Why Congress Isn't Liable for Insider Trading
By Lawrence Greenberg | More Articles
January 10, 2012 | Comments (26)
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At one time or another, Congress self-servingly said its members didn't need to obey laws as varied (and burdensome) as the Civil Rights Act and the Freedom of Information Act. Nevertheless, Congress didn't exempt itself from the law against insider trading -- at least in part because there isn't one.
Unlike some other countries, the United States has no law forbidding people from trading on inside information. Does that mean that famous convicted inside-traders such as ImClone's Sam Waksal, corporate-raider Gordon Gekko, or Galleon Group's Raj Rajaratnam should call their lawyers and appeal their criminal convictions? No (although Gekko is fictional and Waksal already served his time).
What the law says
For lawyers, one of the neat characteristics of U.S. securities laws is that they're made up of statutes, Securities and Exchange Commission regulations, and court decisions interpreting those laws and regulations. The SEC's Rule 10b5, under the Securities Exchange Act of 1934, makes it illegal for anyone to "employ any device, scheme, or artifice to defraud" in connection with the purchase or sale of a security.
Over time, the courts have held that people engage in fraud or deception under Rule 10b5 when they trade on material, nonpublic information obtained as part of a relationship of trust or confidence -- so, to simplify, it's generally illegal for you or me to trade on the inside information we learn from our employers.
It's important to recognize, though, that the SEC's rules, as interpreted by the courts, don't make it illegal for people merely to trade on information that others don't have. We want people to conduct research and develop unique information. Rather, the securities laws try to level the playing field between corporate insiders, who generally have access to lots of information, and outsiders, who have less. That's why the courts have required that, in order for a person's trading on nonpublic information to be illegal, the person must have obtained that information because of a special, trusted status and have a duty to keep it confidential -- typically because the person has a position at a company or enjoys a relationship of confidence, as would a lawyer, for example.
Two theories of insider trading
There are two main theories of insider trading. The "classical" theory applies when people trade in a company's stock based on information they receive from that company, when they have some obligation to keep that information secret. In other words, if you're an executive at XYZ Co., and you learn that XYZ has been awarded a big defense contract, your decision to buy XYZ stock before the deal is announced could be a fashion choice, as well as an investment decision, and you'd better hope that you look good in prison stripes (or orange jumpsuits, as applicable).
Members of Congress aren't likely to be subject to liability under this theory because they don't owe confidentiality to companies in the marketplace. They're Congress, dagnabbit, not corporate flunkies (I could write something snarky here, but I won't).
The "misappropriation" theory of insider trading says that when people have a fiduciary or similar obligation to someone, they can't use that person's information for their own gain without disclosing their use of the information to that person. An example helps here: If a lawyer who represents PQR Co. learns that PQR is about to buy XYZ, he can't just run out and buy XYZ stock. Note that in a misappropriation case, the "victim" is actually the source of the information, not the faceless, uninformed chump on the other side of the transaction.
The enforcement challenge
You might think, as some legal scholars do, that members of Congress owe the American people at least as much loyalty as lawyers owe their clients, so that members who used congressional information for their own ends would be misappropriating it and thus breaking the law.
But other legal scholars, as well as the SEC, doubt that members owe that sort of duty. As Thomas Newkirk, former associate director of the SEC's Division of Enforcement, told The Wall Street Journal, members don't have "a duty of confidentiality to anybody and therefore ... would not be liable for insider trading."
Similarly, Robert Khuzami, director of the Enforcement Division, testified before Senate in November that to win an insider trading case against a member of Congress, the SEC would have to demonstrate that the lawmaker violated a fiduciary or other duty of trust and confidence, and it is not clear that such congressional trading "violates the fiduciary duty he or she owes to the United States and its citizens, or to the federal government as his or her employer."
Without a firm understanding that the law is on their side, SEC regulators or Justice Department prosecutors are unlikely to bring cases against members who trade on congressional information. Bringing an action against a member of the branch of government that sets your budget is hard enough, but it's particularly daunting when your legal basis is shaky.
So, for now, it appears that unlike the rest of us, members of Congress can trade on inside information with legal impunity. They didn't create that situation, but unless they pass the STOCK Act, or something like it, they're certainly perpetuating it.