Financial Advisors

Insider Trading Act Seeks to Close Case Law Gap

The case law on insider trading has developed over decades, bolstered through multiple legal statutes and numerous court decisions. Despite the girth accumulated over these many years, however, unscrupulous individuals still find new ways to try to skirt the law for profit by exploiting nonpublic information. The Insider Trading Prohibition Act (H.R.2578), introduced by Rep. Jim Himes (D, Conn.), seeks to give prosecutors a more certain means of combating insider trading.

Insider trading is no trivial matter in investment markets. Markets are built on trust between counter parties, often unknown to each other. Anything that undermines that trust, therefore, undermines investment markets. It is the ultimate betrayal in the financial world, arising from the exploitation of closely held secrets entrusted to the clandestine leakers by their employers, colleagues, clients, friends, or even their spouses, all for someone’s nefarious financial or other gain.

The Himes bill is that rarest of all documents in Washington DC: a truly bipartisan bill developed jointly and collaboratively for what both sides perceived as what is best for the nations’s investors and markets. Even after a Republican amendment was rejected, the bill passed by a vote of 410 in favor versus 13 against.

Concerns about the porous nature of insider trading laws surfaced during the so-called Newman case (United States v. Newman, 773 F.3d 438 (2d Cir. 2014)). In that case, the U.S. Court of Appeals for the Second Circuit in New York overturned a lower court conviction of Todd Newman and Anthony Chiasson for accepting and trading on confidential information received from an investor relations officer. According to the Harvard Law School Forum on Corporate Governance and Financial Regulation, the Appeals Court held the duo did not have “a meaningfully close personal relationship” with the tipper, and therefore had not breached any trust.

It is this gap that the Insider Trading Act intends to bridge. The bill would lower the threshold for culpability in an insider trading case by making investment actions taken “while aware” of insider information the standard for prosecution, rather than a more onerous “possession” of such information. It also will give prosecutors options to enforce the prohibitions.

But experience suggests caution against irrational exuberance about this bill.

Gaps that the Insider Trading Prohibition Act seeks to close

The bill seeks to fill a gap that the courts have already addressed and introduces the risk that the new law will be perceived as duplicative and unnecessary. In the U.S. Supreme Court case, Salman v. United States, the justices concluded that the brother-in-law of the tipper’s brother was closely enough connected to the beneficiary of the information to satisfy the personal-benefit requirement. Even the Second Circuit annulled its own Newman decision in U.S. v Mortoma, by concluding a tipper can receive a personal benefit from a gift of insider information even without a close personal relationship.

Further, while the Act intends to translate common law jurisprudence into statute, there are plenty of provisions within the securities acts and the regulatory structure that address insider trading. The SEC’s Rule 10b-5, for instance, provides a principles-based definition of what constitutes market manipulation, including insider trading.

Moreover, even a wholly bipartisan effort can’t ensure against unintended consequences. Codifying a definition for insider trading is useful in enforcement, but it also creates a road map for avoidance. And, despite best efforts to prevent expansive application of the new law, implementation or interpretation could prove so all-encompassing that it stifles appropriate communication or trading for fear of violating some provision.

Finally, all legislation suffers from inertia. The phrase, “it would take an act of Congress,” recognizes the difficulty inherent in getting laws passed by any legislative body. Changing or repealing those laws once in place is even more difficult. If the Insider Trading Prohibition Act overreaches in unforeseen ways, it would take another act of Congress, or a Supreme Court decision to change it, not to mention the many years, countless court cases and costs, and missed opportunities before we get there.

All that said, it is difficult to argue against measures seeking to punish those who take unfair advantage and abuse the trust of others. And it appears the parties in development of this law have taken great pains to address as many of these contingencies as they can. Here’s hoping their fine-tuning ultimately works for the benefit of investors and markets for the foreseeable future.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Jim Allen

Jim Allen, Managing Director, CFA Institute, leads advocacy and outreach efforts for the CFA Institute office in Washington, DC. He represents the organization with lawmakers, regulators, and other financial policy professionals on issues ranging from Dodd-Frank and fiduciary standards to global and domestic systemic risks. Prior, he worked in investment banking, research and journalism.

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