With Bipartisan Support, House Passes Explicit Ban on Insider Trading
The U.S. House of Representatives recently approved a bill that aims to create the first federal statute explicitly banning insider trading. By a 410-13 margin, the House voted to amend the Securities Exchange Act of 1934 to prohibit financial trades based on confidential information and related communications by those who possess material, nonpublic information. The Insider Trading Prohibition Act (the “Bill”)1 now moves to the U.S. Senate.
Current State of Insider Trading
Because there is no federal law that explicitly defines or bans insider trading, individuals accused of insider trading are often charged with violating other explicit anti-fraud statutes, such as bank fraud or wire fraud. Many are prosecuted under case law that has developed for violations of sections 10(b) and 32 of the Securities Exchange Act and Securities and Exchange Commission rules, which prohibit, in relevant part, the use of “manipulative and deceptive devices” in securities transactions.2 The lack of legislative clarity into insider trading has resulted in discrepancies in the federal courts, as courts have attempted to determine the limits of liability for those who provide or receive material, nonpublic information about a security.
For example, in 2014, the United States Court of Appeals for the Second Circuit reversed a conviction of two hedge fund managers who allegedly profited from tips received from a network of analysts and company representatives; the court found that there was insufficient evidence to show that the “tippee” knew that an insider had disclosed confidential information and that he did so in exchange for a personal benefit. United States v. Newman, 773 F.3d 438, 451 (2d Cir. 2014).
The court found there had to be a “meaningfully close personal relationship” between the tipper and tippee that would suggest a “quid pro quo” from the recipient, or an intention to benefit the recipient. Id. A few years later, however, the United States Supreme Court disagreed with the Second Circuit’s holding and held that the requirement that the tipper must also have received something of a “pecuniary or similarly valuable nature” was inconsistent with its prior decision in Dirks v. SEC, 463 U.S. 646, 648 (1983), which applied only to the insider or person who misappropriates confidential information about a security. Salman v. United States, 137 S. Ct. 420, 428 (2016) (upholding a conviction from criminal violations of insider trading laws). Thus, pursuant to Salman, the Second Circuit revisited its prior holding, and held that
an insider or tipper personally benefits from a disclosure of inside information whenever the information was disclosed with the expectation that the recipient would trade on it, . . . and the disclosure resembles trading by the insider followed by a gift of the profits to the recipient, . . . whether or not there was a meaningfully close personal relationship between the tipper and tippee.
United States v. Martoma, 869 F.3d 58, 70 (2d Cir. 2017) (cleaned up).
Overview of the Insider Trading Prohibition Act
The Bill seeks to add clarity to the laws regarding insider trading that have developed over the past 50–60 years by creating a clear definition of insider trading and by providing a consistent standard for courts and financial market participants. Specifically, the Bill provides the following:
- Trading while aware of material, nonpublic information relating to securities, or any nonpublic information, from whatever source, that has, or would reasonably be expected to have, a material effect on such securities, is prohibited if such person knows, or recklessly disregards, that such information has been obtained wrongfully, or that such purchase or sale would constitute a wrongful use of such information.
- The communication of material, nonpublic information relating to such securities, or any nonpublic information, from whatever source, that has, or would reasonably be expected to have, a material effect on the market price of such securities to any other person is prohibited if:
- the other person (a) purchases, sells, or causes the purchase or sale of, any securities to which such communication relates or (b) communicates the information to another person who makes or causes such a purchase, sale, or entry while aware of such information; and
- such a purchase, sale, or entry while aware of such information is reasonably foreseeable.
- Knowledge Requirement
- Knowledge of the specific means by which the information was obtained or communicated, or knowledge of whether any personal benefit was paid or promised by or to any person in the chain of communication is not required, so long as the person trading while aware of such information or making the communication was aware, consciously avoided being aware, or recklessly disregarded, that such information was wrongfully obtained, improperly used, or wrongfully communicated.
- Derivative Liability
- Except as provided in Section 20(a) of the Securities Exchange Act of 1934,3 there is no derivative liability for the actions of an employee or a person in one’s control if the controlling person or employer did not participate in, or directly or indirectly induce, the acts constituting a violation of the provisions described under the Prohibitions section above.
- Affirmative Defenses
- The SEC may exempt any person, security, or transaction, or any class of persons, securities, or transactions from all provisions upon such terms and conditions as it considers necessary or appropriate.
- The Prohibitions described above do 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 material, nonpublic information would be unlawful.
- The Prohibitions described above do not apply to any transaction that satisfies the requirements for the affirmative defenses outlined in SEC Rule 10b5–1 (17 C.F.R. § 240.10b5–1), or any successor regulation. This Rule defines what does and does not meet the definition for trading “on the basis” of material, nonpublic information.
- Rule 10b5-1 provides that a purchase or sale of a security is not “on the basis” of material, nonpublic information if the information was received after the person entered into a binding contract to purchase or sell the security, instructed another to do so the same, or adopted, in good faith, a written plan that was not altered or deviated from after new information was received, for the trading of securities.
- The Rule further provides that the plan or contract must either specify the amount of securities to be sold or purchased or provide a written formula, algorithm, or computer program for calculating the same, and must not provide the person the ability to exercise any subsequent influence over how, when, or whether to affect the purchase or sale of such securities.
- The Rule also provides a defense for an entity to demonstrate that they did not trade “on the basis of” material, nonpublic information if it can demonstrate that the trade was made on behalf of another who was not aware of the confidential information. In addition, it is an affirmative defense for an entity to have reasonable policies and procedures to ensure compliance with laws prohibiting trading on the basis of material, nonpublic information.
While it is too soon to tell what effects would come from the Bill if it were to become law, there is no denying that the Bill would make it easier for the government to prove insider trading violations by providing more certainty. In addition, some provisions set a relatively low threshold for the elements of insider trading.
First, under the Bill, there is no “actual knowledge” requirement. This means that a prosecutor does not have to prove that the defendant knew how a piece of material, non-public information was obtained or whether there was a personal benefit paid to anyone in the chain of communication. Instead, to obtain a conviction, a prosecutor need only prove that the recipient or provider was “aware, consciously avoided being aware, or recklessly disregarded that such information was wrongfully obtained, improperly used, or wrongfully communicated.”
Second, under the Bill, a prosecutor need not prove that the person communicating the material, nonpublic information knew that the recipient of the information would actually trade on the information or share it with others. Instead, the prosecutor need only show that the other person used the information to purchase, sell, or cause the sale of any securities, or communicated the information to someone else who did so, and that such purchase, sale, or entry was “reasonably foreseeable.”
Prosecutors and financial market participants should watch to see if and how the U.S. Senate reacts to the Bill and the charge to create more certainty around insider trading.
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1 Insider Trading Prohibition Act, H.R. 2534, 116th Cong. (2019).
2 See 15 U.S.C. §§ 78j(b), 78ff; 17 C.F.R §§ 240.10b–5, 240.10b5–2; and 18 U.S.C. § 2.
3 Section 20(a) of the Securities Exchange Act of 1934 speaks to the liability of a person for the actions of another under their direct or indirect control and provides that a person is liable for the actions of those they control unless that controlling person acted in good faith and did not directly or indirectly induce the acts that constituted the violation of the person under his control.