On May 7, 2019, Representative James Himes (D-Conn) introduced the “Insider Trading Prohibition Act” (H.R. 2534). The proposed legislation would amend the Securities Exchange Act of 1934, §§15 U.S. Code § 78a et seq. (the “Act”) by inserting a new section that defines the elements of criminal insider trading.
The bill’s objective is to eliminate the ambiguity of the offence as it is conceived under current law. It would also significantly expand the potential scope of criminal liability for insider trading in several ways: first, by eliminating the existing “personal benefit” requirement; second, by expanding the scienter requirement from willful to reckless use of “wrongfully obtained” material non-public information; and third, by expanding the definition of “wrongfully obtained” information to include stolen, hacked, and fraudulently obtained information.
The insider trading offense is currently based on multiple statutes that make it a crime to employ “manipulative and deceptive devices” in securities transactions (see Section 10(b) of the Act (15 U.S.C. § 78j) and Securities and Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder) and decades of interpretive case law. These prohibited devices include “the purchase or sale of a security . . . on the basis of material nonpublic information . . . in breach of a duty of trust or confidence.” 17 C.F.R. § 240.10b5-1(a). These statutes are deliberately short on guidance. The preliminary note to § 240.10b5-1 expressly acknowledges that “[t]he law of insider trading is otherwise defined by judicial opinions construing Rule 10b-5, and Rule 10b5-1 does not modify the scope of insider trading law in any other respect.” Because the statute does identify a requisite mens rea for the offence, criminal common law applies a standard of willfulness – in other words, one cannot recklessly commit insider trading.
There are several gaps as a result of the current insider trading framework. First, the coupling of material nonpublic information (or “MNPI”) to a fiduciary duty precludes the use of the Act to prosecute those who trade on stolen MNPI (e.g., through hacking, corporate espionage, or outright theft), as opposed to MNPI voluntarily passed on by a corporate insider. See Dirks v. S.E.C., 463 U.S. 646, 660 (1983) (holding that tippee liability depends on whether the tipper “has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach”). Second, the “personal benefit test” developed in case law to determine tippee liability precludes an insider trading conviction of tippees who knowingly trade on MNPI, unless they are also aware that the tipper who gave them the information also received a personal benefit as a result of the tip. See id. at 662 (“Absent some personal gain [to the tipper], there has been no breach of duty.”). To make matters more complicated, there is a circuit split over whether the personal benefit test requires a special relationship between the tipper and the tippee. See, e.g., Salman v. U.S., 137 S.Ct. 420 (2016) (rejecting “meaningfully close” relationship requirement under U.S. v. Newman, 773 F.3d 438 (2d Cir. 2014), to infer a personal benefit to a tipper who gifted information to the tippee); U.S. v. Martoma, 894 F.3d 64, 77 (2d Cir. 2017) (finding that jury may not find a personal benefit in the form of a “gift of confidential information to a trading relative or friend” without finding either “evidence of a relationship between the [tipper] and the [tippee] that suggests a quid pro quo from the [tippee], or an intention to benefit the [tippee”) (internal quotation marks omitted).
These gaps allow for inconsistent application of the law, with sometimes absurd results. For example, a defendant tippee’s guilty plea was recently thrown out, despite that the defendant admitted that he knowingly trading on the basis of MNPI that he knew had been obtained in breach of a fiduciary duty, because there was no evidence that the defendant was aware of any personal benefit received by the tipper. See U.S. v. Lee, 13 Cr. 539 (S.D.N.Y. June 21, 2019).
The proposed Insider Trading Prohibition Act would eliminate these gaps by codifying the requisite elements for an insider trading violation. The bill would make it a violation to:
(1) trade on inside information with knowledge or reckless disregard that such information was wrongfully obtained or that such trading would constitute “wrongful use” of that information; or
(2) wrongfully communicate inside information to another person, who then trades on it or passes it on to a third person who trades on it, when such trading is “reasonably foreseeable.”
For starters, the bill explicitly eliminates the “personal benefit” test. Instead, the bill sets forth an explicit “knowledge requirement.” The tippee need not know how the information was obtained or whether the tipper received a personal benefit. Rather, the tippee need only be “aware, consciously avoid being aware or recklessly disregard that such information was wrongfully obtained or communicated.” In other words, any trader could be criminally liable for trading on information that the trader knew or should have known was “wrongfully” obtained.
This language expands the scope of criminal liability in two ways. First, by eliminating the personal benefit test, it removes a significant barrier for prosecution of tipees who receive information several links down the chain from the original tipper (so called “remote tipees”). Under the current law, these tippees cannot be convicted unless the government is able to show their awareness of a personal benefit received by the tipper. Second, this language also expands the knowledge requirement for criminal liability to include reckless – not just willful – use of “wrongfully obtained” MNPI to commit insider trading.
In addition, the bill’s definition of “wrongful use” expands the covered scenarios for obtaining MNPI from one (i.e., MNPI obtained in breach of a fiduciary duty) to four. Under the bill, use of MNPI is “wrongful” if the MNPI was obtained:
- By theft, bribery, or espionage;
- In violation of computer fraud, data privacy, or intellectual property laws;
- Through “conversion, misappropriation or unauthorized and deceptive taking of such information;” or
- In breach of a fiduciary duty, confidentiality agreement, contract, or “any other personal or other relationship of trust and confidence.”
Every law is subject to the rule of unintended consequences, and the proposed Insider Trading Prohibition Act is no exception. As discussed above, if enacted, the law may cast a substantially wider net than its drafters intended. For example, the third scenario, above, is arguably a catch-all intended to cover the use of any MNPI while trading. Imagine you accidentally overhear two corporate insiders discussing a planned merger. They have not intentionally passed along any information, and have not breached their fiduciary duty (assuming they took reasonable care to keep their conversation private). If you then go on to trade on that information, there is no bar against a prosecutor arguing you converted and/or took the information without authorization. However, even without this scenario, the expanded definition of “wrongfully obtained” could dramatically increase the number of insider trading prosecutions brought by the federal government. Where the current law limits prosecutions to instances involving the insider’s breach of a fiduciary duty, the proposed law would allow for prosecution any time a trade was based on “wrongfully obtained” MNPI – be it stolen, hacked, bribed, espied, or in breach of a duty, whether fiduciary or contractual. Finally, couple this expanded net with the bill’s looser scienter requirements and the universe of potential defendants litigating what it means to recklessly trade on MNPI explodes. That explosion would in turn lead to more judge-made tests for determining what is reckless insider trading, which may very well revert back to the old fiduciary duty/personal benefit formula, leaving us right back where we started.
After its introduction on May 7, the bill passed unanimously in the House Financial Services Committee on May 10, with Ranking Member Patrick McHenry (R-NC) agreeing to work with Himes to pass the bill in the House. See https://himes.house.gov/media-center/in-the-news/himes-bipartisan-insider-trading-bill-passes-financial-services-committee-0. Given its unanimous passage through committee, the chances of the bill ultimately becoming law appear to be at least marginally better than the first time the bill was introduced in 2015, when it failed to get out of committee. See H.R. 1625. However, regardless of whether the bill passes now, later, or never, the tension in insider trading law is clear and present, and demands resolution. Whether that tension is resolved legislatively or through further case law remains to be seen. But in either case, resolution will necessarily result in changes to insider trading law.