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News April 6, 2015 Issue

Three Bills Seek to Define Insider Trading in Wake of Second Circuit Ruling

The fallout continues from the U.S. Court of Appeals for the Second Circuit’s December decision narrowing what constitutes insider trading.

First, there was the decision of the U.S. Attorney’s Office for the Southern District of New York to appeal the Second Circuit ruling (ACA Insight, 2/2/15). Now, three bills – one introduced in the Senate and two others in the House – seek to create a statutory definition of insider trading, something that does not currently exist.

The most recent bill is a House bill, the Insider Trading Prohibition Act, introduced March 25 by representative James Himes (D-CT), a member of the House Financial Services Committee. The bill, according to Himes’ office, "makes it a federal crime to trade a security based on material, nonpublic information that was wrongfully obtained, ending decades of ambiguity for a crime that has never been clearly defined by law."

The Senate bill, the Stop Illegal Insider Trading Act, was introduced on March 11 by senators Jack Reed (D-RI) and Robert Menendez (D-NJ), both senior members of the Senate Banking Committee. The bill, according to Reed’s office, "aims to define the offense of insider trading with a clear and simple, bright line rule: If a person trades a security on the basis of material information that he or she knows or has reason to know is not publicly available, then he or she has engaged in unlawful insider trading."

The other House bill, the Ban Insider Trading Act of 2015, was introduced February 27 by representative Stephen Lynch (D-MA). It "would establish that it is a federal crime to purchase or sell any security based on information that the individual knows or should know is material inside information," according to Lynch’s office.

Each of these bills differs in a variety of ways, including definition of terms, the legal standard that would have to be met to prove insider trading, and whether they take into account past judicial precedents.

Would any of the bills be a good thing for investment advisers? Depends on who you ask. But the question may be moot, given that none is currently given much of a chance of passage. First, all the bills’ sponsors are Democrats in a Congress controlled by Republicans, although the Himes bill has one Republican co-sponsor. Beyond that, govtrack.us, which tracks the progress of bills introduced in Congress, currently gives the Himes House bill a 10 percent chance of getting out of committee and a 2 percent chance of being enacted. It gives the Reed-Menendez Senate bill an 8 percent chance of getting out of committee and a 4 percent chance of being enacted. The Lynch House bill is given a 6 percent chance of getting out of committee and a
1 percent chance of being enacted.

Good or bad?

"Any definition would be better than what we have now," said

University of North Carolina School of Law professor Thomas Lee Hazen. The problem with current law is that, because there is no statutory definition of insider trading, the SEC prosecutes it under Rule 10b-5, which is a fraud statute. But insider trading should really not be a fraud issue, he said, but be about "providing equal access in the marketplace." Prosecuting it as fraud is like "putting a square peg in a round hole."

Columbia Law School

professor John Coffee Jr., who helped draft the Himes House bill, said that one of the advantages of that bill is that it is consistent with the key 1983 Supreme Court case, Dirks v. SEC, which requires a breach of fiduciary duty for insider trading to have occurred. In addition, the Himes bill "liberally expands the definition of ‘wrongfully obtained’ to cover much more than just a fiduciary breach. It also uses a recklessness standard and not a simple negligence standard."

As for the other two bills, he said that neither is satisfactory, although he said the Lynch House bill is "less sweepingly drafted" than the Reed Senate bill. His main criticisms come down to two points:

  • Both bills substitute a negligence standard for the current severe recklessness standard.
  • The Senate bill reverses Dirks. "There should be a law," Coffee said, but not one that goes so far as overturning Dirks. "It is not hard to define insider trading in a crude, overbroad way, and both bills do this by overruling the Supreme Court’s decision in Dirks, which has been the law of the land for 30 plus years."

Coffee offered two examples of how overturning Dirks might be problematic:

Corporate merger: A company purchases stock in a target company and then makes a merger offer to its management (something he said happens commonly). When the stock price soars on the announcement of the proposed merger, the acquiring company looks as if it has used material, non-public information as to its own plans in buying the stock before the announcement. "This is no problem under Dirks, but it would violate any broader standard of liability," Coffee said.

  • Hedge fund purchase: A hedge fund manager purchases stock in a company in advance of filing a Schedule 13D, which might suggest significant changes in the company or its management, which typically boost its stock price. That would increase the value of the shares the hedge fund manager purchased, leaving the manager open to being accused of trading on the basis of material nonpublic information.

 

The challenge from the Second Circuit

The decision that led to the introduction of these bills was from a three-judge panel of the Second Circuit in United States of America v. Todd Newman and Anthony Chiasson, which reached near-landmark decision status almost immediately after it was released (ACA Insight, 1/26/15

). The ruling not only reversed the convictions and threw out the indictments of two hedge fund portfolio managers accused of insider trading, but, according to legal scholars and practicing attorneys, rewrote insider trading case law and has already been cited by defense attorneys arguing for their clients and judges in making rulings.

This has led to sharp disagreements among government prosecutors, defense attorneys and the securities industry in general over the merits of the decision. A common theme in all the arguments was that there was no statutory definition of insider trading, which all three of these bills seek to provide.

For investment advisers, any of these bills, once passed, would create a learning curve, and would involve some time as the industry comes up with new guidelines and practices, Hazen said. For any new law, this could take as long as five years. But once the new guidelines and practices are learned, understanding insider trading and knowing when it is violated "will be an easier job for the industry."