Coronavirus, Congress, and Insider Trading

There were reports last week of potential insider trading by members of Congress. Several of them sold millions of dollars in stocks as the coronavirus crisis was just beginning to unfold, before the major stock market decline. At the time, they were receiving regular, confidential briefings on the dangers of the virus. Some were publicly downplaying the severity of the problem while they privately unloaded their stock holdings. But although some of these stock trades may have been deplorable, proving they were criminal would likely be an uphill battle.

The Law of Insider Trading

Insider trading is the purchase or sale of securities based on material, nonpublic information, in violation of a duty of trust and confidence. Classic insider trading involves corporate executives or other company insiders trading their own company’s stock based on nonpublic information, in violation of the duty they owe to their shareholders not to exploit company information for their own private gain. A simple example would be a CEO who knows her company is about to be acquired and purchases large amounts of stock in the company before that information becomes public.

Under the much broader misappropriation theory, an individual is liable for insider trading if he trades stock based on material nonpublic information in violation of a duty owed to the source of that information. In the leading Supreme Court misappropriation theory case, United States v. O’Hagan, the defendant was an attorney whose firm represented the acquiring company in an unannounced takeover bid. He bought large quantities of stock and options in the company that was going to be acquired, and made several million dollars once the deal became public. As an outsider, O’Hagan didn’t owe any duty to the shareholders of that company. But he did owe a duty to his own firm and its client not to misappropriate the client’s confidential information for his personal gain. His trades in violation of that duty thus constituted insider trading.

A key in any insider trading case, therefore, is identifying the relevant duty. Trading on material nonpublic information is only insider trading if using that information for a personal benefit violates a duty the trader owes to someone. If you acquire material, nonpublic information through diligent research and hard work, or even by overhearing two corporate insiders talking on an airplane, it’s not insider trading for you to trade based on that information. There must be a violation of a duty.

The Impact of the STOCK Act

Members of Congress, by the nature of their work, necessarily learn a great deal of information that could impact the stock market. In 2012, in response to concerns about Members profiting off such information, Congress passed the Stop Trading on Congressional Knowledge, or STOCK Act. The Act prohibits Members of Congress and their employees from using information learned during the course of their duties for private profit. It directs the Ethics Committees of both Houses of Congress to issue guidance concerning this prohibition. The Act also states that “Members of Congress and employees of Congress are not exempt from the insider trading prohibitions arising under the securities laws.” The Act specifies that Members and Congressional employees owe a duty “arising from a relationship of trust and confidence” to the Congress and to the American people.

This legislative recognition of a duty is significant for insider trading purposes. As just noted, the existence of such a duty is a prerequisite for insider trading liability. The STOCK Act makes it clear that Members of Congress owe a duty of trust and confidence to Congress and the American people not to personally profit from information they learn in the course of their duties. If Members trade stock in a company based on material, nonpublic information learned through their work, they may be liable for insider trading for breaching that duty.

Senator Richard Burr
Senator Richard Burr

The Congressional Trades and Insider Trading

The allegation concerning several Members of Congress is that they received nonpublic information during briefings about the Coronavirus and traded stocks based on that information in anticipation of the coming market crash. Not all such transactions involved stock sales; for example, Senator Kelly Loeffler bought stock in a company that specializes in software that allows people to work from home, and other congressional aides reportedly bought stock in companies such as Clorox, Inc.

To prove insider trading, prosecutors would have to establish that these purchases and sales were based on material, nonpublic information learned during the course of Congressional duties. If they were, then the STOCK act makes clear that such transactions for private gain would violate a duty owed to Congress and the American people and therefore would potentially be insider trading. But there are several factors that suggest establishing insider trading could be challenging.

1) Was the Information Truly Nonpublic?

To evaluate any claims of possible insider trading, it is critical to know exactly what information was relayed at the Congressional briefings. Prosecutors would need to show the briefings included information that was not yet public and that would likely lead those who received the information to conclude the stock market is going to decline. Any investigation into these Congressional trades, criminal or civil, therefore would have to explore what exactly the Members were told in these briefings.

There was a lot of public information already floating around about the coronavirus at the time of the briefings in January and February. Were Members really given information that was not otherwise publicly available? Or did the briefings simply serve to educate the Members and try to get them to focus on the problem, without necessarily relying on material nonpublic information?

The answer may vary depending on the briefing. At least some of the briefings reportedly were classified, which suggests a greater likelihood that they contained information not otherwise publicly available. But as to a more routine, unclassified briefing, it may be that any diligent researcher could have readily come up with the same information that was being given to the Members. And if that’s the case, then acting on that information would not be insider trading.

2) Was the Information Material?

Even if the briefings contained nonpublic information, that information must have been material. Information is material if it is likely to be deemed important to a person deciding whether to buy or sell the stock. One issue here would be that even if some of the information in the briefings was nonpublic, was it so different from what was already available that it would materially influence anyone’s decision to buy or sell? In other words, there was already so much information available that any additional information received in the briefings, even if not otherwise public, may not have made a material difference to a potential trader. Was there actually something disclosed in the briefings that was both nonpublic and so dramatically different from the other available information that it would have tipped the scales on whether to buy or sell?

Another wrinkle when it comes to materiality is that this information likely did not relate to any particular company, or even any particular industry, but to the risks to the country and economy as a whole. Insider trading cases usually involve nonpublic information that relates directly to the stock that was traded. Charging insider trading based on information suggesting that the overall economy in general is going to decline would be unusual. Even if there is information suggesting that the economy as a whole might suffer, how does one prove that information was material to the stock price of any one company? You could try to argue that certain industries seemed more likely to suffer or to profit, and focus on trades based on those industries (such as sales of hotel or airline stocks), but it still could be challenging to prove materiality as to any particular trade.

Once again, what was said at the briefings could be key; for example, if a briefing focused specifically on likely damage to the airline industry, that might support allegations of subsequent insider trading in airline stocks. But if a briefing was focused more on the overall health risks to the country and less on the economic impact, then proving the materiality link to trading stock in any particular company could be much more challenging.

3) Were the Trades Actually Based on the Information Received?

Another possible defense would be that even if there was nonpublic information provided during the briefings, the trades were not based on that information. In the wake of the insider trading allegations, Senator Richard Burr put out a statement claiming his trades were based only on public information, such as reports on CNBC. Burr is claiming, in other words, that even if he received nonpublic information, his trades were based not on that information but on other information that was widely available to the general public.

If there was material, nonpublic information provided at the briefings, then it likely will not be enough for Burr just to claim he relied on other, public information when making the trades. Under SEC Rule 10b5-1, if a person possesses material, nonpublic information at the time of a purchase or sale of a security, there is a presumption that the trade was based on that information. The purchaser can rebut that presumption, but only by showing that there was a pre-existing, written plan or order to sell the stocks that predates the receipt of the nonpublic information. Absent such a pre-existing order, a Member or staffer will be presumed to have relied upon any material nonpublic information received when making a trade.

A related issue will be whether the Member or other individual who received the information actually ordered the trades in question. Senator Kelly Loeffler, for example, has claimed on Twitter that she does not make decisions about her stock trades and that those decisions are made by third-party advisors without her input. Senator Diane Feinstein has claimed that her stocks are held in a blind trust and that this particular trade was made in her husband’s account, and so any trades were made without her knowledge or participation. If trues, these would be defenses to any claim of insider trading.

One question raised by Senator Loeffler’s defense is whether she had any communications with those “third party advisors” where she shared information learned during the briefings. She may not make the decisions herself, but if she passed along material, nonpublic information and her advisors traded on that information then she could still be liable for insider trading as a “tipper” or for aiding and abetting. The same would be true if she passed the information to her husband, who happens to be Chairman of the New York Stock Exchange, and he then relied on that information to trade or to direct others to trade on their behalf.

Representative Chris Collins

The Case of Representative Chris Collins

These allegations have led some to compare these Members of Congress to Representative Chris Collins, who was recently sentenced to 26 months in prison for insider trading. But the cases have almost nothing in common. Collins served on the board of a pharmaceutical company and sold stock in that company after receiving confidential information from the board chairman that a major drug trial had failed. The Collins case differs from these current allegations in two important respects. First, the inside information Collins gained was not as a result of his work on Capitol Hill. His status as a Congressman was irrelevant to his insider trading case, as was the STOCK Act. Collins could have been just any board member, trading on confidential information received from the chairman. And second, the information Collins received was specific to the one company in whose stock he subsequently traded – it wasn’t information about a potential overall market decline.

The Appropriate Remedy

These stock trades deserve to be investigated. Some certainly seem to violate the spirit of the STOCK Act. But given the issues described above, it seems unlikely that any will result in a criminal case. And a criminal remedy is not necessarily the answer; there are many possible consequences for these actions besides a criminal prosecution. The SEC may pursue civil insider trading charges, where the penalties may include fines and disgorging of profits. Other shareholders in companies that were dumped may sue for civil stock fraud. The Ethics Committees can explore the allegations and impose sanctions as well; Senator Burr, for example, has already requested an Ethic Committee investigation of his own stock trades. Members of Congress could face calls to resign, as some already have. And of course, voters have the ultimate political sanction at the ballot box for any offenders who run for re-election.

One good outcome would be for this scandal to lead to reforms that include a requirement that every Member of Congress hold their stocks and other assets in blind trust, with absolutely no control over investment decisions. Until that is the norm, allegations like this will continue to arise and there will always be suspicions that some Members are using the power of their office unfairly to line their own pockets. Such conduct may not always be criminal, but it’s always wrong.

The Supreme Court, Salman, and Insider Trading: Why Stock Tips Make Bad Stocking Stuffers

Almost exactly two years ago, this blog posed the following question in a post about insider trading:

Suppose your brother-in-law has too much eggnog at Christmas dinner and starts blabbing about confidential inside information concerning the company where he works. If you trade the company’s stock based on that information, do you risk finding a subpoena from the SEC in your stocking?

Last week, in Salman v. United States, the Supreme Court provided some answers to this holiday conundrum. The bottom line: insider stock tips still make lousy holiday gifts.

Image of the bull on Wall St., home of insider trading

The Standards for Tippee Liability: Dirks v. SEC

Salman involves a subspecies of insider trading called “tippee” liability. Insider trading is defined as buying or selling securities based on material, non-public information, in violation of a duty of trust and confidence. Corporate insiders and others who acquire company secrets may not use that information to enrich themselves in violation of a duty owed to the source of the information.

But the ban on insider trading would be easily evaded if a corporate insider, forbidden to trade herself, could simply tip off an outside friend or family member and encourage them to trade instead. Accordingly, in some circumstances such tippees may themselves be charged with insider trading.

The Supreme Court first addressed tippee liability in Dirks v. SEC in 1983. Dirks held that a tippee who does not owe a direct duty to shareholders may nevertheless be liable for insider trading, but only if: 1) the tipper was violating a duty by providing the information; and 2) the tippee knew or should have known about that violation.

Whether the tipper was violating a duty, the Court said, turns on the purpose of the tip: “[T]he test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach [by the tippee].”

The Court recognized that potential benefits to tippers are not limited to monetary gains and may include reputational benefits or other intangibles. In particular, a benefit could be inferred when an insider “makes a gift of confidential information to a trading relative or friend.”

An important aspect of the Dirks test, therefore, is determining whether the tipper received a personal benefit sufficient to find a breach of duty. The Court took the Salman case to shed some light on how courts should approach this question.

Teeing up Salman: The Second Circuit’s Newman Decision

To fully appreciate Salman one must first consider the U.S. Court of Appeals for the Second Circuit’s 2014 decision in United States v. Newman, the subject of my post two years ago. Corporate insiders in Newman had disclosed confidential information to several securities analysts who passed the information along to others, including the defendants.

After they were convicted for trading on that information, the defendants appealed and argued the government had failed to satisfy both prongs of the Dirks test: they claimed there was insufficient evidence the insiders had received a personal benefit in exchange for the tips and thus violated their duty, and even if they did, there was no evidence the defendants knew about that violation.

The Second Circuit agreed that the government’s evidence of personal benefit to the tippers was inadequate. The government had argued that one tipper received occasional career advice from an analyst to whom he leaked information, while the other tipper and another analyst were social friends who attended the same church.

The Court agreed that “personal benefit” could include intangible benefits, but this did not mean the government could simply establish that the tipper and tippee were friends. If that were sufficient this requirement would practically disappear, because at least a casual friendship between tipper and tippee probably exists in almost all such cases.

Accordingly, the court held, proof of a personal benefit requires evidence of a “meaningfully close relationship [between tipper and tippee] that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”   The evidence in Newman did not meet that standard, and so the court reversed the convictions.

The Supreme Court turned down the government’s request to review Newman, but then just three months later it granted certiorari in Salman, a Ninth Circuit case that also raised the “personal benefit” issue. (I wrote about Salman at the time, in a post you can find here.)

Image of street sign for Wall Street, the home of insider trading

Salman: What Qualifies as a Benefit to the Tipper?

Salman represents the Supreme Court’s first foray into tippee liability since Dirks. Maher Kara, a Citigroup investment banker, repeatedly passed confidential information about upcoming mergers and acquisitions to his brother Michael, knowing that Michael would use it to trade. Michael, in turn, shared the information with Bassam Salman, a close friend whose sister was married to Maher. Salman made more than $1.5 million by trading on these tips before the scheme was discovered. He was convicted of insider trading and sentenced to 36 months in prison.

On appeal to the U.S. Court of Appeals for the Ninth Circuit, Salman urged that court to apply Newman to overturn his conviction. Salman argued that Maher, the tipper, was simply helping his brother out and did not receive anything of a “pecuniary or similarly valuable nature” in exchange. Under the Newman test, he claimed, that meant no violation of a duty by Maher and thus no tippee liability for Salman.

The Ninth Circuit rejected Salman’s arguments, finding that his case involved a straightforward application of Dirks and disagreeing with the analysis in Newman. That created a circuit split that likely led the Supreme Court to take Salman’s case. But when it came to convincing the high court to adopt Newman, Salman was swimming upstream.

In a unanimous opinion by Justice Alito, the Court agreed with the Ninth Circuit and held that Dirks “easily resolves the narrow issue presented here.” Dirks, the Court observed, held that a personal benefit may be inferred when an insider “makes a gift of confidential information to a trading relative or friend.” Maher passed information to his brother knowing he would trade on it, which falls squarely within this language. Game, set, match.

The Court noted that if Maher had traded on the information himself and given the proceeds to his brother, there is no question that would be insider trading. By passing the information to his brother knowing he would trade himself, Maher achieved exactly the same goal. “In such situations, the tipper benefits personally because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.” Because he obtained this personal benefit, sharing the information was a violation of Maher’s duty of trust and confidence to his clients – a duty that Salman inherited and then violated when he traded on the information with full knowledge of its improper origins.

The Supreme Court expressly rejected the more stringent benefit test adopted by Newman: “To the extent that the Second Circuit [in Newman] held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends . . .we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.”

The Court also rejected Salman’s claim that the benefit test was unconstitutionally vague. Although it agreed that determining whether a benefit occurred might be difficult in some cases, the Court said it did not need to confront that issue because “Salman’s conduct is in the heartland of Dirks’s rule concerning gifts.”

Image of Christmas Stockings - stock tips make bad holiday gifts

Issues Remaining after Salman: Moving Beyond Friends and Family

The most significant aspect of Salman is its rejection of Newman. Because the Second Circuit includes New York and Wall Street, Newman had caused quite a stir and was seen as a significant blow to the government. Prosecutors were forced to drop a number of insider trading cases in the wake of the decision. Salman thus should give a boost to both criminal and civil insider trading investigations.

The court of appeals in Newman had also considered what the government must prove concerning the tippee’s knowledge – the second part of the Dirks test. The government argued it had to prove the tippee knew the information was given in violation of the tipper’s duty but did not need to prove the tippee knew the tipper had received a benefit. The Second Circuit, however, held that the government must prove that the tippee knew both.

The knowledge issue was not before the Supreme Court in Salman, as the Court noted in a footnote. But the briefs, oral argument, and opinion all indicate the government now agrees it must prove the tippee knew both that the tipper violated a duty and that he received a benefit. Salman therefore provides some clarity on the knowledge prong of the Dirks test as well, and that portion of Newman appears to remain good law. And that means cases like Newman involving “remote tippees” – those several steps removed from the source of the information and thus less aware of the details of the tipper’s activities – may continue to be challenging for the government.

Some commentators have suggested Salman leaves unanswered how close a friendship must be before the tipper can be said to benefit from disclosure. Must there be a close, personal friendship, or would the standard apply to an occasional golfing buddy or even a casual Facebook friend? And who qualifies as a “relative”? In-laws? Second cousins twice removed?

I think future cases are unlikely to hinge on such questions. Basing criminal liability on determining, for example, whether a friendship was sufficiently “meaningfully close,” as the Second Circuit suggested in Newman, would likely be vague and unworkable.

The Court in Dirks listed a gift of information to a friend or relative merely as an example of an improper disclosure, not as the definition of one. It would be a mistake to believe that a court must now determine whether a tippee is truly a “friend” or “relative” and what exactly that means. The test should focus not on the nature of the relationship but on the purpose behind the tip.

Dirks held that whether disclosure is a breach of duty “depends in large part on the purpose of the disclosure,” and the Court in Salman reaffirmed this language. Much of the Salman oral argument also focused on the purpose of the gift, with the Justices (and the government) pointing out that Maher’s gift of inside information was done for a personal purpose and not a corporate one.

The government in Salman argued that the benefit requirement of Dirks is met any time an insider discloses information for a personal purpose rather than a corporate purpose. The Court did not need to go that far because Salman fell squarely within the language of Dirks about disclosure to a relative, and the Court simply took the narrowest path possible to decide the case at hand. But for future cases a test that hinges on the tipper’s purpose is the logical outgrowth of Dirks and Salman.

To borrow an analogy used during oral argument, suppose I see a sad person on the street and feel bad for them, so I give them inside information intending that they trade on it. If I traded on the information myself and give the stranger the money, that would be insider trading. That tip benefits me – it allows me to make the desired charitable gift without actually taking money out of my pocket. As the Court said in Dirks: “[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.”

A test based on the tipper’s purpose does not make criminal liability rest upon something as nebulous as the closeness of the relationship between tipper and tippee. Instead it focuses on intent, with which criminal law is accustomed to dealing. An insider who tips to a family member, occasional golfing buddy, or stranger on the street does not act for any proper corporate purpose. All such disclosures violate the insider’s duty to refrain from using corporate information for some personal end.

Tippee liability based on gifts of information is unlikely to be limited to close friends and family. Anyone who believes Salman leaves them free to act on improper tips from casual acquaintances will likely find that prosecutors and courts disagree. The Supreme Court’s reaffirmation of Dirks and rejection of Newman signify that it remains very comfortable with a robust theory of insider trading liability.

And as for that errant brother-in-law, tell him you’d rather have a nice sweater or something — and ask him to pass the eggnog.

Note: This post is adapted from a commentary I published in the George Washington Law Review’s “On the Docket.”  You can find that commentary here.

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