60 Minutes ran a piece last night on members of Congress who may have used confidential information obtained through their positions to make profitable stock trades. Curiously, the correspondent asserted that the practice is “perfectly legal” and legislation is necessary to prohibit the conduct.
Yet this common wisdom -- that insider trading by Congressional insiders may be unethical, but is legal -- is “a specious claim,” according to Professor Donna Nagy, who has written a law review article, “Insider Trading, Congressional Officials, and Duties of Entrustment” (available on SSRN), as well as a shorter Roll Call piece, “Enforce Laws to Fight Lawmaker Insider Trading." Professor Nagy explains that this fundamental misunderstanding stems from two misconceptions: “a lack of regard for the broad and sweeping duties of entrustment that attach to public office and an unduly restrictive view of the Supreme Court’s precedents….” As she explains, “the (un)lawfulness of Congressional insider trading therefore turns on whether these officials owe duties of trust and confidence to others who would be deceived and defrauded by the self-serving use of nonpublic Congressional knowledge.”
Is there any debate about the answer to that question? While legislation to clarify insider trading law generally may be useful, there is no “legal loophole” that permits insider trading by Congressional insiders.
Wrong. First, there is debate. Second, with all due deference to Prof. Nagy, for whom I have great respect, I firmly believe that those of us on the other side of the debate have the better argument.
As I've mentioned several times lately, in my article Insider Trading Inside the Beltway I explained that:
Under current law, it is unlikely that Members of Congress can be held liable for insider trading. The proposed Stop Trading on Congressional Knowledge Act addresses that problem by instructing the Securities and Exchange Commission to adopt rules intended to prohibit such trading.
Here's the relevant excerpt (in thanks for which you should go download a copy of the whole article, yes?):
Where a Member of Congress, a Congressional staffer, or other government information obtains material nonpublic information in the course of their duties and then uses it to trade in the stock of the relevant issuer, their conduct could be colloquially described as a theft of the information, but under O’Hagan any potential insider trading liability under the misappropriation theory would require proof of a duty of disclosure between the official and the source of the information. The initial question is whether that duty must arise out of a fiduciary duty or whether the requisite duty can be created, inter alia, by agreement. This is so because, as we shall see, while Congressional aides and other government employees have duties arising out of both their fiduciary relationship with their employer and their employment contract, Members of Congress are bound only by the implied obligations created by Congressional ethics rules.[1] Whether those latter obligations rise to the level of a contractual duty to refrain from insider trading is debatable, but they clearly do not rise to the level of a fiduciary duty.
SEC Rule 10b5-2 purports to resolve this issue by providing “a nonexclusive list of three situations in which a person has a duty of trust or confidence for purposes of the ‘misappropriation’ theory....”[2] First, such a duty exists whenever someone agrees to maintain information in confidence.[3] Second, such a duty exists between two people who have a pattern or practice of sharing confidences such that the recipient of the information knows or reasonably should know that the speaker expects the recipient to maintain the information’s confidentiality.[4] Third, such a duty exists when someone receives or obtains material nonpublic information from a spouse, parent, child, or sibling.[5]
Whether the SEC has authority to create a rule imposing misappropriation liability on the basis of an arms-length contractual duty of confidentiality—as opposed to a fiduciary duty-based duty of confidentiality—has not been fully tested. In S.E.C. v. Cuban,[6] a district court held that a non-fiduciary could be help liable for misappropriation-based insider trading liability only where the trader had agreed both to keep information confidential and not to use the information for personal gain.[7] In doing so, the court criticized Rule 10b5-2 and held that the SEC lacked authority to adopt the rule as drafted:
The court concludes that, by its terms, Rule 10b5-2(b)(1) attempts to base misappropriation theory liability on an agreement that lacks an obligation not to trade on or otherwise use confidential information. … Nothing in Rule 10b5-2(b)(1) requires that the agreement encompass an obligation not to trade on or otherwise use the information.
That Rule 10b5-2(b)(1) relates to an agreement to preserve confidentiality is supported by the language and design of Rule 10b5-2 as a whole. …
Because Rule 10b5-2(b)(1) attempts to predicate misappropriation theory liability on a mere confidentiality agreement lacking a non-use component, the SEC cannot rely on it to establish Cuban’s liability under the misappropriation theory. To permit liability based on Rule 10b5-2(b)(1) would exceed the SEC’s § 10(b) authority to proscribe conduct that is deceptive. … This is because, as the court has explained, under the misappropriation theory of liability, it is the undisclosed use of confidential information for personal benefit, in breach of a duty not to do so, that constitutes the deception.[8]
The present state of the law thus leaves unresolved which of three viable alternatives is correct:
- As per Rule 10b5-2, a fiduciary duty is not required; rather, a mere agreement to keep information confidential suffices.
- As per Cuban, a fiduciary duty is not required; rather, an agreement is sufficient provided it explicitly bans the undisclosed use of the information in question sufficient.
- In light of the emphasis in Chiarella and Dirks that liability is premised on a duty arising out of a fiduciary relationship, the SEC lacked authority to adopt Rule 10b5-2 and a fiduciary duty is required.
As it turns out, however, we need not resolve which of these approaches is correct.[9] Executive Branch and Congressional employees can be held liable under the misappropriation theory under all three alternatives, while Members of Congress cannot be held liable under any of them.
The Standards of Ethical Conduct for Employees of the Executive Branch provide that: “Public service is a public trust, requiring employees to place loyalty to the Constitution, the laws and ethical principles above private gain.”[10] Accordingly, an employee of the Executive Branch should be deemed an agent of the government or, at least, to stand in a similar relationship of trust and confidence with the government.[11] The Standards further provide that: “An employee shall not engage in a financial transaction using nonpublic information, nor allow the improper use of nonpublic information to further his own private interest or that of another, whether through advice or recommendation, or by knowing unauthorized disclosure.”[12] As such, the relationship between the government and one of its employees is such that the undisclosed use by the latter of information gained in the course of his employment would give rise to liability under the misappropriation theory.
Likewise, both members of a Congressman’s staff and Committee staffers are employees of their respective houses.[13] In addition, both are subject to an ethical obligation never to “use any information received confidentially in the performance of governmental duties as a means for making private profit.”[14] These employment relationships should suffice for Congressional staffers to be deemed to have an agency or other relationship of trust and confidence with their employing agency. In S.E.C. v. Cherif,[15] for example, the court held that “a person violates Rule 10b-5 and Section 10(b) by misappropriating and trading upon material information entrusted to him by virtue of a fiduciary relationship such as employment.”[16] Put into O’Hagan’s terminology, “a [staffer’s] undisclosed, self serving use of [Congressional] information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the [Congress].”[17]
A different answer seemingly obtains, however, when we turn to the case of Members of Congress. Of whom are Members of Congress agents or fiduciaries? With whom do they have the requisite relationship of trust and confidence out of which the requisite duty to disclose before trading arises? The only logical candidate is the electorate. Although there is some precedent in other contexts for the proposition that “a public official … owe[s] a fiduciary duty to the public to make governmental decisions in the public’s best interest,”[18] such a duty would be irrelevant to the problem at hand. What is needed under insider trading law is either a duty to the person with whom one trades or to the source of the information, not some generalized duty to members of the public in the abstract. Accordingly, the predominant view, as stated by former SEC enforcement official Thomas Newkirk, is that “[i]f a congressman learns that his committee is about to do something that would affect a company, he can go trade on that because he is not obligated to keep that information confidential …. He is not breaching a duty of confidentiality to anybody.”[19]
To be sure, if either Rule 10b5-2 or the Cuban opinion alternative prevails, and the Congressional ethics manuals’ prohibition of insider trading by members are deemed to provide the requisite agreement, liability might be imposed on members who violate that obligation. As we have seen, however, those alternatives remain controversial.[20] In addition, unlike ethics rules embedded in an employee policy manual that is incorporated into an employment contract, it is conceptually more difficult to regard the Congressional ethics rules as an agreement of the sort contemplated by the Cuban decision.[21] With whom is a Member of Congress in privity? If consideration is required, is there a quid pro quo?
An apt precedent for treating stock trading by Congressional staffers and Members of Congress differently is provided by U.S. v. Carpenter.[22] R. Foster Winans wrote the widely read “Heard on the Street” column for the Wall Street Journal, which provides investing information and advice. Because that column apparently had a short lived effect on the price of the stocks it covered, someone who knew the column’s contents in advance could profit by trading in the affected stocks. Although Wall Street Journal policy stated that prior to their publication the contents of columns were the Journal’s confidential property, Winans, before publication, disclosed the contents of his columns to several friends who then traded in the affected stocks. Winans and his friends were convicted of mail and wire fraud and insider trading under Rule 10b-5 pursuant to the misappropriation theory.[23]
In Carpenter, the Second Circuit held that Winans and his fellow conspirators committed illegal insider trading by “secreting, stealing, purloining or otherwise misappropriating material non-public information in breach of an employer-imposed fiduciary duty of confidentiality,” on the basis of which they then traded in the stock of issuers mentioned in Winans’ columns.[24] In dicta, the court indicated that the Wall Street Journal could have traded on the basis of the information in question:
Appellants argue that it is anomalous to hold an employee liable for acts that his employer could lawfully commit. Admittedly, … the Wall Street Journal or its parent, Dow Jones Company, might perhaps lawfully disregard its own confidentiality policy by trading in the stock of companies to be discussed in forthcoming articles. … Although the employer may perhaps lawfully destroy its own reputation, its employees should be and are barred from destroying their employer’s reputation by misappropriating their employer’s informational property. … Here, appellants, constrained by the employer’s confidentiality policy, could not lawfully trade by fraudulently violating that policy, even if the Journal, the employer imposing the policy, might not be said to defraud itself should it make its own trades.[25]
Nothing in O’Hagan is inconsistent with the distinction drawn in Carpenter. The misappropriation theory bans undisclosed trading by an agent or other fiduciary in breach of a duty of loyalty to the principal; it does not ban trading by the principal in the same information, even if the agent in question developed the information for the principal. As an employer, a Member of Congress is free to trade; as an employee, the staffer is not.
[1] See generally Jerke, supra note 12, at 1467-70 (describing relevant provisions of the House and Senate ethics manuals and rules).
[2] Exchange Act Rel. No. 43,154 (Aug. 15, 2000).
[3] 17 C.F.R. § 240.10b5-2(b)(1).
[4] 17 C.F.R. § 240.10b5-2(b)(2).
[5] 17 C.F.R. § 240.10b5-2(b)(1).
[6] ___ F.Supp.2d ___, 2009 WL 2096166 (N.D. Tex. 2009).
[7] Id. at *8 (“Because under O’Hagan the deception that animates the misappropriation theory involves at its core the undisclosed breach of a duty not to use another’s information for personal benefit, there is no apparent reason why that duty cannot arise by agreement.”).
[8] Id. at *12-13.
[9] Suffice it to say that this author regards both Rule 10b5-2 and Cuban decision as being inconsistent with the well-accepted proposition that a fiduciary relationship is required. See, e.g., Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372, 389 (5th Cir. 2007) (holding that “the [Supreme] Court . . . has established that a device, such as a scheme, is not ‘deceptive’ unless it involves breach of some duty of candid disclosure”); see generally Donna M. Nagy, Insider Trading and the Gradual Demise of Fiduciary Principles, 94 Iowa L. Rev. 1315 (2009) (arguing that, although the Supreme Court precedents mandate a fiduciary relationship, some lower courts are disregarding that requirement in favor of a broad rule banning wrongful use of material nonpublic information).
[10] 5 C.F.R. § 2635.101. I assuming here that government ethics rules embodied in the terms of employment of government employees banning the use of nonpublic information for personal gain will be deemed to constitute the requisite agreement. In fact, however, the question of whether an employee handbook constitutes a contract arises in many legal settings and, in general, does not admit of easy resolution. See generally 19 Williston on Contracts § 54:10 (4th ed. 2009) (discussing cases).
[11] Joseph Kalo, Deterring Misuse of Confidential Government Information: A Proposed Citizens’ Action, 72 Mich. L. Rev. 1577, 1581 (1974) (“The application of fiduciary duties to activities of government employees is not novel.”).
[12] 5 C.F.R. § 2634.703(a). Nonpublic information is defined for this purpose as “information that the employee gains by reason of Federal employment and that he knows or reasonably should know has not been made available to the general public.” Id., § 2634.703(b).
[13] Email from Mary Baumann, U.S. Senate Historical Office, to Jenny Lentz, UCLA School of Law Library, Friday, July 31, 2009 (copy on file with author).
[14] House Ethics Manual 249 (2008).
[15] 933 F.2d 403 (7th Cir. 1991), cert. denied, 502 U.S. 1071 (1992).
[16] Id. at 410. See also SEC v. Clark, 915 F.2d 439, 453 (9th Cir. 1990) (“[A]n employee’s knowing misappropriation and use of his employer’s material nonpublic information regarding its intention to acquire another firm constitutes a violation of § 10(b) and Rule 10b-5.”).
[17] U.S. v. O’Hagan, 521 U.S. 642, 652 (1997). See generally Andrew George, Public (Self)-Service: Illegal Trading on Confidential Congressional Information, 2 Harv. L. & Poly’ Rev. 161, 165-66 (2008) (concluding that staffers can be held liable either for trading on or tipping of material nonpublic information learned on the job).
[18] United States v. Woodard, 459 F.3d 1078, 1086 (11th Cir. 2006). See generally Jerke, supra note 12, at 1483-85 (describing views of courts and commentators who believe that elected officials owe a duty to the public).
One court has noted that some statutes make “a distinction between Members of Congress and its officers and employees,” while others “treat Senators and Representatives as officers and employees of the government.” Operation Rescue Nat'l v. United States, 975 F.Supp. 92, 103 (D.Mass.1997), aff'd, 147 F.3d 68 (1st Cir.1998). The same court posited that “Senators are elected by the people, but employed in the legislative branch and, therefore, fit within the literal definition of ‘employee of the government ….’” Id. The court cited no authority for that proposition, however. In any case, there is no precedent treating Members of Congress as fiduciaries, agents, or employees of the federal government for purposes of the insider trading laws.
[19] Brody Mullins, Bill Seeks to Ban Insider Trading by Lawmakers and Their Aides, Wall St. J., Mar. 28, 2006, at A1.
[20] See supra note 91 and accompanying text.
[21] But see George, supra note 99, at 166-68 (arguing that the House and Senate ethics manuals constitute the requisite agreement). George notes that “some observers appear to believe” the House ethics rules “cannot provide a basis for applying the misappropriation theory” because they are “not a law.” George, supra note 99, at 167. He goes on to assert that “there is simply no reason why this need be the case under SEC Rule 10b5-2(b)(1), because the Rule seeks an agreement, not a law.” Id. The problem is that he gives us no reason to think that the ethics rules constitute an “agreement.”
[22] 791 F.2d 1024 (2d Cir. 1986), aff’d on other grounds, 484 U.S. 19 (1987).
[23] The Supreme Court affirmed on all counts, but the securities fraud convictions were affirmed only by an evenly divided Court (4-4). Carpenter v. U.S., 484 U.S. 19 (1987). By long standing tradition, a decision by an evenly divided court affirms the lower court result but has no precedential or stare decisis effect, which left the legitimacy of the misappropriation theory uncertain until the O’Hagan decision validated it.
The federal mail and wire fraud statutes, 18 U.S.C. §§ 1341 and 1343, respectively prohibit the use of the mails and “wire, radio, or television communication” for the purpose of executing any “scheme or artifice to defraud.” The mail and wire fraud statutes protect only property rights, McNally v. U.S., 483, U.S. 350 (1987), but confidential business information is deemed to be property for purposes of those statutes. Carpenter v. U.S., 484 U.S. 19, 25 (1987). Hence, the Supreme Court held, the Wall Street Journal owned the information used by Winans and his co-conspirators and, moreover, that their use of the mails and wire communications to trade on the basis of that information constituted the requisite scheme to defraud.
[24] Carpenter, 791 F.2d at 1032.
[25] Id. at 1033-34.
