Monday, January 30, 2017

Public Officials And Securities Investments - A Parade of Horribles?

Although it may have gotten a bit lost in the shuffle of the POTUS's first ten days in office, the nomination of Representative Tom Price for the post of Secretary of Health and Human Services has received some negative attention in the press.  In short, as reported by a variety of news outlets (e.g., here and here and here), some personal stock trading transactions have raised questions about whether Representative Price may have inappropriately used information or his position to profit personally from securities trading activities, in violation of applicable ethical or legal rules.  This post offers some preliminary insights about the nature of the concerns, which are set forth in major part in this New York Times editorial from January 18, and joins others in calling for reform.

Concerns about legislators' securities trading activities are not new.  As you may recall, a 2011 study (using data from 1985-2001) found that members of the U.S. House of Representatives do make abnormal returns on stock trades.  A 60 Minutes exposé, "Insiders," then followed, which helped catalyze the adoption in 2012 of the Stop Trading on Congressional Knowledge ("STOCK") Act.  A recently released paper catalogues this history and effects on those abnormal returns.  The findings in this paper, which focuses on Senate trading transactions, are summarized below.

Before “Insiders” aired, the market-value weighted hedged portfolio earns an annualized abnormal return of 8.8%. This abnormal return comes entirely from the sell-side of the portfolio, which earns an annualized 16.77% abnormal return. Post-60 Minutes, we find no evidence of continued outperformance in our market-value weighted portfolios. On average, abnormal returns to the market-value weighted sell portfolio are 24% lower post-60 Minutes, relative to the pre-60 Minutes sample. Taken together, our evidence suggests that, Senators, on the whole, outperformed the market pre-60 Minutes, and this systematic outperformance did not survive the attention paid to Senators’ investments surrounding the broadcast of “Insiders” and subsequent passage of the Stop Trading On Congressional Knowledge (STOCK) Act.

As a general matter, under House ethics rules, "[o]fficial position and confidential information may not be used for personal gain."  (See this summary memorandum from which this quote was taken.)   The full House Ethics Manual includes few mandates in this regard, but offers significant guidance under the heading "Voting and Other Activities on Matters of Personal Interest" that argue for cautious, conservative judgments relating to investments in individual firm securities that may be the subject of legislation. The manual also generally advises as follows:

Members, officers, and employees of the House should:

  • Conduct themselves at all times in a manner that reflects creditably on the House;
  • Abide by the spirit as well as the letter of the House rules; and
  • Adhere to the broad ethical standards expressed in the Code of Ethics for Government Service.

They should not in any way use their office for private gain. Nor should they attempt to circumvent any House rule or standard of conduct.

Beyond these rules, however, are insider trading regulations--both generally under Section 10(b) of and Rule 10b-5 under the Securities Exchange Act of 1934, as amended, and under the STOCK Act.  Decisional law insider trading prohibitions focus on trading on and tipping material nonpublic information in violation of a fiduciary or fiduciary-like duty of trust and confidence, undertaken with scienter.  The STOCK Act, among other things, affirms that members of Congress have a duty that is cognizable under these federal insider trading prohibitions.  Other aspects of the STOCK Act include reporting requirements and a ban on special access to initial public offering securities.  

As many observers have noted, none of these rules prohibit a member of Congress from many investments and trading transactions that would or could benefit from that member's general or specific legislative activity.  So, as my husband concluded in a conversation we had about this issue last week, a legislator's activities may enhance his or her personal wealth, whether intentionally or by chance, if he or she invests in securities that relate to those lawmaking activities.  By making investments in those securities, legislators put themselves in an inherent potential position of conflict.

The lack of knowledge of the legislator that a trade is being made, while important for insider trading analyses, does not clear the conflict.  When a broker or trustee is trading securities on behalf of a legislator, that broker or trustee may (and arguably must, under professional duties of loyalty the broker or trustee has to a client in that role) pay careful attention to the legislator's activities that may impact the value of those investments and engage in transactions on behalf of the legislator accordingly.  Even in circumstances involving no communication between a broker or trustee and a legislator client (i.e., a complete blind trust), the connection between the legislator's activities and his or her portfolio compromise our trust in the legislative process.  This is why executive branch appointees must divest themselves of direct investments in private firms (as Tom Price will be required to do if he is confirmed as a cabinet official)--to facilitate trust.

I do not want to get into an analysis of the individualized facts about Representative Price's various securities trading transactions here.  That is not my purpose.  Others (e.g., here and here and here) have begun to do that in public forums.  But I do want to raise questions about whether our federal securities laws, when read in concert with legislative ethics rules, adequately protect investors and best assure the integrity of our capital markets.  Our colleague Professor Donna Nagy says it best in a recent opinion piece she penned for the WaPo:

Even if Price’s stock purchases were permissible under federal securities law, his sizable investment portfolio nevertheless places his legislative judgments into question: Did personal stock holdings influence his legislative activity? That very question points to the urgent need for new legislation to guard against the possibility — or even just the appearance — of self-interested decision-making by members of Congress.

 . . .

What’s needed is legislation that would, subject to some narrowly crafted exceptions, prohibit members of Congress and senior staff officials from owning any securities other than government securities or shares in diversified mutual funds. Such a proscription would hold the legislative branch to the same high standards of ethics and integrity that Congress already demands from federal judges and agency officials in the executive branch, including Tom Price — if he becomes secretary of health and human services.

Current Affairs, Ethics, Financial Markets, Joan Heminway, Securities Regulation | Permalink


I find, for elected representatives, that a Code of Ethics and Conflict of interest rules are largely aspirational. Serving in Washington, DC, is not “public service.” It is transactional. There is a reason that great wealth is accumulated while purportedly “serving the constituents.” This does not mean that there are not issues that motivate a person to run for Congress or that they will not work towards accomplishing those ends tied to the issues. I certainly respect that your posting is viewed through the lens of investors and integrity of the marketplace. However, you have chosen a topic where the legislators write their own rules and restrictions.

However, I think we must realistically look to return on investment. As of 2012, it cost an average of $1.7M to run for a job in the House that pays $174k for a two year term ($348k or a return of 20% of the principal investment – thus not recovering $1.3M). As of 2012, it cost an average of $10.5M to run for a job in the Senate that pays $174k for a six year term ($1,044,000 or a return of a little less than 10% of the principal investment – thus not recovering $9,456,000). This does not include Members Representational Allowance. See gen., Plus, leadership positions pay more.

So, what is the real incentive? Well, for most elected officials they are relocating to an area where the cost of living is higher than for their district. During the Great Recession, Washington, DC and its suburbs were relatively unaffected. . So, one can infer that there is an inherent financial interest.

The STOCK Act, which was initially introduced in 2006, only received some prominent attention and passage as a result of the broadly disparate market outcomes achieved by John Boehner and Nancy Pelosi (among others) where tied to oversight and regulation of markets by they and others. I would point out that the STOCK Act does not prohibit those “affected” by the legislation from holding stocks in areas in which they can affect with political power. In great part, the STOCK Act was and remains primarily political cover. So, if we actually reform this process and reach that plateau of ethics and retardation of conflict – will we find candidates willing to “take the hit” (other than those already financially comfortable) to engage in “public service?” I think we will simply watch another mutation in the form of hidden remuneration.

Posted by: Tom N. | Jan 31, 2017 3:11:39 PM

Wow, Tom N. I hardly know where to begin with you on this. We seem to be miles apart in our thinking. And I admit that I am unfamiliar with the numbers you quote in your comment.

I will just say this: if qualified candidates for Congress are dissuaded in running for office because of the cost, we should work to fix that problem. There are many possible solutions. But allowing members of Congress to profit from their legislative activities is not a solution that I can endorse. It is likely to be both under-inclusive and over-inclusive and borne of self-interest. That self-interest also may affect voting decisions, even if only tacitly. Trading activity of this kind, as I note in the post, erodes faith in those legislative officials—and ultimately Congress itself.

I know that this will sound naïve, but I still believe that our legislators represent those of us in their districts—all of us, not just the majority that can re-elect them. Legislators are fiduciaries with duties to the public. In a 2011 article, Professor Nagy (whom I quote in the post) set forth and explained these duties in detail. Her article can be found at Like corporate fiduciaries, legislators should not be permitted to selectively benefit from securities trading based on material non-public information they gain—or can create—through their government positions. I know that there are those who disagree with me on that and also would allow corporate directors and officers to trade on material nonpublic information for personal benefit in most, if not all, cases. But I have concluded that insider trading regulation is a public good. That view informs the observations I share in the post.

Thanks, as always for commenting, Tom.

Posted by: joanheminway | Jan 31, 2017 4:27:44 PM

I would expand my comment and state that the cost to run for Congress is not the limitation. Clearly, individuals will raise expend those resources required to attain the elective office. However, I believe the history and facts are that office holders parlay these positions for accumulation of wealth and "they write the rules." Thus, the loopholes - in one fashion or another - will be preserved.

Posted by: Tom N | Jan 31, 2017 5:48:18 PM

You say:

"I believe the history and facts are that office holders parlay these positions for accumulation of wealth and 'they write the rules.' Thus, the loopholes - in one fashion or another - will be preserved."

I do understand what you mean. I hope that you are wrong, however, that there are not enough votes to get sensible rules or legislation through on this. It may take something on the order of the 60 Minutes episode that I refer to in the post to catalyze action . . . .

Posted by: joanheminway | Jan 31, 2017 6:12:39 PM

I'm with Tom in not thinking that this is a big deal, absent evidence of insider trading. Suppose a politician will make $50,000 in stock gains if a particular bill passes, and it will pass only if he voted for it. Also assume that the politician will get a $1 million campaign contribution if the bill fails, and it will fail unless he votes for it. Which side is he likely to go? When you figure in the fact that the impact of any piece of legislation on any given publicly held security is going to be hard to quantify -- how much will Citibank stock go up if Dodd-Frank is eliminated? -- whereas the campaign contributions are hard cash, it strikes me as a nothingburger.

Posted by: Frank Snyder | Feb 1, 2017 8:45:20 AM

Thanks for these thoughts, Frank. First off, I am not suggesting that members of Congress divest all of their stock in publicly held companies. What I am suggesting is that we should consider rules on divestment with respect to investments in firms that are affected in direct ways by the activities of a committee on which a member of Congress serves. Interestingly, Senate committee staffers already are prohibited from investing in firms regulated by the committee for which they work—but not members of the Senate or House, and not House committee staffers. Why the difference? It’s not enough, imv, that the legislators are elected, since most constituents would have no idea of the magnitude of the gains made by their elected official. So, election would not be an effective check. And disclosure alone does not cleanse a conflicting interest transaction . . . .

It’s true that, in light of the U.S. Supreme Court opinion in the Citizens United case, powerful folks can exercise their First Amendment rights by making campaign contributions and subjecting them to quid pro quos and that legislators are impacted by those and other influences. Of course, campaign contributions do not go into the personal bank account of the legislator. Stock profits do. And I abhor the fact that a legislator would vote on legislation merely to secure his or her re-election. A legislator should be focused, instead, on doing what is right for the populace served.

As fiduciaries (and you may disagree with that characterization), legislators should resist all of these influences. If we take the stock conflicts off the table, then legislators will not be tempted to get close to ethical or legal prohibitions relating to their stock ownership and will not have to worry about even the appearance of impropriety from their stock trades. If I were serving in the legislature, I would welcome the clarity of a rule that asked me to divest. The irony of Representative Price’s specific situation—that he must divest health care investments if he’s making health care policy from the executive branch because of the potential for a conflict but that he can keep trading in the same securities while making health care policy in the legislative branch—is not lost on me.

Finally, large, diverse public companies (you mention Citibank) do not raise as much concern with many observers. Largely, this is because of a view that little is material to an entity that large and that diverse. But immateriality is not a defense to a claim of self-interest. I am concerned about the possibility—regardless of the actual effect on the firm as a whole—that legislators may profit differentially from their activities and may be influenced by their ownership of firms under their legislative authority. Even the appearance of impropriety erodes trust in government.

But we can agree to disagree. And I am grateful for the dialogue!

Posted by: joanheminway | Feb 1, 2017 11:38:39 AM

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