Why Congress Isn't Liable for Insider Trading

At one time or another, Congress self-servingly said its members didn't need to obey laws as varied (and burdensome) as the Civil Rights Act and the Freedom of Information Act. Nevertheless, Congress didn't exempt itself from the law against insider trading -- at least in part because there isn't one.

Unlike some other countries, the United States has no law forbidding people from trading on inside information. Does that mean that famous convicted inside-traders such as ImClone's Sam Waksal, corporate-raider Gordon Gekko, or Galleon Group's Raj Rajaratnam should call their lawyers and appeal their criminal convictions? No (although Gekko is fictional and Waksal already served his time).

What the law says
For lawyers, one of the neat characteristics of U.S. securities laws is that they're made up of statutes, Securities and Exchange Commission regulations, and court decisions interpreting those laws and regulations. The SEC's Rule 10b5, under the Securities Exchange Act of 1934, makes it illegal for anyone to "employ any device, scheme, or artifice to defraud" in connection with the purchase or sale of a security.

Over time, the courts have held that people engage in fraud or deception under Rule 10b5 when they trade on material, nonpublic information obtained as part of a relationship of trust or confidence -- so, to simplify, it's generally illegal for you or me to trade on the inside information we learn from our employers.

It's important to recognize, though, that the SEC's rules, as interpreted by the courts, don't make it illegal for people merely to trade on information that others don't have. We want people to conduct research and develop unique information. Rather, the securities laws try to level the playing field between corporate insiders, who generally have access to lots of information, and outsiders, who have less. That's why the courts have required that, in order for a person's trading on nonpublic information to be illegal, the person must have obtained that information because of a special, trusted status and have a duty to keep it confidential -- typically because the person has a position at a company or enjoys a relationship of confidence, as would a lawyer, for example.

Two theories of insider trading
There are two main theories of insider trading. The "classical" theory applies when people trade in a company's stock based on information they receive from that company, when they have some obligation to keep that information secret. In other words, if you're an executive at XYZ Co., and you learn that XYZ has been awarded a big defense contract, your decision to buy XYZ stock before the deal is announced could be a fashion choice, as well as an investment decision, and you'd better hope that you look good in prison stripes (or orange jumpsuits, as applicable).

Members of Congress aren't likely to be subject to liability under this theory because they don't owe confidentiality to companies in the marketplace. They're Congress, dagnabbit, not corporate flunkies (I could write something snarky here, but I won't).

The "misappropriation" theory of insider trading says that when people have a fiduciary or similar obligation to someone, they can't use that person's information for their own gain without disclosing their use of the information to that person. An example helps here: If a lawyer who represents PQR Co. learns that PQR is about to buy XYZ, he can't just run out and buy XYZ stock. Note that in a misappropriation case, the "victim" is actually the source of the information, not the faceless, uninformed chump on the other side of the transaction.

The enforcement challenge
You might think, as some legal scholars do, that members of Congress owe the American people at least as much loyalty as lawyers owe their clients, so that members who used congressional information for their own ends would be misappropriating it and thus breaking the law.

But other legal scholars, as well as the SEC, doubt that members owe that sort of duty. As Thomas Newkirk, former associate director of the SEC's Division of Enforcement, told The Wall Street Journal, members don't have "a duty of confidentiality to anybody and therefore ... would not be liable for insider trading."

Similarly, Robert Khuzami, director of the Enforcement Division, testified before Senate in November that to win an insider trading case against a member of Congress, the SEC would have to demonstrate that the lawmaker violated a fiduciary or other duty of trust and confidence, and it is not clear that such congressional trading "violates the fiduciary duty he or she owes to the United States and its citizens, or to the federal government as his or her employer."

Without a firm understanding that the law is on their side, SEC regulators or Justice Department prosecutors are unlikely to bring cases against members who trade on congressional information. Bringing an action against a member of the branch of government that sets your budget is hard enough, but it's particularly daunting when your legal basis is shaky.

So, for now, it appears that unlike the rest of us, members of Congress can trade on inside information with legal impunity. They didn't create that situation, but unless they pass the STOCK Act, or something like it, they're certainly perpetuating it.

Lawrence Greenberg is The Motley Fool's chief legal officer.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 10, 2012, at 3:49 PM, TMFDitty wrote:

    Succinctly put. Thanks, Lawrence!

    TMFDitty

  • Report this Comment On January 10, 2012, at 4:53 PM, mdk0611 wrote:

    Query - Would there currenly be a limited prohibition against insider trading under current law for those members of Congress who are on intelligence/security committees where the hearings and findings are required to remain confidential?

    Otherwise I guess it will have to wait for the STOCK Act.

  • Report this Comment On January 10, 2012, at 4:56 PM, tramagli wrote:

    Just because it may be legal doesn't mean it's right.

  • Report this Comment On January 10, 2012, at 5:24 PM, mdtopper wrote:

    Actually, you cant have it both ways. A legislator probably doesnt have the same opportunity to obtain inside information in the course of his normal duties (he doesnt work for the company) UNLESS an individual who does work for the company improperly confides in the legislator.

    Then THAT person is guilty, not the legislator.

    (Maybe the legislator has a moral responsibility NOT to gain from info he shouldnt have, but perhaps not a legal one)

  • Report this Comment On January 10, 2012, at 5:51 PM, gsgreen wrote:

    As Congress DOES have a fiduciary duty to the government, and by extension to the citizens, then using information gleaned in the performance of their jobs would indeed be a breach of that fiduciary trust, and well subject to the misappropriation theory. So, if a member of Congress learns that the Government, or for that matter decides than the government, is about to make a material regulatory or purchasing decision regarding XYZ Corp, then it would seem pretty staight forward that they are very guilty of "insider trading" if they purchase (or sell) shares in XYZ Corp.

    That Government agencies are reluctant to bite the hand that feeds them is neither here nor there in regards to that Member's culpability.

  • Report this Comment On January 10, 2012, at 5:56 PM, mountain8 wrote:

    I'm sorry. This involves ethics. And congress is excempt from that.

  • Report this Comment On January 10, 2012, at 6:26 PM, C2S1 wrote:

    Mr. Greenberg,

    Horse apples! The DC 535 have the power to send stocks soaring or tumbling with their legislation, excessive attention, or convenient lack of attention to market segments &/or individual companies. And given that ability and all the "gambling tools" available to them / us in today's market, they should have no ability to profit in any way with their bets for or against companies based on this definite "insider info". Have you forgotten the "Martha Stewart standard"? Why should she have gone to jail for her actions while 90 or so of these "leaders" have doubled or tripled their net worth in the past several years...because of their "insider information".

  • Report this Comment On January 10, 2012, at 6:26 PM, xetn wrote:

    In fact, members of congress are not liable for anything they do in connection with their duties. They are not even required to pass legislation that is outside of the constitution, even though they take an oath to uphold same. It seems that they don't even consider the constitution when creating laws.

    As for insider trading, all regulation of securities etc should be totally independent and private. That would remove any "temptation".

  • Report this Comment On January 10, 2012, at 8:28 PM, truman1987 wrote:

    After reading this I was wondering how they convicted Martha Stewart. She didn't have a fiduciary obligation to ImClone. Turns out Stewart was found guilty of conspiracy, obstruction of an agency proceeding, and making false statements to federal investigators, not insider trading.

  • Report this Comment On January 10, 2012, at 8:49 PM, Sunny7039 wrote:

    No, mtopper. Any constituent should be able to confide any information about a legal activity to their elected representative without fear of liability. Notice I said "confide," not "sell."

    It is the representative who should not be allowed to use that information for private gain, for themselves or for anyone else. Any such information should only be taken into consideration when legislating for the public good.

    Obviously this isn't how it really works. Otherwise, why would anyone spend millions to obtain a job that pays a few hundred thousand? But if we're going to talk about how it should work, well . . . then this is how it should work.

  • Report this Comment On January 10, 2012, at 8:56 PM, Sunny7039 wrote:

    Securities regulation should be private? That's one brilliant comment. I suppose we should all travel from corporation to corporation and demand to examine all of their books -- and talk to their bankers personally -- before we invest.

    Uh, buddy -- how long do you think anyone but insiders would even approach our equity markets if there were no public regulation whatsoever? How long do you think foreign investors would remain invested? Or do you think the DJIA wouldn't collapse if all foreign investors pulled out? Considering the track record of deregulation, if we had "self-policing," why would anyone trust any statement to represent more than one entity's claim written on some paper?

  • Report this Comment On January 10, 2012, at 10:05 PM, MichaelDSimms wrote:

    Congress has control of billions of dollars for appropriations. And knows who, and when that money goes too, in advance of others. If that isn't insider information, I am from Mars.

  • Report this Comment On January 11, 2012, at 12:43 AM, TMFLaw wrote:

    I don't often write for Fool.com, and I appreciate that you read the article and thought enough to post comments.

    @TMF Ditty -- Thank you, Rich. You started this.

    @mdk0611 -- That's a good question. I'll look into that.

    @tramaqli -- You're completely right. The law is a floor for behavior (and who wants to eat off the floor?)

    @mtopper -- If someone gave an improper "tip" to a member of Congress, who traded on the information, then both "tipper" and "tippee" could be liable, under either theory of insider trading. The sort of disclosure we're worried about is on information that Congress obtains in the course of its duties. As my colleagues have been discussing elsewhere (and will continue to discuss) there have been times when Congress has received market-sensitive information and some members may have traded upon it, arguably legally.

    @mountain8 -- to paraphrase Alice Roosevelt, if you're going to be that cynical, then come sit by me.

    @gsgreen -- I think you're identifying our reason for covering this issue -- members SHOULD have a duty to Congress, the government, or the American people, but the law hasn't been widely interpreted that way. Some versions of the STOCK Act in the Senate would make it clear that such duty exists.

    @C2S1 -- Again, that's why we've advocated legislation to address the problem. Without such legislation, it doesn't appear that the SEC will feel empowered to do anything about it.

    @xetn The Department of Justice and FBI have had some success (and failures) in prosecuting members who accepted bribes. As to your argument about private enforcement, much enforcement of the antifraud provisions of the securities laws takes place through private lawsuits, but I'm not sure how helpful that is.

    @truman1987 Yes. If Martha Stewart had been convicted of insider trading, it would likely have been because of receiving tips that originated with people who had duties not to disclose. But, as you point out, that wasn't what she went to jail for.

    @Sunny0739 Yes. There's case law holding someone making a disclosure not for personal gain (and personal gain might be defined broadly) wouldn't be liable as an improper tipper.

    @MichaelDSimms I don't think that you're from Mars.

  • Report this Comment On January 11, 2012, at 1:19 AM, Merton123 wrote:

    Lawrence - you have done a great job explaining the legal theory behind inside trading. I believe that inside trading makes the markets more efficient. What do you think? If that is the case why are we trying to make the market less efficient?

    Theoretically the outside analysts and so-for should have have already guessed that something was already up so the insider advantage is illusionary. The publication of the news creates suddent interest by investors and maybe drives the price of the stock up. Sometimes the market simply ignores the news with so much noise going on out there.

  • Report this Comment On January 11, 2012, at 1:42 AM, BBLBBD wrote:

    Is this for real ? This is one of the most moronic analysis I've ever read.

    Let's use this logic on any government regulation....that IRS rule is not really "the law" so go ahead and don't follow it....if you are in Congress you won't get penalized, but if you are a common clod, tough luck...

    Oh, yeah...that health care bill that sucks for everyone except the unions we exempted, and ourselves..we are not going to include ourselves on that either...

    It's not a "law" only a regulation....

    This type of "I'm more clever than you" crap is the problem.

    Tell you what...tell me what the definition of "is" is, and then you can start with this type of crap.

    This idiocy makes me consider getting a refund on my MF newsletter.

  • Report this Comment On January 11, 2012, at 1:51 AM, BBLBBD wrote:

    MF should not use this as their banner article. This is too stupid and harms the credibilty of this service.

    This may even cross the line on giving legal advice without a license...unless this guy has a law license, in which case he needs to give more cites and back up what he claims.

    Is he saying that case law is not law ? Precedent is not precedent ? What statute does he cite ?

    This is really low quality, half-assed crap.

    I may not even disagree wtih the opinion, but give some cites and some law.

  • Report this Comment On January 11, 2012, at 2:02 AM, BBLBBD wrote:

    I think this guy is practicing law without a license, and he should be sanctioned for it

    Let's use his analysis on that:

    1. Is there a law against practicing law without a license ?

    no, not if the practice of law is not clearly defined, so no there is not....so he did nothing wrong...

    2. Is there a "law" ?....not really....just a bunch of statutes, court opinions, and case precendent....

    no big deal

    3. Did someone interpret the law to give legal advice ? ...no, not really, not to get too snarky here.

    4. Do some people get sentenced to jail and/or sanctioned for doing the very thing this guy does ?....yes, unless you are in Congress...

  • Report this Comment On January 11, 2012, at 5:56 AM, JacksonInVA wrote:

    Great article. It seems Congress needs to pass a law stating that members do have a fiduciary responsibility as elected civil servants. LOL. That will never happen. Congress is loaded with criminals supported by richer criminals.

  • Report this Comment On January 11, 2012, at 8:15 AM, ravenesque wrote:

    And exactly why has someone gotten away with this, Counselor?

    http://michaelfury.wordpress.com/2011/11/11/illicit-but-ill-...

  • Report this Comment On January 11, 2012, at 10:18 AM, DaveKATL wrote:

    So... why did Martha Stewart get nailed? She got her information from her broker who allegedly go it form a CEO.

    She didn't have any confidentiality and she owed no one fiduciary responsibility.

    She shouldn't have been prosecuted let alone gone to jail. then.

  • Report this Comment On January 11, 2012, at 12:15 PM, TMFLaw wrote:

    For those who are interested in some of the details that we thought would be excessive for an article like this one:

    The Supreme Court set out the classical theory of insider trading as a Rule 10b-5 violation (including the importance of a relationship of trust and confidence) in Chiarella v. United States, 445 U.S. 222 (1980) and Dirks v. SEC , 463 U.S. 646 (1983). The Court explained the misappropriation theory and distinguished the two theories in U.S. v. O’Hagan. 521 U.S. 642 (1997). Dirks is also helpful in explaining how people may be liable for trading on tips from insiders who couldn’t trade themselves.

    For discussion of the conflict among legal scholars about whether or not members of Congress could be liable for trading on Congressional information, please see:

    Stephen M. Bainbridge, Insider Trading Inside the Beltway, 36 Iowa J. Corp. L. 281 (2011) (no liability) and Donna M. Nagy, Insider Trading, Congressional Officials, and Duties of Entrustment, B.U.L. Rev. 1105 (2011) (liability).

  • Report this Comment On January 11, 2012, at 12:28 PM, DJDynamicNC wrote:

    Not sure why people are saying this is a moronic article and then "proving" their case with words the author never used.

    I found it enlightening, as I am not a lawyer and had only a vague understanding of how insider trading was regulated - enough to know I shouldn't do it!

    One of the things that's important about the Fool is that the articles are pitched to thousands of regular folk like me. If you are too sophisticated an investor to glean much from this article, good on you, but taking to the comments to bash the author for being "moronic" serves only to dissuade others from commenting more thoughtfully.

    Conversely, I also don't have any trouble recognizing the distinction between a law passed by the legislative branch and a regulation enacted by the executive branch, and I suspect that is the source of some of the confusion.

    Oh, and since we're taking completely unrelated asides to talk about the health care law, I thought I'd like to point out that Affordable Care Act doesn't suck if you have a pre-existing condition, which under the old rules would mean you would simply be killed in order to preserve shareholder profits. I recognize that this is an investing site, but I think a certain degree of human compassion still holds sway.

  • Report this Comment On January 11, 2012, at 1:18 PM, TMFNoCeilings wrote:
  • Report this Comment On January 11, 2012, at 2:34 PM, Sumflow wrote:

    The House bill is a cover up that creates new loop holes for congress, congressional investments in ETFs, options and mutual funds based on inside information aren’t covered under the House bill, nor is tipping off outside sources. But the Senate bill S.1903 - STOCK bill (http://goo.gl/Eh1p2), closes up two major leaks. There is a “duty arising from a relationship of trust and confidence,” that is owed by members of Congress to the people, and traders need to "disclose trades nearer to real time,” to substitute a philosophy of full disclosure for the current philosophy of caveat emptor.

    The loophole in which members of congress and legislative staffers are immune from enforcement of insider-trading laws, is because the delayed reporting of securities transactions by congress, defeats, obstructs, and impairs its use as timely evidence. Insider-trading cases are hard to prove, because the trades must be tightly linked to the events or information on which they are allegedly based. They should amend the SEC rules to include prompt disclosure on electronic, searchable forms., and put them in jail if they do not, so that the memories of potential witnesses are fresh, and suspects do not have time to cover up their actions.

    Lack of information is part of the reason why no Congress people were investigated under the current laws.

  • Report this Comment On January 11, 2012, at 3:32 PM, bhessel wrote:

    TMFLaw wrote:

    >There are two main theories of insider trading.

    > The "classical" theory applies when people trade

    > in a company's stock based on information they

    > receive from that company, when they have

    > some obligation to keep that information

    > secret….

    >

    > The "misappropriation" theory of insider trading

    > says that when people have a fiduciary or

    > similar obligation to someone, they can't use

    > that person's information for their own gain

    > without disclosing their use of the information to

    > that person.

    I have worked for a couple of public companies and their insider trading policies enjoined employees against trading when in possession of any pertinent, material, non-public information, regardless of how the employee came into possession of it. Possibly the authors of these policies were engaging in good grey conservative CYA-legal-speak, in that if you traded your own company’s stock whilst in possession of inside information it would be extremely difficult to prove you came by it in a kosher manner—not to mention the danger of getting some innocent-bystander-fellow-employee who was/could have been the source of the inside info into trouble—so better not to have that argument. But are there circumstances where it is permissible to trade on material, non-public information?

    For example, let’s say a merger agreement has been negotiated secretly between two public companies. Prior to the announcement of the deal, a bunch of paper copies of some of the legal docs are needed and I am related to the grunt who cranks the photocopier and he slips me one of them. Clearly if I trade on that info—or pass the info on to someone who trades on it—that falls under the misappropriation theory.

    But what if the copying is outsourced to the same vendor I use and one of those copies is accidentally mixed in with my stuff? Or a copy is e-mailed to me by mistake? Or I pick one up blowing east along 49th Street? Is it legal for me or someone I pass that info to to trade on that material, non-public information? My old corporate insider trading policies would say “no” but I am thinking you would say “yes.”

  • Report this Comment On January 17, 2012, at 3:25 PM, silentnomore wrote:

    Government must do what is possible to create a fair marketplace. Our representatives should not be allowed to trade on private information. They can wait until information is made public, like the rest of us.

    The idea of privatizing this function of government is ludicrous! This is an activity for the public good, not a means to make a profit.

  • Report this Comment On January 18, 2012, at 8:53 PM, Netteligent09 wrote:

    America is a much better countries without these lawyers, politicans, and Securities and Exchange Commission

  • Report this Comment On February 10, 2012, at 7:22 AM, MFMerlin wrote:

    Call me crazy, but I am astonished that anyone thinks that Congress, or the President for that matter, has any sort of fiduciary duty or trust towards the American people after passing the laws they have passed and spending the money they have spent.

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