Unintended Consequences of the STOCK Act

Brad Karp is chairman and partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP. This post is based on a Paul Weiss client memorandum.

On February 16, 2012, the House of Representatives sent its version of the Stop Trading on Congressional Knowledge Act (the “STOCK Act”) to the Senate for reconciliation. Although it remains to be seen how the two bodies will resolve their differences, the core of the legislation will amend the securities laws to forbid members of the three branches of the federal government and their employees from profiting from insider information. The two versions of the STOCK Act do so by specifying that, for purposes of the securities laws, each covered person “owes a duty arising from a relationship of trust and confidence to the Congress, the United States, government, and the citizens of the United States with respect to material, nonpublic information” derived from such person’s position or gained from the performance of such person’s official responsibilities. Much of the public debate concerning the STOCK Act has centered on this explicit establishment of a duty of trust and confidence, but less attention has focused on the bill’s practical implications for private parties who routinely obtain information from those covered by the new statute.

Many constituents, including of course representatives of private sector interests that could be affected by legislation or rulemaking, regularly communicate with members of the Executive Branch, Congress, and their staffs regarding pending legislation and other governmental initiatives. As a matter of fundamental public policy, it is desirable that government officials communicate openly with the public; an exchange of information and perspectives is normally regarded as healthy in a democracy. But the new legislation leaves unanswered practical questions about whether and when a person who learns information from dialogue with a covered person has become a “tippee” under the securities laws, and therefore must refrain from trading securities whose value may be materially affected by the disclosure of the information imparted.

Liability may arise under the securities laws when the tipper discloses material, nonpublic information in breach of a duty of trust or confidence, and the recipient of that material nonpublic information trades on it. Although earlier versions of the STOCK Act sought to require the SEC to define “material” and “non-public” information through rulemaking, the current versions of the bill being reconciled contain no such language, leaving the Select Committee on Ethics of the Senate and the Committee on Standards of Official Conduct of the House of Representatives to “issue interpretive guidance” on the new legislation.

In the absence of a definition of “material information” in the governmental context, the STOCK Act gives rise to difficult questions of how broadly the ban on trading based on insider information is to be applied. Federal statutes and rules often apply to entire sectors of the economy rather than to individual companies. If a person learns through a communication with a congressional staffer that a new statute is being drafted, or that a key senator is leaning against voting for a bill, is that information material to trades in companies that may foreseeably be affected by the legislation? It is fair grounds for concern that judgments about materiality, often difficult enough to make in the traditional context of company-specific information, will be far more difficult in this new and very different context. Materiality questions will come up in at least two key respects.

First, legislation or rules can have a foreseeable effect on both specific companies and on entire sectors of the economy. To take a simple example, does the recipient of information about a new solar energy bill require the “tippee” to refrain from buying or selling stock in all solar energy companies? All energy companies? In a statement before the Senate Homeland Security and Governmental Affairs Committee in December 2011, Senator Scott Brown, one of the bill’s sponsors, seemed to suggest this might be the case:

Consider this: A Member of Congress hears during a meeting that a program is going to be cut the next day. That member could then sell his or her stock in that sector and score a profit – or avoid losses – when the news breaks.

Second, given the vicissitudes and unpredictability of the legislative process, judgment calls will also need to be made about whether the information received is genuinely material to an assessment of the likelihood of the federal action actually occurring. Take our prior example: would knowledge of the leanings of one senator, however prominent her role, be material information in this context?

A related question about the scope of the legislation’s applicability arises due to the major difference between the SEC’s definition of “public” information and the manner in which information is disclosed in the political arena, including hearings and town hall meetings. While these meetings are undeniably public in the colloquial sense, the information so disseminated is not likely to meet the SEC’s definition of “public” information, which requires dissemination in a manner that makes the information available to investors generally.

Finally, we believe that the STOCK Act will give rise to difficult issues concerning the circumstances that will permit our hypothetical tippee to resume trading. Legislation is in constant flux. Must a tippee wait until the legislative initiative or rule is enacted or defeated? Can he resume trading while the bill is still alive but the key senator has announced how she will cast her vote? Or may he buy once the congressional rumor mill has picked up on the senator’s inclinations? Without language in the STOCK Act and without any precedents of SEC-enforcement of insider trading laws against those covered by the legislation, potential tippers and tippees will be left to make tough judgment calls.

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One Comment

  1. JC Atwood
    Posted Wednesday, March 14, 2012 at 5:39 pm | Permalink

    Your very first sentence misleads readers to think the Senate plans to reconcile its version, in public debate, with the gutted House version of the Stock Act. As though Congress dares anger Wall Street, by doing their job of reconciliation! Your analysis of potential problems in the Stock Act ignores the biggest problem of all, which your biggest clients are trying to get everyone else to ignore, as well. Do you agree with Eric Cantor that the Senate should just bypass reconciliation completely, accepting the House version that the GOP gutted behind closed doors, with no public debate nor amendments allowed?

    Why does your analysis lack anything about the giant insider trading industry, doubling every couple of years, already worth over $400 million a year in sales of DC insider tips to wealthy investors? Congress knows that if they fight for the effective Senate version of the Stock Act, that they will pay greatly, personally. They will be misleadingly painted as hoping to inside trade themselves, lose access to lucrative consulting work after working in Congress, and lose precious donors. Since these are pretty much the sum of Congressional incentives, the outlook is grim for the Senate version of the Stock Act.

    You lament the deletion from the Stock Act of Wall Street demands for the SEC to issue new rules to define “Public” and “material(profitable)”. Are you hoping to bury the Stock Act for another 6 years? Too bad you aren’t as interested in the most important parts of the Stock Act, the Senate’s insider trading and enforcement provisions.

    A great example of the current insider trading in DC is at propublica. See political intelligence example at http://www.propublica.org/special/taking-stock-of-the-stock-act-a-side-by-side-comparison .

    Demand your representative, senator, and Obama reconcile the Senate version with the gutted House version at http://action.citizen.org/p/dia/action/public/?action_KEY=9494 . The only incentive that could possibly compete with donors and lobbyists would be overwhelming voter demand.

    Otherwise, we can just conclude with Jon Stewart that it’s time to buckle up our seat belts, because no one is flying this plane. http://www.thedailyshow.com/watch/wed-february-15-2012/stockblockers—political-intelligence .