In the last year the STOCK Act (Stop Trading on Congressional Knowledge Act) of 2012 has been in the news from allegations of members of Congress trading ahead of the severe impacts of the COVID-19 pandemic and the government’s likely response. The STOCK Act is again making headlines as it relates to transactions in companies that could benefit from the new administration’s focus on environmental protections and combating climate change. The STOCK Act prohibits members and employees of Congress from using any nonpublic information derived from the individual's position or gained from performance of the individual's duties for their personal benefit. While previous transactions ahead of the widespread news pertaining to the COVID-19 pandemic raised questions about access to information and securities transactions that could lead to profits and avoided losses, the current transactions under scrutiny raise additional issues concerning whether investments by members of Congress in companies who could benefit by their legislative actions is improper. It is legal for members of Congress or their spouses to own stocks, however, recent scrutiny of Congress members and their families’ stock transactions could lead to more regulation concerning the ability of members of Congress to engage in securities transactions. This article will discuss insider trading laws and how they are currently applied to lawmakers and congressional employees.

Insider Trading Law Overview

Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and SEC Rule 10b-5, 17 C.F.R. 240.10b-5 (collectively the “Antifraud Provisions”) provide the primary regulatory and statutory framework restricting insider trading. Section 17(a) generally proscribes fraud in the offer and sale of securities while Section 10(b) and Rule 10b-5 prohibits manipulative and deceptive devices in connection with the purchase or sale of securities. The Antifraud Provisions prohibit (i) engaging in a scheme to defraud in connection with the sale or purchase of a security, (ii) engaging in a course of conduct that operates as a fraud or deceit on any person in connection with the sale or purchase of a security, and (iii) making untrue or misleading statements in connection with the sale or purchase of a security. The Securities and Exchange Commission (SEC) relies upon the Antifraud Provisions when prosecuting insider trading. A person who engages in insider trading could be subject to: (i) disgorgement, (ii) injunction, (iii) civil fines and penalties, (iv) criminal conviction, (v) an officer and director bar, and (vi) a cease and desist order. For civil fines and penalties, the Insider Trading Sanctions Act of 1984 of the Securities and Exchange Act, authorizes district courts in SEC actions to impose sanctions up to three times the profits gained, or loss avoided.

In prosecuting insider trading cases, the SEC generally proceeds under one of two theories of liability: the classical theory or the misappropriation theory. The classical theory only applies to insiders such as (i) officers, directors, and controlling shareholders; (ii) others who temporarily become fiduciaries, and (iii) tippees of insiders. Under the classical theory, insiders owe a fiduciary duty to the corporation’s shareholders which bars them from trading on insider information for personal benefit, and therefore, any trade an insider makes on material nonpublic information violates Section 10(b) and Rule 10b-5.

The misappropriation theory, on the other hand, applies more broadly and bases liability for insider trading on whether that individual breached a duty of trust to the source of the information. This theory extends the Antifraud Provisions to outsiders who would not ordinarily be deemed insiders under the classical theory, but who still owe a duty of trust and confidence. Rule 10b5-2 provides a non-exclusive list in which a person has a duty of trust and confidence under the misappropriation theory, which includes; (i) an express agreement, (ii) the parties have a history or pattern of sharing confidences, and (iii) there was an expectation of confidentiality. Notably, the misappropriation theory does not apply to a situation in which the recipient of material nonpublic information revealed its intent to trade to the source of the information.

In United States v. O'Hagan, 521 U.S. 642 (1997), the court adopted the misappropriation theory expanding the views on insider trading it outlined in Chiarella.[1] O’Hagan, a partner at a law firm that was retained to represent an acquirer in a potential deal, appealed his conviction of securities fraud based on insider trading. After learning of the deal through his role as an attorney, O’Hagan acquired shares in the target company. O’Hagan argued that he did not commit fraud by purchasing shares of the target company because he did not owe any fiduciary duty to the target company. The Supreme Court disagreed and explained that a person commits fraud in connection with a securities transaction when he or she misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. O’Hagan owed the acquiring company such a duty, and therefore, committed securities fraud when he acted upon the confidential nonpublic information he gained. In affirming his conviction, the Supreme Court explained that self-serving use of a principal’s confidential information defrauds the principal of the exclusive use of the confidential information resulting in a breach of loyalty and confidentiality sufficient to support a finding of insider trading under the misappropriation theory.

STOCK Act

In their role as lawmakers and overseers of federal agencies, members of Congress are privy to non-public information regarding future governmental actions, national defense, and other confidential information gathered by various governmental regulatory agencies. Although making trading decisions on information gained by lawmakers in their representative capacity, which often is either classified or not available to the public, raises serious ethical and moral concerns and can even potentially compromise national security, prior to the STOCK Act, the restriction of lawmakers from acting on nonpublic market information were hotly debated yet rarely enforced. Arguably, under the misappropriation theory, lawmakers who have a duty of trust and confidence to the public have always been subject to the Antifraud Provisions and prohibited from using non-public information learned through government sources for their financial benefit.[2] However, the SEC left policing of these practices to the corresponding Ethics Committee, which in turn prosecuted lawmakers infrequently. [3] The STOCK Act specifically granted the SEC the power to pursue violators through existing security laws.

The STOCK Act clarified this landscape explicitly decreeing that lawmakers and congressional employees “are not exempt from the insider trading prohibitions arising under the securities laws, including the Securities Exchange Act of 1934 and Rule 10b-5.” Additionally, it amended the Securities Exchange Act of 1934, to clarify that each lawmaker and congressional employee “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 as a Member of Congress or employee of Congress or gained from the performance of such person’s official responsibilities.” This duty is what makes both classical and misappropriation theories of insider trading apply to lawmakers and their staff. There have been few cases alleging charges for insider trading since the STOCK Act was enacted. These cases generally involved charges arising from the use of governmental material nonpublic information involving the healthcare and pharmaceutical industries.

For example, in 2017, the SEC charged Christopher Worrall, a former employee of the Centers for Medicare & Medicaid Services with violating the STOCK Act.[4] Worrall provided confidential information to David Blaszcak, an employee of a political intelligence firm. Blaszcak then provided the information to two hedge fund employees. The two hedge fund employees used the information to make almost $4 million in trades. Further in 2011, the Department of Justice (DOJ) and the SEC charged Cheng-Yi Lang, an FDA chemist, for trading on confidential information he obtained from the FDA in advance of at least 28 public announcements regarding drug approval decisions.[5] In one instance, the SEC alleged that Liang traded ahead of an FDA announcement approving the Clinical Data’s application for the drug Viibryd. Liang, through his position, gained access to confidential FDA documents about the review of Clinical Data’s application, and purchased shares of Clinical Data based on that information.

Last year the STOCK Act came into the spotlight as news sources reported stories about several members of Congress potentially profiting from confidential information concerning the severity of the COVID-19 pandemic and the likely future governmental actions in responses to such a pandemic. During the first quarter of 2020, Senate records show a significant jump in transactions amongst Senators. While the trading activity alone is not evidence of improper conduct, and no charges were pursued, the trading itself gained national attention.

Defenses

There are several defenses that lawmakers, as well as others, may employ to combat the claim of insider trading. These defenses include among other things (i) materiality, (ii) an alternative basis for trading, (iii) Safe Harbor for Rule 10b5-1, (iv) the mosaic theory and (v) the good faith reliance on advice of counsel.

The government bears the burden of proving that a defendant traded based on material nonpublic information. Information is material if there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having altered the 'total mix' of information made available.”[6] To date, materiality is largely assessed as a fact question and there is no “bright line” rule for assessing materiality making it a prime area for litigation. In certain circumstances, courts view materiality from the prism of how the information affects the market. In those situations, courts use a “probability magnitude” test which assesses the likelihood that an event will occur against its magnitude if it should occur. Along the same lines, materiality is presumed if a there is major market movement following the formal release of the confidential information to the public. This can be rebutted of course by showing that other information was the principal cause of the market movement. Additionally, an absence of market movement does not necessarily indicate immateriality since the information may have become generally available prior to the release of the information. Other courts considered an issuer’s attempts to keep information confidential as evidence of its materiality. In sum, whether a piece of information is material largely depends on the circumstances, and is often clouded by historical revisionism, which looks back at information with the knowledge of how the market reacted and not how it was expected to react.

An alternative reason for engaging in the transactions, such as where the decision was based on publicly available information, can defeat the claim of insider trading. Using the COVID-19 example, lawmakers could have defended against potential claims by citing the plethora of publicly available information concerning the virus. Generally, to assert this position, those under scrutiny must support their trading activity with actual research based on public information. However, courts have held that “a trier of fact may find that information obtained from a particular insider, even if it mirrors rumors or press reports, is sufficiently more reliable, and, therefore, is material and nonpublic.”[7] In other words, even if the information was available through public means, there could still be liability if the trier of fact concludes that the nonpublic information was more reliable than the “public rumors”, and therefore, material.

Another possible defense lies in the fact that mere “knowing” possession of material nonpublic information while trading is not a per se violation of the Antifraud Provisions.[8] However, a strong inference will arise that such information was used, but the insider may rebut this inference by providing evidence that there was no causal relationship between the information and the trade. Additionally, a defendant may support its argument by showing that the transactions were consistent with past trading behavior.

SEC rule 17 C.F.R. § 240.10b5-1(c), sometimes called the “safe harbor” provision, allows for an affirmative defense to insider trading. This rule allows a person to trade while aware of material nonpublic information if a trading commitment was made prior to such awareness. Specifically, there is no liability for insider trading if a person, prior to becoming aware of the information: (i) enters into a binding contract to buy or sell; (ii) instructed another person to buy or sell; or (iii) adopted a written plan for trading securities. This affirmative defense applies only if the transaction was entered into in good faith and not to avoid the Antifraud Provisions.

The mosaic theory is a defense through which pieces of information are assembled, in which each piece standing alone, is not considered material to a reasonable investor. Though after the information is coupled together, and along with the defendant’s own analysis and insight, provides for the discovery of material information. This theory is consistent with the policy of encouraging valuable independent investment research. The situation changes however when it is an insider who pieces together the information, as the insight may not be the result of skill, but the result of access. In S.E.C. v. Binette, 679 F. Supp. 2d 153 (D. Mass. 2010), the Court held “that a defendant may be liable under the misappropriation theory when he pieces together incomplete fragments of confidential information provided through his employment to identify likely acquisition targets and then trades stock in those target companies.”

Lastly, a defendant may invoke the “advice of counsel” defense. This defense is not a complete defense, but the jury will consider it in determining willfulness. In invoking this defense, the defendant must prove (i) that it requested the advice of counsel of the proposed action, (ii) that it disclosed all relevant information, (iii) that counsel provided assurance of the action’s legality, and (iv) good faith reliance. This defense however requires the waiver of attorney client privilege as it relates to the contents of the advice.

Conclusion

In sum, although recent articles suggested potential violations of the STOCK Act by lawmakers, there are many alternative explanations that may offer defenses against prosecution or liability. Further, unless or until new legislation is passed to restrict lawmaker securities transactions, existing precedent will apply. Nevertheless, any lawmaker or congressional staff member should be wary when managing their own or families’ investment portfolio and should consult counsel to address issues of liability prospectively.