if an employee has access to protected information about their own company, a competing one, or a certain industry in general that would provide them with an unequal advantage through this insight, they shouldn’t be able to buy or sell securities that relate to said insight.

Throughout the 2000s, insider trading was almost exclusively focused on internal corporate affairs of this variety. The only law that existed was the Insider Trading and Securities Fraud Enforcement Exchange Act of 1988 that amended a racketeering law from 1934. This law would then go on to become prominent within insider trading law discourse. [2] However, all of this changed in 2011 when a 60 Minutes special exposed that congressmen often have access to similar, or even the same, information as many of these corporate actors. [3] If these congressmen were not in their government positions, they would have faced major criminal charges. However, the only reason they had access to such information in the first place was due to their elected status. Suddenly, a consequence-free loophole exists for congressmen to trade publicly on information that could potentially provide an advantage. Of course, this supposes the notion that elected officials are actually capable of exploiting this information to begin with, but even if they aren’t, it is principally an unfair advantage.

Due to public upset, it didn’t take long for the White House to respond to this uncovered information.. President Obama released a statement a few months later saying, “send me a bill that bans insider trading by members of Congress; I will sign it tomorrow.” [4] Sure enough, Congress passed a bill that was quickly signed into law by President Obama on April 4th, 2012. Some hold that this maneuver was simply to reestablish public trust as several amendments were included soon after that limited its reach. However, it did still extend Congress to be subject to all the current insider trading laws in addition to internal discipline from within their respective chambers. [5]

Unfortunately, when you fast forward to the present, the problem still exists. As recent as October 19th, forty members of Congress have been caught violating the law. [6] Even high-ranking politicians, such as Nancy Pelosi (D-CA), Rand Paul (R-KY), and Mitch McConnell (R-KY), have received public scrutiny over their suspiciously consistent annual returns in investments. While it can’t be proven that these profit margins are correlated directly to insider trading, it paints an unsavory picture in voters' minds about the state of our democracy. [7] In order to actually incriminate someone, you would first need to trace a particular trade back to the congressman and show it relates to a subcommittee they are on. Then, you must prove that the congressman’s knowledge can create an advantageous gain. Even with all of this, you would still have to conduct the test of materiality, where you must prove that they have enough comprehension of the stock market to consciously abuse that information. [8] With so many unknowns and moving parts, it has proven to be one of the few areas in our legal system with essentially no clarification. Fortunately, the solution might be simpler than we think.

To understand how this insider trading relates to congressional members, it’s crucial to first understand the complicated, incomplete, and nightmarish jurisprudential history of insider trading regulations. These regulations are not defined by specific legislation, but instead, come from a slew of Supreme Court interpretations rooted in SEC regulations. These court decisions extended cases of insider trading to be pursued under the broad anti-fraud provisions of the Securities Exchange Act of 1934; [9] legislation originally designed to regulate more general acts of racketeering and the same legislation that was amended by the Insider Trading and Securities Exchange Act of 1934. Specifically, the Supreme Court looked to §10(b) and Rule 10b-5 of the law where the general anti-fraud provisions originate. For all intents and purposes, the language in this section is broad enough to cover this specific type of fraud as it prohibits the use of any “device, scheme, or artifice to defraud” in the exchange of securities. [10] The courts have also concluded that Rule 10b-5 provides an implied private right of action to sue, so long as the party that brings the suit forward has traded the securities in question in some facet. [11] However, the notorious drawback of broad language in legal framework is that it leads to a lack of clear enforcement. In many ways, the unclear nature of this definition has resulted in substantial market abuses going unchecked, yet other less serious offenses being criminalized heavily. While many would rather see guilty offenders walk free than innocent traders wrongfully prosecuted, it begs the question of whether or not there is a better way to define, enforce, and regulate such a complicated financial crime.

The obvious solution would be to create new statutes that more clearly define insider trading; this should’ve been done by the STOCK Act of 2012. It could also be achieved through a more narrowed judicial interpretation at the Supreme Court. At the very least, a clearer definition would make the current laws more enforceable. But legal theorists see a slew of reasons why that is not likely to happen. First and foremost, it’s essentially impossible to identify a victim of the crime itself. [12] While it can be argued that the victim is, generally speaking, all other traders on the market that were deprived of such information, it’s difficult to see that holding up in the legal process. Even if it did, it would be unhelpful in the actual process of prosecuting the offender. Second, going through the Supreme Court to more narrowly define the offense would more than likely have to overturn the 6-3 decision in United States v. O’Hagan. This was actually a 7-2 decision in all four parts except for the second, in which Antonin Scalia dissented on matters relating to the court’s analysis of certain convictions under §10(b) and Rule 10b-5. [13] Scalia argued that for something to fall under the category of insider trading, “(it) must be construed to require the manipulation or deception of a party to a securities transaction.” [14] To overturn that decision is to overturn major financial-legal precedent, something that most, but especially conservative leaning justices are hesitant to do based on the potential consequences it can create in future discourse. The last reason is perhaps more cynical and far-reaching, but many hold that because certain aspects of insider trading are both beneficial for the economy and allow for some degree of internal exploitation, there is little incentive for law-makers to extend regulations further. After all, they can hide behind the sheer fact that laws technically do exist in writing that are both designed and intended to stop insider trading, creating an illusion of regulation for the vast majority of Americans and effectively allowing the activity to ensue. From a fiscal standpoint, it has even been argued that using non-public information to trade securities creates market and allocational efficiency because securities prices are more rapidly and accurately reflected. The result, some argue, is optimal allocation of capital resources though this more accurate capital-asset pricing. [15] Others have said that beyond increased efficiency alone, efficient allocation of capital also makes the market wealthier in general regardless of how it affects the actual share price of the securities in question. [16]

Considering all of these financial factors, it’s not necessarily a reach to see why congressmen feel no incentive to respond to public opinion on the matter. From their perspective, they’ve provided enough regulation to minimize constituent backlash, yet not enough to impede market efficiency nor the growth of their own portfolios. Any further prohibition would likely affect every congressional member's ability to freely trade, even the ones that aren’t breaking any laws. Considering this is one of the only streams of income that elected officials are allowed to have while in office, it’s not difficult to see why Congress feels they have a lot to lose by putting any further regulations on themselves.

This subject is more than just complicated: it’s ever evolving. As recently as Thursday, October 21st, the Federal Reserve has implemented a massive, self-imposed restriction on trading to the unelected bureaucrats employed by the agency that could obtain non-public information, including the presidents of the 12 banks and the board of examiners in Washington. [17] The restrictions will render these employees, their senior officials, and any other employee of the Fed that have access to sensitive information to trading only diversified assets such as mutual funds. This means no more buying or selling of individual bonds, the holding of agency securities, derivative contracts, or even individual stocks for individual companies. [18] The regulation will also affect how Fed officials must report their trades: now requiring a 45 day notice for any action and a minimum hold time of one year. They will also be highly restricted during times of heightened financial-market stress. [19]

While the Federal Reserve is by no means an elected body of officials, this is still a huge step in the right direction in the scope of insider trading regulation because it provides a framework as to how this can be solved on the Congressional front. Based on the unclear definition of insider trading, the complexity involved in both prosecuting and proving the violation of such an act, and the unlikelihood that new legislation nor judicial review will be introduced to reconcile the legal conundrum, I propose a solution that falls somewhere between the regulations taken by the Federal Reserve and the self-imposed procedures that have been taken by a vast majority of U.S. Presidents. To clarify, Congress would still be barred from the buying, selling, and trading of all forms of non-diversified assets; similarly to the regulations just recently put in place by the Federal Reserve. However, it would be taken a step further in that, similarly to that of every President in recent history (with the exception of one), would force their money into a blind trust rather than just a mutual trust. While no law has existed since 1989 that obligates the seizure of private assets, all but President Donald Trump opted to put the entirety of their assets in a blind trust. [20] Trump instead opted to list his children as the holders and managers of his funds- a maneuver that received a lot of public backlash. [21] By adopting the Federal Reserve’s model of insider trading regulation and adding a blind trust mandate, it renders elected officials in the legislative branch effectively unable to trade while in office. This means that neither reporting of trading maneuvers forty-five days in advance nor the one-year holding requirement need to be implemented, as the entirety of their portfolios would essentially be frozen, or rather, temporarily transferred to a third party wealth manager while serving office. Because it is extremely unlikely that Congress would purposely vote something like this into law, the most viable way to see this enforced would be through a new interpretation of the STOCK Act of 2012, particularly the provisions pertaining to internal disciplinary procedures.

This proposed solution to insider trading by elected officials provides a lot of collateral benefits if adopted. First and foremost, it provides a clear, unequivocal solution to an age-old problem that has too much nuanced legal grey area within it to be enforced somewhere in between legal and illegal. As stated earlier, the current approach of partial regulation has criminalized mostly mild offenses while leaving more serious offenders to walk scot-free, whereas this solution would leave no one in doubt of whether or not abuse of power is occurring or not because it wouldn’t allow for any trading actions whatsoever, legal or illegal. Secondly, support in favor of this regulation is seemingly growing. While surprisingly, no U.S. wide statistics, studies, or polls seem to yet exist regarding this subject matter, the volume of opinion pieces, stories, and general coverage suggests that there is a massive growing movement for full on prohibition, especially in light of the recent reports regarding the Federal Reserve’s new rules which have created further stir in the media. Finally, and perhaps most crucially of all, it is one of the many ways we can inch closer to the bipartisan goal of removing money from politics. According to Pew Research Center, over 65% of Americans want to restrict campaign finances in some substantial way, which suggests disapproval of the general idea of wealth influencing politicians. [22] It wouldn’t be a reach to suggest that if that many Americans feel this way about campaign contributions and how it can ultimately influence a politician’s loyalties, they would certainly feel the same way about how such a position of power could affect a politicians ability to be an honest trader while in possession of knowledge that can substantially grow their wealth. By removing the action in question entirely, politicians would be forced to choose between dedicating their foreseeable future to their constituents and their liquid assets rather than some unclear line in the middle. I think this would soon be followed by a substantial drop in career-politicians and unresponsive incumbents in office- many of whom are worth millions of dollars and do not serve their constituents' needs as is. Instead, the door would open up to more honest candidates that are less inclined to commit an act that could be perceived as exploitative based on their position, all the while putting a swift end to the question of insider trading.


 


[1] Peter J. Henning, “What’s So Bad About Insider Trading Law?” The Business Lawyer 70, no. 3 (2015): 751–76. https://www.jstor.org/stable/26417515.

[2] Insider Trading and Securities Fraud Enforcement Act of 1988, H.R.5133, 100th Cong.

[3] Zeke Miller, '60 Minutes' Blows The Lid Off Congressional Insider Trading, Bᴜsɪɴᴇss Iɴsɪᴅᴇʀ (Nov. 14, 2011), https://www.businessinsider.com/congressional-insider-trading-revealed-on-60-minutes-2011-11.

[4] Press Release, White House, FACT SHEET: The STOCK Act: Bans Members of Congress from Insider Trading (Apr. 4, 2012), https://obamawhitehouse.archives.gov/the-press-office/2012/04/04/fact-sheet-stock-act-bans-members-congress-insider-trading.

[5] Mark Strand, Tim Lang, Can Members of Congress Engage in Insider Trading?, Cᴏɴɢʀᴇssɪᴏɴᴀʟ Iɴsᴛɪᴛᴜᴛᴇ (Aug. 16, 2018), https://www.congressionalinstitute.org/2018/08/16/can-members-of-congress-engage-in-insider-trading/.

[6] Dave Levinthal, 57 members of Congress have violated a law designed to stop insider trading and prevent conflicts-of-interest, Bᴜsɪɴᴇss Iɴsɪᴅᴇʀ (Feb. 15, 2022), https://www.businessinsider.com/congress-stock-act-violations-senate-house-trading-2021-9.

[7] Strand, supra note 5.

[8] Henning, supra note 1.

[9] Id.

[10] United States Code: Securities Act of 1933, 15 U.S.C. §§ 77a-77mm (1934).

[11] Id.

[12] Henning, supra note 1.

[13] United States v. O'Hagan, 521 U.S. 642 (1997).

[14] Id.

[15] Lawrence M. Ausubel, “Insider Trading in a Rational Expectations Economy.” The American Economic Review 80, no. 5 (1990): 1022–41. http://www.jstor.org/stable/2006759.

[16] Henning, supra note 1.

[17] Nick Timiraos and Michael S. Derby, Fed Imposes New Restrictions on Officials’ Investment Activities, Tʜᴇ Wᴀʟʟ Sᴛʀᴇᴇᴛ Jᴏᴜʀɴᴀʟ (Oct. 21, 2021), https://www.wsj.com/articles/fed-imposes-new-restrictions-on-officials-investment-activities-11634839207.

[18] Jeff Cox, Fed to ban policymakers from owning individual stocks, restrict trading following controversy, CNBC (Oct. 21, 2021), https://www.cnbc.com/2021/10/21/fed-to-ban-policymakers-from-owning-individual-stocks-restrict-trading-following-controversy.html.

[19] Id.

[20] Jennifer Wang, Why Trump Won't Use A Blind Trust And What His Predecessors Did With Their Assets, Fᴏʀʙᴇs (Nov. 15, 2016), https://www.forbes.com/sites/jenniferwang/2016/11/15/why-trump-wont-use-a-blind-trust-and-what-his-predecessors-did-with-their-assets/?sh=351898ee29c0.

[21] Lyle Denniston, Does the Constitution put limits on a president’s private business ties?, Cᴏɴɢʀᴇssɪᴏɴᴀʟ Iɴsᴛɪᴛᴜᴛᴇ (Nov. 22, 2016), https://www.congressionalinstitute.org/2018/08/16/can-members-of-congress-engage-in-insider-trading/.

[22] Bradley Jones, Most Americans want to limit campaign spending, say big donors have greater political influence, Pᴇᴡ Rᴇsᴇᴀʀᴄʜ Cᴇɴᴛᴇʀ (May 8, 2018), https://www.pewresearch.org/fact-tank/2018/05/08/most-americans-want-to-limit-campaign-spending-say-big-donors-have-greater-political-influence/.


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