Will Congress Expand the Insider Trading Prohibition?

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A common complaint about insider trading law is that there is no statute that expressly sets forth the requirements to prove insider trading. That can make it difficult to determine whether a violation has occurred.

The House Financial Services Committee is seeking to remedy that. It recently passed a bill that would — for the first time — set forth what is required to prove insider trading.

One of the advantages of the current state of the law is its flexibility. The Securities and Exchange Commission and the Justice Department can apply it to new situations as they arise rather than being tied down to a single definition of what constitutes a violation. The new legislation, the Insider Trading Prohibition Act, would continue to allow the government to take a broad approach and pursue the same wide range of cases that it does already. And it may even allow an expansion into new areas.

The current insider trading prohibition requires the government to prove that a defendant breached a fiduciary duty, or other duty of trust and confidence, by using or tipping the information for personal profit. The S.E.C. and prosecutors have at times had to stretch to find a relationship close enough to show that a defendant breached a duty by trading on confidential information.

For example, in a recent settlement, the S.E.C. accused a defendant of being a guest in the home of a longtime friend and surreptitiously viewing documents about an impending merger, which resulted in profits of more than $250,000. Is friendship enough of a relationship to prove a breach of a duty of trust and confidence?

Under the new legislation, it would appear it would be. The bill would make it a violation to trade while in possession of material, nonpublic information “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.” That would make it easier to use circumstantial evidence to show that a defendant knew, or at least turned a blind eye, to the source of the information. The bill would also make it a violation for a person “wrongfully to communicate” confidential information if it was “reasonably foreseeable” that the recipient, known as a tippee, would trade on it.

The legislation also would move insider trading law away from its focus on a duty to keep information confidential by more broadly describing what constituted “wrongful” trading or transmission of confidential information. There would be four ways to show that the information had been obtained wrongfully: by theft, bribery or espionage; by violation of any federal law protecting computer data; by conversion, misappropriation or unauthorized and deceptive taking of information; and by breach of a fiduciary duty or breach of “any other personal or other relationship of trust and confidence.”

All that is quite broad, and would make it easier to prove a violation.

By including a breach of a federal data privacy law or even just theft of information, insider trading law would cover hackers who obtained information before its release to the public. The S.E.C. recently filed a case against nine defendants for hacking into the agency’s computer system to obtain information before its release to the public, resulting in at least $4.1 million in profits.

Hackers do not owe any duty of trust and confidence as the current law requires. Under the new legislation, their efforts to obtain confidential information by breaching computer security measures would be subject to the insider trading prohibition.

The government also could pursue cases in which a person lawfully obtained information and then put it to personal use by trading on it profitably. In Morissette v. United States, the Supreme Court explained that “conversion may include misuse or abuse of property.” That means the government would have to show only that the defendant had used it for personal gain, not that there had been any abuse of a personal relationship by trading on it.

Current law also requires that the government show that a benefit flowed from the tippee to the tipper. The legislation would eliminate that requirement, making it easier to prove a violation.

The bill provides that it is not necessary for the government to show “whether any personal benefit was paid or promised by or to any person in the chain of communication, so long as the person trading while in possession of such information or making the communication, as the case may be, was aware, consciously avoided being aware or recklessly disregarded that such information was wrongfully obtained or communicated.” Thus, simply knowing that information was wrongfully obtained, or consciously disregarding that fact, would be enough to prove a violation regardless of any personal relationship with the source.

The legislation provides two potential safe harbors for traders. It would allow the S.E.C. to “exempt any person, security or transaction, or any class of persons, securities or transactions, from any or all of the provisions” of the law. Whether the agency would be willing to authorize insider trading by companies or management is questionable because it could be seen as favoring Wall Street and corporate executives over ordinary investors.

The bill also allows individuals to engage in “automatic trading,” which means trades that occur under an established plan of sales or have been made through an “advance election.” These trades are currently permissible for executives who sell shares on a regular basis without regard to any current information about the company.

If the legislation makes it through the House and then the Senate — an open question — it will significantly expand insider trading law in the United States. And it will make proving insider trading much easier for the S.E.C. and the Justice Department.

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