Friday, April 29, 2022
"We Know Wrongful Trading When We See It" - Some Observations Concerning the Recent Senate Hearing on the Insider Trading Prohibition Act
Earlier this month, the U.S. Senate Committee on Banking, Housing, and Urban Affairs held a hearing on the Insider Trading Prohibition Act (ITPA), which passed the house with bipartisan support in May of last year. Some prominent scholars, like Professor Stephen Bainbridge, have criticized the ITPA as ambiguous in its text and overbroad in its application, while others, like Professor John Coffee, have expressed concern that it does not go far enough (mostly because the bill retains the “personal benefit” requirement for tipper-tippee liability).
My own view is that there are some good, bad, and ugly aspects of the bill. Starting with what’s good about the bill:
- If made law, the ITPA would end what Professor Jeanne L. Schroeder calls the “jurisprudential scandal that insider trading is largely a common law federal offense” by codifying its elements.
- The ITPA would bring trading on stolen information that is not acquired by deception (e.g., information acquired by breaking into a file cabinet or hacking a computer) within its scope. Such conduct would not incur Section 10b insider trading liability under the current enforcement regime.
- The ITPA at least purports (more on this below) to only proscribe “wrongful” trading, or trading on information that is “obtained wrongfully.” Since violations of our insider trading laws incur criminal liability and stiff penalties, I have argued for some time that liability should be limited to conduct that is morally wrongful.
- The ITPA preserves the “personal benefit” test as a limiting principal on what otherwise would be an ambiguous and potentially overbroad test for when tipping would breach a fiduciary or similar duty of trust and confidence. Traders need (and justice demands) bright lines that will allow them to determine ex ante whether their trading is legal or will incur 20 years of prison time (but more on this below).
Now, turning to what is bad about the bill, I share some concerns raised by Professor Todd Henderson in his testimony before the Senate Committee:
- Though the ITPA codifies the personal benefit test as a limit on liability, it includes “indirect personal benefit[s]” within its scope. As Henderson points out, “[i]t is possible to describe virtually any human interaction as providing an ‘indirect benefit’ to the participants. Instead, the law should reflect the common sense notion that the source of information either received something tangible and valuable in return or what amounts to a monetary gift to a relative or friend.” The personal benefit test only fulfills its intended function as a limiting principle if it imposes real limits on liability. The test should therefore only be satisfied by objective evidence of self-dealing. If indirect psychological or other benefits that can be found in any voluntary human action can satisfy the test, then it cannot function as a limit on liability.
- At least some versions of the ITPA include a catchall provision to the definition of wrongfully obtained or used information that would include “a breach of a confidentiality agreement, [or] a breach of contract.” Not only does this challenge the time-honored concept of efficient breach in the law of contracts, but as Professor Andrew Verstein has argued, this provision can open the door to the weaponization of insider trading law through the practice of “strategic tipping.” Professor Henderson raised this concern before the Senate committee, noting that so broad an understanding of wrongful trading is “ripe for abuse, with companies potentially able to prevent individual investors from trading merely by providing them with information whether they want it or not.” The recent examples of Mark Cuban and David Einhorn come to mind.
- The ITPA would impose criminal liability for “reckless” conduct. As Henderson explained to the Committee, under the ITPA, “anyone who ‘was aware, consciously avoided being aware, or recklessly disregarded’ that the information was wrongfully obtained or communicated can have a case brought against them. The ITPA is silent on the meaning of ‘recklessly disregarded,’ which would appear to rope in innocent traders along with actual wrongdoers.” Moreover, permitting mere recklessness to satisfy the mens rea element of insider trading liability will no doubt have a chilling effect on good-faith transactions based on market rumors that would otherwise be value enhancing for traders, their clients, and the markets. The loss of such trades will diminish market liquidity and reduce price accuracy.
- Finally, Henderson raised the concern that the ITPA lacks an “exclusivity clause stating that it will be the sole basis for bringing federal insider trading claims.” Henderson explained that “allowing prosecutors to cherry pick their preferred law is no way to provide clear rules for the market.” Professor Karen Woody has written about how prosecutors may be starting to bring insider trading cases under 18 U.S.C. § 1348 to avoid the court-imposed personal benefit test under Exchange Act §10b. Without an exclusivity clause, prosecutors will be free to make the same end run around the personal benefit test imposed by the ITPA.
Finally, the ITPA is straight-up ugly because, while it promises that it will limit insider trading liability (which can be punished by up to 20 years imprisonment) to only “wrongful” conduct, the bill defines the term “wrongful” in a way that suggests the drafters have no intention of delivering on that promise. For example, as noted above, some versions of the bill define any breach of contract as “wrongful,” but this is in clear tension with common sense, common law, and the doctrine of efficient breach.
In addition, though there is ambiguity in the text, current versions of the ITPA appear to embrace SEC Rule 10b5-1’s “awareness” test for when trading on material nonpublic information incurs insider trading liability. Under the awareness test, a corporate insider incurs insider trading liability if she is aware of material nonpublic information while trading for totally unrelated reasons. In other words, liability may be imposed even if the material nonpublic information played no motivational role in the decision to trade. But if the material nonpublic information played no motivational role, then the trading cannot be judged “wrongful” under any common-sense understanding of that term.
For these (and other reasons there is no space to address here), the ITPA leaves too much room for play in its definition of what constitutes “wrongful” trading and tipping to cohere with our common-sense understanding of that term. Former SEC Commission Robert J. Jackson assured the Committee that “we know wrongful trading when we see it.” Presumably Professor Jackson’s implication was that the SEC and DOJ can be trusted to exercise sound discretion in interpreting the play in the statutory language. In response, I offer the following question for Professor Jackson or any reader of the ITPA to consider: Would issuer-licensed insider trading violate the statute? I have defined “issuer licensed insider trading” as occurring where:
(1) the insider submits a written plan to the firm that details the proposed trade(s);
(2) the firm authorizes that plan;
(3) the firm has previously disclosed to the investing public that it will permit its employees to trade on the firm’s material nonpublic information when it is in the interest of the firm to grant such permission; and
(4) the firm discloses ex post all trading profits resulting from the execution of these plans.
I have argued that trading under these conditions is neither morally wrongful nor harmful to markets. If it violates ITPA, what provisions? I hope some readers will share their thoughts on this in the comments below!