WASHINGTON, DC – The fact that there is no federal statute on the books specifically banning insider trading is not a secret, but it is shocking. Rather, the unlawfulness of insider trading is predicated on the notion that insider trading is a type of securities fraud under the Securities Exchange Act of 1934 and subject to broad judicial interpretation. With courts left to define much of the law on a case-by-case basis, the result has been an unnecessarily complex, inconsistent, and uncertain legal standard.
Seeking to improve the fairness of our securities markets and crack down on harmful insider trading, U.S. Senators Jack Reed (D-RI) and Bob Menendez (D-NJ), two senior members of the Senate Banking Committee, today introduced the Stop Illegal Insider Trading Act to establish a clear statutory prohibition against insider trading. This legislation seeks to clearly define the offense of insider trading under the law and remove some of the uncertainty that has curtailed securities regulators’ and law enforcement’s ability to effectively prosecute insider trading cases.
According to the Securities and Exchange Commission (SEC), illegal insider trading, as currently defined by the courts, refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information.
The Reed-Menendez Stop Illegal Insider Trading Act aims to define the offense of insider trading with a clear and simple, bright line rule: if a person trades a security on the basis of material information that he or she knows or has reason to know is not publicly available, then he or she has engaged in unlawful insider trading.
“Insider trading puts the average investor at a disadvantage and reduces both public trust and confidence in our markets. Cracking down on unlawful insider trading should be a bipartisan priority,” said Senator Jack Reed. “This legislation provides a clear definition of insider trading, with appropriate safety valves, that will help protect the investing public. Sharpening the definition of insider trading will clear up ambiguity in the law and help repair a broken system.”
“Insider trading makes our markets less fair, hurting families’ ability to save and deterring regular investors from entering the market,” said Senator Bob Menendez. “This legislation would establish commonsense protections and close gaps in the current law that create opportunities for evasion. The Stop Illegal Insider Trading Act would set a clear, strong, and fair standard, with appropriate flexibility to accommodate the complexity of today’s markets.”
In the absence of a statutory definition, an inconsistent and complicated body of common law – an accumulation of cases and judicial precedents – has developed as the courts have used varying interpretations of anti-fraud statutes in order to decide insider trading cases.
On December 10, 2014, the United States Court of Appeals for the Second Circuit decided in United States v. Newman that the portfolio managers in this case were not guilty of insider trading because, as the New York Times summarized, “prosecutors had to show that both men knew that the original source of the inside information had breached a fiduciary duty and had received a personal benefit in return.” The Newman standard for insider trading prosecutions has contributed to greater confusion in the legal system. Indeed, Judge Barrington Parker of the Second Circuit Court of Appeals, who delivered the Newman opinion remarked during oral arguments, “I’m concerned the government’s position on key points of the law seems to vary depending on which judge you’re talking to.”
Under the Stop Illegal Insider Trading Act, it would be irrelevant whether a trader knew of a source’s fiduciary duty or whether the source derived any personal benefit for tipping the inside information. What would matter is whether the trader knew or had reason to know that he or she had an unfair advantage in being given material information that was not shared with the broader public. In addition, the proposed bill takes care to ensure that those who take the time and the effort to independently develop their own information from publicly available sources can trade on this independently developed information, so that publicly available information can be analyzed and interpreted without fear of liability. Because there may be situations that do not necessarily rise to the level of unlawful insider trading, the legislation provides the SEC with the flexibility to provide exemptions from insider trading liability as long as such exemptions are necessary or appropriate in the public interest and consistent with the protection of investors.
A 2014 study published by professors at New York University’s Stern School of Business and McGill University looked at 1,859 corporate transactions stretching from the beginning of 1996 to the end of 2012, and their findings provide a window into the extent of insider trading in the financial industry. For each deal, the professors pored over stock options for shares of both the acquirer and the target over a period of 30 days prior to the announcement of the deal, looking for abnormalities in volume or movement. The study found that 25% of these public mergers and acquisitions transactions may be tainted by some form of insider trading, and only a fraction of those instances result in government prosecution. The professors wrote that the odds of the trading abnormalities they uncovered “arising out of chance” are roughly “three in a trillion.” According to the study, the average profit garnered through these trades over the professors’ sample period was $1.57 million.
WHAT EXPERTS ARE SAYING ABOUT THE STOP ILLEGAL INSIDER TRADING ACT:
“Insider trading law in the U.S. has developed as a matter of common law rather than pursuant to a clear statutory statement of what constitutes illegal trading on material nonpublic information. This means that traders who should be held accountable have slipped through the cracks created by the uneven common law development of the law. The current state of the law creates many inconsistencies and makes prosecution of improper activity more difficult than it should be.
“I have carefully reviewed the proposed Senate bill and believe it does a terrific job of eliminating the current law’s inconsistencies and lack of clarity. Passage of this bill would greatly increase the integrity of the U.S. Securities markets as it would guarantee that all investors would participate on a level playing field.”
– Professor Thomas Lee Hazen, University of North Carolina Law School
“A common sense and compelling update to the law on insider trading, the Reed-Menendez proposal would be entirely fair and completely consistent with well-functioning financial markets. It would discourage the kind of behavior that too often skews the playing field against people who are simply saving for retirement or to pay for their children’s education. The law as written would also be straightforward to enforce.”
– Simon Johnson, Professor of Entrepreneurship at the MIT Sloan School of Management & former Chief Economist at the International Monetary Fund (IMF)
“Public Citizen supports Senators Reed and Menendez’s efforts to keep our markets honest and to equip the SEC with the legal tools necessary to police illegal and unsavory insider trading. Repairing the Newman decision will help ensure that average investors aren’t abused by those sharing privileged information.”
– Lisa Gilbert, Director of Public Citizen’s Congress Watch Division
“Consumer Federation of America proudly endorses this important legislation to curb insider trading. Proving an insider trading case shouldn’t come down to having to jump through artificial hoops, and this legislation gives prosecutors and regulators the tools they need to bring the types of cases that are most appropriate. As a result, this bill will help to promote market integrity.”
– Micah Hauptman, Financial Services Counsel for the Consumer Federation of America
“The recent Newman decision overturning convictions of hedge fund traders threatens the SEC's ability to enforce insider trading restrictions generally. This legislation creates a long overdue statutory definition of insider trading that restores SEC enforcement powers regarding insider trading and will increase the fairness of equity markets for ordinary investors.”
– Marcus Stanley, Policy Director at Americans for Financial Reform