Insider Trading: Historic US House Bill Would Clarify What It
Is And When It Is Illegal

2019 Year-In-Review Part 3

For many years, it has been axiomatic that
insider trading is illegal. 
However, what exactly insider trading is and how to define it
has caused some difficulty and conflict among the courts.

In large part that is because — believe it or not — there is
no federal statue actually defining what insider trading is.

Therefore, what the U.S. Securities and Exchange Commission
commonly does is to bring cases for the “employment of
manipulative and deceptive devices”, in violation of Section
10b of the Securities Exchange Act of 1934,
15 U.S.C. § 78j(b); Section 17 of the Securities Act of 1933,
15 U.S.C. § 77q; and/or
SEC Rule 10b-5, 17 CFR § 240.10b-5.

The insider trading is then put forth as the “manipulative and
deceptive device” that was used to violate those laws.

Without a specific insider trading statue, it has been left to
the federal courts on a case-by-case basis to try to define
what insider trading is, and what elements have to be proven
to hold someone liable for it.

As can be imagined, different judges may have different
opinions.  Over time this led to differing views as to what
exactly constitutes insider trading.

That confusion came to a head in December 2014, when one U.S.
Court of Appeals issued a ruling in an insider trading case
that to many appeared to clash with more than 30 years of
legal precedent.

During 2019, the U.S. House of Representatives introduced a
potentially historic insider trading bill to try to clear up
the confusion and establish a single set of statutory elements
to be applied in insider trading cases.

Why Is Congress Dealing With Insider Trading Now?

Chiarella insider trading case (1980)

For decades, the seminal insider trading cases have been
Chiarella v. U.S., 445 U.S. 222 (1980), and
Dirks v. SEC, 463 U.S. 646 (1983).

Then, in 2014, the U.S. Court of Appeals for the Second
Circuit set
securities attorneys and the
legal world abuzz by reversing the insider trading convictions
of two portfolio managers in a case called
U.S. v. Newman, 773 F.3d 438 (2d Cir. 2014).

It was not the reversal of the convictions that created so
much controversy; it was the reasons the Second Circuit gave
for doing so.

Dirks insider trading case (1983)

The government had accused the two portfolio managers of being
“tippees”.  Broadly speaking, a “tippee” is someone who
receives confidential, non-public inside information from
someone else and then trades (buys or sells) securities based
on that non-public inside information.

The Second Circuit held that in order to convict a tippee of
insider trading, the government must prove that an insider
(the “tipper”) disclosed confidential inside information.  In
addition, the government has to prove (1) that the tipper
received a personal benefit from providing the inside
information to the tippee, and (2) that the tippee knew that
he or she was trading on confidential information that the
tipper provided to them in violation the tipper’s fiduciary
duties.  There is not too much that is controversial about
those statements.

Newman insider trading case (2014)

But the Second Circuit went further by holding that for a
tippee to be liable for insider trading, he or she must also
know that the tipper received a personal benefit from
providing that inside information to him or her.

Furthermore, the Second Circuit held that in order to draw an
inference that a tipper received a benefit from tipping off a
friend or relative, the government has to prove “a
meaningfully close personal relationship that generates an
exchange that is objective, consequential, and represents at
least a potential gain of a pecuniary or similarly valuable
nature.”  (Newman, 773 F. 3d at 452.)

In 2016, the U.S. Supreme Court ruled on a case called
Salman v. U.S., 137 S. Ct. 420 (2016).  In that case,
the Supreme Court said that the Second Circuit’s
Newman ruling did not properly follow
Dirks v. SEC.

According to the Supreme Court, under Dirks, a jury
is allowed to infer that the tipper personally benefitted from
making a gift of the confidential inside information to a
relative (tippee) who then traded on that information.  (Salman, 137 S. Ct. at 428.)

Salman insider trading case (2016)

However, the Supreme Court did not review the Second Circuit’s
other ruling in Newman that a tippee has to
know that the tipper received a personal benefit from
providing that inside information to him or her. 
(Salman, 137 S. Ct. at 425 n.1.)

Because of the Supreme Court’s narrow decision
in Salman, there has continued to be disagreement and
confusion over whether the Second Circuit’s other ruling
in Newman — that a tippee has to actually know that
the tipper got a personal benefit — is correct and should be
followed.

Enter Congress

On May 7, 2019, the “Insider Trading Prohibition Act” was
introduced
in the U.S. House of Representatives (H.R. 2534).

On September 27, 2019, The House Committee on Financial
Services released its
Report
on the bill.

The Report explains the purpose of the insider trading bill:

H.R. 2534, the Insider Trading Act … formally codifies the
prohibition against insider trading, creating a clear,
consistent standard for both courts and market participants to
follow.  The bill largely codifies the existing case law on
insider trading.  However, the bill overturns a controversial
judicially-imposed requirement that an individual who receives
insider information know about the specific personal benefit
received by the individual who discloses the information.

A footnote in the Report specifically identifies the Second
Circuit’s Newman opinion as the “controversial
judicially-imposed requirement” being referred to in the
passage quoted above.  (Report at 3 n.1, and at 4.)

The House’s Insider Trading Prohibition Act (May
2019)

The bill would amend the Securities Exchange Act of 1934 by
adding a new Section 16A titled “Prohibition On Insider
Trading”.

Subsection 16A(a) of the bill would make it:

… unlawful for any person, directly or indirectly, to
purchase, sell, or enter into, or cause the purchase or sale
or entry into, any security, security-based swap, or
security-based swap agreement, while aware of material
nonpublic information … from whatever source, that has, or
would reasonably be expected to have, a material effect on the
market price … 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.

Subsection 16A(b) describes conduct that would give rise to
tipper liability for insider trading.

Subsection 16A(c)(1) states that communicating or trading on
material non-public information is only wrong if the
information was obtained by, or if its communication would
constitute, directly or indirectly, certain types of conduct.
 The list of those types of conduct is extensive.

Some of the types of conduct listed include various forms of
theft, misrepresentation, deceptive taking, bribery, and
violations of federal computer data or computer privacy laws.
 The list also includes breaches of fiduciary duty, breaches
of contract, or breaches:

… of any other personal or other relationship of trust and
confidence for direct or indirect personal benefit (including
pecuniary gain, reputational benefit, or a gift of
confidential information to a trading relative or friend).

Subsection 16A(c)(2) makes clear that “it shall not be
necessary” that either a tipper or a person trading on the
inside information

… knows the specific means by which the information was
obtained or communicated, or whether any personal benefit was
paid or promised by or to any person in the chain of
communication, so long as the person … was aware, consciously
avoided being aware, or recklessly disregarded that such
information was wrongfully obtained, improperly used, or
wrongfully communicated.

The bill contains several provisions and subsections in
addition to those described above.  To read the bill for
yourself, click
here.

On December 5, 2019, the House bill was passed by a
vote
of 410 – 13, with 7 not voting.

The House vote on the Insider Trading Prohibition Act
(December 2019)

After passing the House, the bill was then received in the
Senate and referred out to committee.  Should the Senate pass
the bill or some variation of it during 2020, it would become
the nation’s first comprehensive insider trading law ever.

For a more detailed discussion of insider trading and the odds
of the Insider Trading Prohibition Act becoming law during
2020, see here.

For Part 1 of my 2019 Year-In-Review, click
here. ->

For Part 2 of my 2019 Year-In-Review, click
here. ->

* * *

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