Are We There Yet? The Latest Attempt at an Insider Trading Statute

August 25, 2020Articles New York Law Journal

In the days before the pandemic, around this time, many families would be on their summer road trip, where some would be searching for an escape from the madness of the trip. Such a feeling is shared by many in the securities defense bar, who have longed for relief from the overbroad effects of the nebulous insider trading standards applied by both the courts and government regulators. Countless attempts have been made to discern any semblance of logic from the myriad of cases in this area, and even federal judges have expressed their dissatisfaction at the current state of insider trading law. SeeTom McParland, “Judicial Inconsistency Frustrates Purpose of Insider Trading Law, Rakoff Says,” New York Law Journal(Feb. 28, 2020).

For decades, the boundaries of insider trading law were primarily determined through cases brought by the U.S. Securities and Exchange Commission (SEC) and the U.S. Department of Justice (DOJ). The U.S. Court of Appeals for the Second Circuit was actively involved in deciding many of the major insider trading cases, and was a shrewd force behind the development of this body of law. The SEC and DOJ have never had a “bright line” test for insider trading actions, and, thus, both agencies often relied upon the vagaries of the general anti-fraud statute found in the federal securities laws—Securities Exchange Act of 1934 (Exchange Act) Section 10(b) and Rule 10b-5 promulgated thereunder—as well as numerous court decisions to bring both civil and criminal cases.

Coupled with this unclear statutory path for insider trading actions, regulators have also periodically been confronted with the securities trading irregularities arising from the actions of certain members of Congress. Although the STOCK Act of 2012 prohibits members of Congress and certain other government officials from trading on non-public material information derived from their work, no case has ever been brought because of the U.S. Constitution’s Speech and Debate Clause as well as the Confidential Information Procedures Act, forbidding the publicizing of classified information, among other things.

Nonetheless, a shift may be coming. Spurred on by the problems encountered by the SEC, DOJ, and many courts, in December 2019, the U.S. House of Representatives passed a bill with strong (and surprising—over 400 members) bi-partisan support explicitly banning insider trading and providing greater enforcement authority to the SEC and DOJ.

The Bill

The legislation known as the “Insider Trading Prohibition Act” amends the Exchange Act. In particular, the bill would add a new provision Exchange Act “Section 16A. Prohibition on Insider Trading.” If enacted, the new Exchange Act Section 16A would make it:

unlawful for any person, directly or indirectly, to purchase, sell, or enter into, or cause the purchase or sale of or entry into, any security, security-based swap, or security-based swap agreement, while aware of material, nonpublic information relating to such security, security-based swap, or security-based swap agreement, or any nonpublic information, from whatever source, that has, or would reasonably be expected to have, a material effect on the market price of any such security, security-based swap, or security-based swap agreement, if such person knows, or recklessly disregards, that such information as been obtained wrongfully, or that such purchase or sale would constitute a wrongful use of such information. See H.R. 2534, The Insider Prohibition Act (as amended), Sect. 2.

The legislation would require that the person be “aware of” the inside information to violate the provision (an amendment was defeated that would have changed the standard to “using”). The legislation would also prohibit the wrongful communication of certain non-public material information:

for any person whose own purchase or sale of a security, security-based swap, or entry into a security-based swap agreement would violate subsection (a), wrongfully to communicate material, non-public information relating to such security, security-based swap, or security-based swap agreement, or any nonpublic information from whatever source, that has or would reasonably be excepted to have, a material effect on the market price of any such security, security-based swap, or security-based swap agreement, to any other person. See Id., Sect. 2(b).

This bill defines this “other person” as someone, who “purchases, sells, or causes the purchase or sale of, any security or security-based swap or enters into or causes the entry into any security-based swap agreement, to which such communication relates….” Id. This person also may meet the criteria if he or she “communicates the information to another person who makes or causes such a purchase, sale, or entry while aware of such information….” Id. Again, the party would have to understand that “such a purchase, sale, or entry while aware of such information is reasonably foreseeable.” Id. This section, essentially, would prohibit the conduct of subsequent purchasers, or sellers, sometimes referred to as “tippees.”

Moreover, for the first time in the insider trading space, the proposed legislation would prohibit the awareness of insider information, not just based upon fraud, but also from theft and hacking, among other things. The bill, if enacted, would create a new knowledge standard requirement providing that covered conduct would include “theft, bribery, misrepresentation, espionage (through electronic or other means); any violation of federal computer or intellectual property, or privacy laws….” Id. at Section 2(c).

The new legislation would also prohibit conduct that is “conversion, misappropriation, other unauthorized and deceptive taking of such information; a breach of any fiduciary duty, a breach of a confidentiality agreement, a breach of contract, a breach of any code of conduct or ethics policy….” Id. Finally, the bill covers conduct where there is “a breach of any other personal or other relationship of trust and confidence for a direct or indirect personal benefit (including pecuniary gain, reputational benefit, or a gift of confidential information to a trading relative or friend),” among other things. Id.

Interestingly, the bill would not require the person, who is trading to be aware of such information or make the communication while knowing, specifically, the nature as to the acquisition or communication of the information. Id. However, if the conduct includes “any personal benefit…paid or promised by or to any person in the chain of communication, so long as the person trading while aware of such information or making the communication…,” that would result in liability. Id. Similarly, if a person “was aware, consciously avoided being aware, or recklessly disregarded that such information was wrongfully obtained, improperly used, or wrongfully communicated,” it would result in a violation. Id.

In short, the proposed legislation would expand liability, or, at the very least, remove any doubt as to its application. However, although the legislation would expand liability, it did limit derivative liability by stating that “[e]xcept as provided in section 20(a), no person shall be liable under this section solely by reason of the fact that such person controls or employs a person who has violated this section….” Id. at Section 2(d).

The bill, thus, provides an exception “if such controlling person or employer did not participate in, or directly or indirectly induce the acts constituting a violation of this section.” Id. That is, there would be no insider trading liability unless there was active participation of those who employed or controlled the person engaged in insider trading.

Affirmative Defenses

Additionally, one of the difficulties in defending insider trading has always been the lack of definitive affirmative defenses.

The House bill provides for certain affirmative defenses in the legislation. The proposed statute would allow the SEC to “exempt any person, security, or transaction, or any class of persons, securities, or transactions, from any or all of the provisions of this section, upon such terms and conditions as it considers necessary or appropriate in furtherance of the purposes of this title.” Id. at Section 2(e).

However, the legislation states it “shall not apply to any person who acts at the specific direction of, and solely for the account of another person whose own securities trading, or communications of materials, nonpublic information, would be lawful under this section.” Id. Thus, the statute allows for those executing tainted transactions to avoid liability.

Further, the drafters were keen to continue the salutary effects of Exchange Act Rule 10b5-1. The SEC promulgated Exchange Act Rule 10b5-1 two decades ago to provide an “out” to persons, who create a trading plan for selling stock. The provisions of Exchange Act Rule 10b5-1 are somewhat stringent, and its application has been somewhat uneven. Many have tried to claim its protection while the SEC has been reluctant to opine over the efficacy of most of these plans.

The proposed statute will, however, not affect Exchange Act Rule 10b5-1 plans, and, in fact, would require the SEC to consider any modification or amendments to Exchange Act Rule 10b5-1 within 180 days if the bill were to be enacted.

Conclusion

In sum, if the Senate passes and the President signs it, this legislation will create a standard that Congress has tried to achieve for decades. Recognizing the polarization of our current political climate during a presidential election year, many may suggest that any effort to enact this legislation will likely be unsuccessful.

However, given the overwhelming bi-partisan support in the House, this may be the most significant opportunity proponents of this legislation may ever have to, finally, promote clarity in the insider trading field. Maybe, just maybe, we have arrived at our destination.

Reprinted with permission from the August 25 issue of the New York Law Journal. (c) 2020 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.