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E-MailStephen M. Bainbridge is the William D. Warren Distinguished Professor of Law at UCLA School of Law. This post is based on his recent paper. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation by Jesse Fried (discussed on the Forum here).
The Insider Trading Prohibition Act (“Act”) passed the U.S. House of Representatives by a wide bipartisan margin on May 18, 2021, and is now awaiting Senate action. The Act’s proponents claim that the bill makes only modest changes in the definition of insider trading as it has been developed in the courts, while at the same time creating “a clear definition of insider trading . . . so that there is a codified, consistent standard for courts and market participants.” Unfortunately, the Act neither codifies nor clarifies.
The Act Likely Will Expand the Current Prohibition
At present, insider trading liability is premised on a breach of a duty of disclosure arising out of a fiduciary relationship or some similar relationship of trust and confidence. The Act changes the focus to whether information was wrongfully used or communicated, which is defined as using or communicating information obtained through such means as “theft, bribery, misrepresentation, . . . misappropriation, or other unauthorized and deceptive taking of such information,” or “a breach of any fiduciary duty, a breach of a confidentiality agreement, a breach of contract, a breach of any code of conduct or ethics policy, or a breach of any other personal or other relationship of trust and confidence for a direct or indirect personal benefit (including pecuniary gain, reputational benefit, or a gift of confidential information to a trading relative or friend).”
Some of the ways in which the Act thus expands the prohibition are not terribly controversial. After all, who thinks thieves should be able to profit from using stolen information? But other ways in which the Act potentially expands the law are more problematic. For example, suppose someone overhears a conversation in which corporate insiders chatting about work and the eavesdropper infers confidential information on the basis of which she proceeds to trade. There is no tip here. There has been no deception. But, unlike under current law, aggressive prosecutors now will be able argue that the information has been stolen, converted, or otherwise wrongfully obtained.
The Act Lacks Clarity
The core prohibition created by proposed § 16A(a) contains two important ambiguities. First, it makes it illegal for someone to trade on prohibited information while she is “aware of” such information. There has been a longstanding debate over whether insider trading liability arises only when one trades on the basis of such information or when one trades while in possession of such information. The SEC attempted to resolve that dispute by promulgating Rule 10b5-1, which adopts a possession standard while creating certain affirmative defenses for situations in which such trading seems unproblematic. There are serious doubts, however, whether the SEC had authority to adopt that rule. There is also doubt as to whether the Rule applies to criminal cases. Instead of resolving these important issues, the Act adopted the new standard that one must be “aware,” which presumably leans towards the possession approach but nevertheless will require judicial definition. If “aware” is interpreted to mean knowing possession, this change “would . . . go a long way toward making insider trading a strict liability crime.” U.S. v. Smith, 155 F.3d 1051, 1068 n.25 (9th Cir.1998).
Second, Section 16(a) also imposes liability where one trades while aware of “any nonpublic information . . . that has, or would reasonably be expected to have, a material effect on the market price of any such security.” What constitutes a “material effect” is undefined. How the information covered by this clause differs from “material nonpublic information relating to such security” also is undefined. Courts are going to have to answer those questions as well.
As Todd Henderson and Lyle Roberts point out, the phrase “indirect personal benefit” in subsection (c)(1)(D) also introduces new uncertainty, since one can “describe virtually any human interaction as providing an ‘indirect benefit’ to the participants.” In addition, the phrase “a breach of a confidentiality agreement, a breach of contract, or a breach of any other personal or other relationship of trust and confidence,” as used in the same section, “is silent on how courts are supposed to assess whether any of these items existed or were breached, an issue that has troubled courts for years.”
The Act also fails to resolve the questions about the legality of brazen or authorized trading. Under current law, liability under the misappropriation theory arises where the trader fails to disclose his trading intentions to the source from whom he obtained the information. Logically, it follows that if a misappropriator brazenly discloses his trading plans to the source, and then trades on that information, Rule 10b–5 is not violated, even if the source of the information refused permission to trade and objected vigorously. Alternatively, suppose the source of the information authorized the trader to go ahead with the planned transactions, which was a common practice known as warehousing in the 1980s. In the O’Hagan decision, the Supreme Court approvingly quoted the statement of the government’s counsel that “to satisfy the common law rule the trustee may not use the property that [has] been entrusted [to] him, there would have to be consent.” U.S. v. O’Hagan, 521 U.S. 642, 654 (1997).
Will the Act Impede Market Efficiency?
The current law of insider trading is driven in large part by a concern that overly zealous enforcement of insider trading bans can have a highly detrimental effect on market efficiency. As the late Justice Lewis Powell explained:
Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market. It is commonplace for analysts to “ferret out and analyze information,” and this often is done by meeting with and questioning corporate officers and others who are insiders. And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation’s securities. The analyst’s judgment in this respect is made available in market letters or otherwise to clients of the firm. It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation’s stockholders or the public generally. [Dirks v. SEC, 463 U.S. 646, 658–59 (1983).]
In a footnote to that passage, Powell further explained that the SEC itself “expressly recognized that ‘[t]he value to the entire market of [analysts’] efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by [their] initiatives to ferret out and analyze information, and thus the analyst’s work redounds to the benefit of all investors.’” [Id. at 658 n.17.]
Given the Act’s expansion of liability and the ambiguities inherent in the ways in which Act does so, however, some courts may be encouraged to further crack down on types of conduct that have long been regarded as legitimate market analysis, which in turn will reduce the efficiency of the capital markets. Investors will not hire analysts to “ferret out” information from insiders, and as a result that information will never reach the market, if investors are at peril of prosecution for trading on the information so acquired. Accordingly, it is hard to argue with Representative Huizenga’s argument that the Act “could expand liability for good-faith traders, which would weaken investor confidence, chill vital information-gathering, and hurt the efficiency of our markets.” As such, the Act will chill precisely the sorts of legitimate market activity Justice Powell sought to protect
Conclusion
Given the serious flaws in the Act, the House should have left the problem of defining insider trading to the courts. Instead, they passed an Act that does not codify existing law, but arguably expands it. They have passed an Act that does not clarify the Act, but instead introduces many new ambiguities.
When a very similar bill passed the House in the 116th Congress, the legislation died in the Senate. The Insider Trading Prohibition Act of 2021 now awaits Senate action. The Senate would be well advised to let this bill die as well.
The complete paper is available for download here.
