Fixing the insider trading prohibition act
The Insider Trading Prohibition Act is back and stalking the halls of Congress again. After being passed by the House in late 2019, ITPA went on to a deserved demise in the Senate. With the change in Senate control this year, the House has passed the bill again, and there is renewed hope for its sponsors — and renewed concerns for market participants who may need to comply with an even more ambiguous set of insider trading rules.
When talking about insider trading, it is important to put aside most common wisdom on the topic. There is nothing unlawful about trading based on “material nonpublic information” about a company.
Investment advisors and stock market analysts make their living seeking information advantages for their clients. Indeed, public policy generally supports the release of as much corporate information as possible into the market, and our regulatory scheme should incentivize investors to seek out and publicize that information.
Insider trading based on an information advantage is only illegal when it results in a violation of the anti-fraud provisions of the federal securities laws. Under existing case law, that generally happens when a corporate insider trades on material nonpublic information for his own benefit, when someone deceptively takes material nonpublic information that does not belong to them and uses it to trade, or when these individuals provide — as a “tipper” — the material nonpublic information to someone else to trade on in return for a personal benefit. The personal benefit requirement for tipper/tippee liability has proven difficult for courts, with a string of recent Second Circuit and Supreme Court decisions attempting to figure out how it should be applied in various factual circumstances.
ITPA purports to merely codify our existing insider trading prohibitions with a few slight changes. The problem with codifying existing insider trading law, however, is that it is a mess. The actual effect of ITPA would be to expand the scope of insider trading liability by turning a number of existing ambiguities, and a few new ones, into the law of the land. The Senate has a lot of work to do.
First, ITPA codifies the existing personal benefit requirement for a tipper, but says it is “a direct or indirect personal benefit (including pecuniary gain, reputational benefit, or a gift of confidential information to a trading relative or friend.)” It is possible to describe virtually any human interaction as providing an “indirect benefit” to the participants. Rather than giving courts clear guidance as to what sort of benefit is necessary to create liability, the provision sets courts up for a game of prosecutorial whack-a-mole. ITPA should reflect the common sense notion that the source of information either received something tangible and valuable in return or provided what amounts to a monetary gift to a relative or friend.
Second, ITPA uncontroversially states that trading on information wrongfully obtained or communicated as a result of theft, deception, or a breach of fiduciary duty will lead to liability. It also contains a catchall provision, however, extending the concept to “a breach of a confidentiality agreement, a breach of contract, or a breach of any other personal or other relationship of trust and confidence.” But the bill is silent on how courts are supposed to assess whether any of these items existed or were breached, an issue that has troubled courts for years. For example, if the source of the information tells the potential trader that the information is confidential, is that enough to form a confidentiality agreement or a relationship of trust and confidence? This is a system ripe for abuse, with companies potentially able to prevent individual investors from trading merely by providing them with information whether they want it or not.
Third, ITPA expands the types of traders who can be held liable for insider trading. Currently, a trader has to act with some form of intent to violate the law. Under the bill, however, anyone who “was aware, consciously avoided being aware, or recklessly disregarded” that the information was wrongfully obtained or communicated can have a case brought against them. ITPA is silent on the meaning of “recklessly disregarded,” which would appear to rope in innocent traders along with actual wrongdoers.
Finally, ITPA does not contain an exclusivity clause stating that it will be the sole basis for bringing federal insider trading claims. Allowing prosecutors to cherry pick their preferred law is no way to provide clear rules for the market. Indeed, there is a federal statute that allows the Department of Justice to bring criminal insider trading claims without having to demonstrate the existence of a personal benefit. So much for ITPA’s personal benefit provision.
There is little dispute that the knowing use of material nonpublic information obtained in clearly illicit ways to reap securities trading gains — commonly known as “stealing” — is what the government should be trying to prevent. At the same time, we do not want to chill the valuable communications that go on between company insiders and market participants, which provide investors with important real-time information about their investments. ITPA is an opportunity for Congress to establish insider trading prohibitions with a clear set of limited rules that the government and investors alike can easily follow.
To that end, Congress needs — at a minimum — to narrowly define “personal benefit,” drop the catchall provision as to how information can be wrongfully obtained or communicated, limit liability to individuals with actual knowledge of their wrongdoing, and make ITPA the exclusive basis for federal insider trading claims.
On the other hand, if Congress is merely going to codify (and expand) our existing ambiguous insider trading law, ITPA’s demise should be permanent this time.
M. Todd Henderson is a law professor at the University of Chicago and the author of “The Trust Revolution: How the Digitization of Trust Will Revolutionize Business and Government.”
Lyle Roberts is a Washington-based partner with Shearman & Sterling LLP.