Imagine you're a United States senator. You own a lot of stock in a big defense contractor. In a confidential briefing from the Pentagon, you learn that a major weapon system being built by that contractor is about to be cancelled. When the decision is made public, the contractor's stock will drop significantly. You're tempted to pick up your phone, call your broker, and sell the stock so as to avoid the loss. Would you?
A study of stock trading by senators found that many of them routinely succumb to that temptation. As the Securities Litigation Watch blog reports:
... the authors of the study conclude that these results "suggest that senators are trading stock based on information that is unavailable to the public, thereby using their unique position to increase their personal wealth...." The study adds that it is as if "senators knew appropriate times to both buy and sell their common stock." The article quotes [one author] as stating in a recent interview that "there is cheating going on, at a 99 percent level of confidence."
The W$J reports that two members of Congress are finally trying to clean up this mess:
Two Democrat lawmakers plan to introduce today a bill that would block trading on such inside information. Current securities law and congressional ethics rules don't prohibit lawmakers or their staff members from buying and selling securities based on information learned in the halls of Congress. ... In addition to banning trading on inside information, the proposal would require that lawmakers and their top aides disclose within 30 days any stock trades. Congressional rules now require lawmakers to disclose their trades once a year. The bill also would require that companies register with Congress if they sell information about congressional activity to Wall Street investors.
A few thoughts:
1. Stock trading by Congressmen and their staffs presents a double-edged conflict of interest. They may vote on the basis of their trading plans or trade on the basis of their voting plans. As Larry Ribstein observes:
Congress's insider trading is bad because it gives our lawmakers the wrong incentives. Do we really want to give Congress more reasons to hurt and help particular firms?
In fact, Congress's trading is worse than trading by corporate insiders, which at least might be rationalized as a way to let employees cash in on their productive efforts. It's far worse than the usual trading on non-public information by outsiders without any breach of duty, which may encourage socially productive investigation and monitoring, as Bruce Kobayashi and I have argued.
2. Congress has lots of access to confidential information, but one key source is its power to investigate. Do we want Congress "investigating" companies so that members or staffers can get stock tips?
3. Congressional insider trading is a real problem. As I reported on my blog last year, a study of trading by US Senators found that they were earning rates of returns from stock trading that would make Warren Buffett proud. The study's authors found that "the senators also appeared to know exactly when to buy or sell their holdings. Senators would buy stocks just before the shares suddenly would outperform the market by more than 25%." As every investor knows, you can't do that sort of thing routinely without having access to nonpublic information.
4. Much Congressional trading based on nonpublic information may not violate the securities laws. As I explain in my online primer on insider trading, there are two basic ways in which persons can be held liable for insider trading.
First, an insider of the company -- i.e., a person in who is an agent or fiduciary of the company or otherwise a person in whom the company has placed its trust and confidence -- may not trade in the company's stock on the basis of material nonpublic information about the company. Obviously, this basis of liability will rarely apply to Congressmen or the staffers, who will rarely have an employee or other inside relationship with the company.
Second, under the so-called misappropriation theory of insider trading, the defendant need not owe a fiduciary duty to the investor with whom he trades. Nor does he have to owe a fiduciary duty to the issuer of the securities that were traded. Instead, the misappropriation theory applies when the inside trader violates a fiduciary duty owed to the source of the information. But how often will the Congressman or his staffer owe such a duty? Typically, one suspects, the Congressman or staffer will be in an arm's-length relationship with the source of the information, as where it is learned in the course of an investigation. (The misappropriation theory might apply to staffers, if the Congressman for whom they work is deemed the source of the information. In that case, the staffer would have breached a duty to his boss by using the information and thus be liable.)
Effective regulation of problematic Congressional trading thus requires a broader prohibition than the securities law definition of insider trading. Fortunately, the proposed legislation apparently recognized the problem, as the Journal reports that the proposed bill would "prohibit lawmakers and their aides from trading based on information obtained in Congress that is not yet public. And it would prohibit lawmakers and staff from giving that information to others for investment purposes."
5. Congressmen and their staffs currently have to report their trading activities only once a year. Under the proposed legislation, they would have to report trades every 30 days. In contrast, when Congress passed the Sarbanes-Oxley law in 2002, they gave corporate insiders only two days in which to report their stock transactions. Is there any good reason Congress shouldn't have to do likewise?
Congress often exempts itself from laws that apply to everybody else. In most cases, we might infer that it is the laws in question that are a bad idea. In this case, however, it is the Congressional exemption that is the bad idea. This gaping conflict of interest needs to be staunched.
Unfortunately, the bill may well get tied up in partisan bickering. The bill's authors are both Democrats and some Hill observers view it as a slap at Bill Frist, whose HCA stock trades have been questioned, and at Tom DeLay, whose former staffer Tony Rudy has engaged in some questioned trades. The problem, however, is a bipartisan one and a legislative fix deserves bipartisan support.