The House passed the Insider Trading Prohibition Act last month, 410-13. Insider-trading law needed clarification, but ITPA proves that bipartisanship is no guarantee of good legislation.
Rather than "let potential wrongdoers know exactly what behavior will cross the line," as the bill's sponsor Rep. Jim Himes (D., Conn.) claimed, ITPA would increase confusion. The bill would perplex investors, give prosecutors too much discretion, and bedevil the courts. The Senate should reject it.
Contrary to popular belief, there is nothing unlawful about trading based on "material, nonpublic information." Such trading is illegal only when it results in a violation of the general antifraud provisions of federal securities laws, something that happens in certain narrow circumstances.
In the classic case, an insider—an officer, director or employee of a company—profits from an informational advantage that rightfully belongs to the company itself. The insider breaches his fiduciary duty to shareholders by trading for his own benefit—or passing the information for someone else to trade—without disclosing the information to the market.
Liability also extends to those who aren't insiders. Under what is known as the "misappropriation theory," those who trade on inside information can be liable if doing so is a breach of fiduciary duty or a similar duty of trust or confidence. Traders may also be liable if they know the information was obtained via such a breach.
The House claims it is merely codifying and clarifying existing law, but ITPA actually turns it on its head. Because insider-trading law is based on antifraud statutes, courts have made clear that a defendant can't be held liable unless he acted with intent to defraud or had a duty not to use the information for his own benefit. ITPA arguably does away with both of these sensible limitations.
First, ITPA appears to expand the factual circumstances under which material, nonpublic information can be described as having been "wrongfully obtained or communicated," thereby triggering insider-trading liability. While some of these changes might make sense, the bill also contains a troublesome catchall provision stating that information can be wrongfully obtained and communicated as the result of "a breach of a confidentiality agreement, a breach of contract, or a breach of any other personal or other relationship of trust and confidence." Courts have been all over the map as to whether these actions can create insider-trading liability.
Take the case against billionaire Mark Cuban. It hinged largely on the issue of whether Mr. Cuban, when he was provided with unsolicited information about a corporate transaction, implicitly "agreed" to keep it confidential. Mr. Cuban spent years in court demonstrating that no such agreement had taken place. Ultimately a jury found him not liable. Congress should avoid establishing a system in which companies can prevent their major investors from trading by simply telling them information about the company. Yet ITPA appears to create precisely such a system, because it provides no guidance about what constitutes the necessary confidentiality agreement, contract, or relationship of trust and confidence.
Second, ITPA would make it easier for a prosecutor to establish that a trader knew what he was doing was wrong. Rather than limiting liability to traders who deliberately engaged in misconduct, the bill would hold liable anyone who "was aware, consciously avoided being aware, or recklessly disregarded" that the material, nonpublic information he traded on was wrongfully obtained or communicated. "Recklessly disregarded"—to the extent that it does not include any need for intent—is a new concept for insider-trading law.
Take a routine example. If a trader overhears a corporate officer on the train and then trades on that information—which doesn't constitute insider trading under current law—have the trader and the corporate officer "recklessly disregarded" that the officer breached a relationship of trust and confidence by speaking too loudly in a public place? Under ITPA, the answer, arguably, would be yes. The bill moves away from the limited concept of a breach of fiduciary duty, which requires a personal benefit to the source of the information. The corporate officer obtains no benefit in this situation, and clearly did not intend to engage in insider trading, but both he and the trader would potentially be liable for insider trading if the bill becomes law.
If all of this were not enough, ITPA would not even become the exclusive basis for federal insider-trading actions. The Justice Department and the Securities and Exchange Commission would still be able to bring actions under the general antifraud provisions of the federal securities laws. In other words, the government could cherry-pick its preferred law based on the facts of the case. So much for clarity and consistency.
As the overwhelming House vote demonstrates, no one is in favor of the current insider-trading regime, which emerged haphazardly through various court decisions. But ITPA is not the answer.
Mr. Roberts is a Washington-based partner with Shearman & Sterling LLP. He represented Mark Cuban in SEC v. Cuban.
Previously published in The Wall Street Journal.
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