The House passed the Insider Trading Prohibition Act in an attempt to clarify the law of insider trading by codifying key definitions in a manner that could also expand insider trading liability. Because insider trading law is largely judge made, it has at times produced confusing judicial decisions regarding the elements of the offense, a trend most recently exemplified by a series of opinions issued by the Second Circuit. The Supreme Court, however, has recently reaffirmed its approach to insider trading, a point underscored by the lone amendment to the bill adopted by the full House. The Insider Trading Prohibition Act passed by a vote of 410-13. The bill now goes to the Senate, although it is at least remotely possible that the bill could be attached to other must-pass legislation.
Bipartisan call for codification. The Insider Trading Prohibition Act may be a rare example of compromise given that it sailed through the House Financial Services Committee by voice vote amid promises by lawmakers on both sides of the aisle to improve the bill as it moved to the House floor. The final product includes an amendment by House FSC Ranking Member Patrick McHenry (R-NC) that clarifies language regarding the personal benefit requirement. However, a second Republican amendment that would have narrowed the bill faltered. The one remaining issue not addressed by the bill deals with whether federal law should be the exclusive law of insider trading in the U.S.
House FSC Chairwoman Maxine Waters (D-Cal) noted that a web of court decisions currently spells out the law of insider trading and has produced much uncertainty about who is and is not liable for insider trading. She said the bill would codify existing law and that the McHenry amendment was a "reasonable bipartisan compromise."
The bill’s sponsor, Rep. Jim Himes (D-Conn), told members on the floor that market place uncertainty about insider trading liability spurred Congress to act. In a later press release, Rep. Himes added: "There is currently no bright line statutory prohibition against insider trading, forcing the SEC and DOJ to rely on more general anti-fraud statutes and decades of case law, subject to interpretation by individual judges. It is past time for Congress to provide direction in this area, as there exists a clear and fundamental disadvantage in prosecuting a crime that has never been properly defined."
Ranking Member McHenry offered an amendment that would achieve three goals: (1) clarify bill text regarding the personal benefit requirement; (2) replace "relating to the market" language contained in the bill that he said was too broad in scope; and (3) strike a rule of construction regarding the application of Exchange Act Sections 10(b) and 14(e). According to Rep. McHenry, codifying a large body of law in a single bill is a difficult task and the result is imperfect, but the end result, in his view, will lessen uncertainty among market participants and reduce the possibility that "activist judges" could expand the law of insider trading.
A day earlier, Rep. Ed Perlmutter (D-Colo) had urged adoption of a resolution under which the Insider Trading Prohibition Act would be considered by the full House. He said that Democrats and Republicans had made good on their mutual pledges to negotiate amendments that would permit the bill to move forward. According to Rep. Perlmutter, the McHenry amendment had the early backing of House FSC Chairwoman Waters and the bill’s sponsor Rep. Himes.
Representative Rob Woodall (R-Ga), speaking on the resolution, explained that the bill, if enacted, would take the courts out of making insider trading law and instead allow Congress to directly exercise its Article I responsibility to define insider trading. Ranking Member McHenry also would emphasize this point while urging adoption of his amendment. Rep. Woodhall had hinted that a Rules Committee compromise resulting in consideration of two Republican amendments would yield greater Republican support for the bill than was previously expected, a prediction that was later reflected in the House’s overwhelming approval of the bill.
Bill mechanics. The Insider Trading Prohibition Act (H.R. 2534; House Rep. No. 116-219; Rules Committee comparative draft), sponsored by Rep. Himes, would codify much of existing insider trading law. A Congressional Budget Office report noted that the bill would expand the SEC’s authorities such that the SEC could bring more insider trading cases, but that the bill also could have a deterrent effect that might result in the SEC bringing fewer such cases.
The bill would provide that it is unlawful for a person to buy, sell, enter into, or cause the purchase or sale of a security (including security-based swaps) while aware of material, nonpublic information (MNPI) relating to the security, or relating to the market for the security, if the person knows, or recklessly disregards, that the information was obtained wrongfully, or that the purchase or sale would be a wrongful use of the information (emphasis added).
One provision in the McHenry amendment would replace the phrase "relating to the market" in the above subsection text with language that emphasizes materiality. Specifically, the amendment provides: "any nonpublic information, from whatever source, that has, or would reasonably be expected to have, a material effect on the market price of any [security]." The House approved the McHenry amendment by voice vote.
It is noteworthy that the Rules Committee Print of the bill replaced the discussion draft’s use of the word "possession" with the word "aware" in this part of the bill. An amendment submitted by Rep. Bill Huizenga (R-Mich) would have replaced "aware" with "using." Unlike with the McHenry amendment, the Huizenga amendment drew strong opposition from Democrats. Chairwoman Waters said the amendment would weaken the bill and hinder the SEC’s ability to pursue those who engage in insider trading. Representative Himes explained that, at the request of Republicans, the word "possession" had already been changed to "aware" because of the possibility that one might possess information without being aware of this fact. Representative Himes also said that a further change to "using" could require prosecutors to probe why someone made a trade. The Huizenga amendment failed by a vote of 196-231.
The bill also prohibits the wrongful communication of MNPI where a person, whose own purchase or sale of a security would violate the general ban on insider trading, wrongfully communicates MNPI to another person who: (1) buys or sells a security to which the communication relates; or (2) communicates the information to another person who makes or causes a purchase or sale of a security while aware of the MNPI; and (3) the purchase or sale while aware of the MNPI was reasonably foreseeable.
Under the bill’s proposed standard, the obtaining or communicating of the MNPI would be wrongful only if such acts fell into one of several categories: (1) breach of fiduciary duty; (2) unauthorized and deceptive takings (e.g., conversion or misappropriation); (3) theft, bribery, misrepresentation, or espionage; or (4) the violation of federal laws regarding computer data, intellectual property, or computer privacy.
Some of these provisions would expand the types of acts that may result in insider trading liability to acts that may not currently be within the general antifraud authority of Exchange Act Section 10(b). Presumably, this would make it easier to bring charges against persons who engage in theft, computer hacking, and related offences.
Another provision in the McHenry amendment would further define the bill’s fiduciary duty language to include breaches "for a direct or indirect personal benefit (including pecuniary gain, reputational benefit, or a gift of confidential information to a trading relative or friend)". Thus, the amended bill would eliminate any ambiguity about whether it retained a personal benefit requirement and instead attempt to codify Supreme Court precedent, in particular the Salman opinion (reaffirming and quoting extensively from the Dirks opinion):
"we instructed courts to ‘focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.’ This personal benefit can ‘often’ be inferred ‘from objective facts and circumstances,’ we explained, such as ‘a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient.’ In particular, we held that ‘[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.’ (emphasis added). In such cases, ‘[t]he tip and trade resemble trading by the insider followed by a gift of the profits to the recipient’ (internal citations omitted, but with the original emphasis retained).The bill also includes a knowledge requirement. As a result, a person trading while aware of MNPI need not know specifically how MNPI was obtained or communicated, or whether any personal benefit was paid or promised, provided that the person who traded while aware of the MNPI (or who communicated the MNPI) was aware, consciously avoided being aware, or recklessly disregarded that the MNPI was wrongfully obtained or communicated, or improperly used.
The bill would provide for derivative liability but it also provides for the non-liability for any controlling person or employer who did not participate in or induce acts that would violate the ban on insider trading. Moreover, the insider trading ban proposed in the bill would not apply to a person who acts at the specific direction, and solely for the account of, another person whose securities trading or communication of MNPI would be lawful under the bill. Moreover, the SEC would have authority to grant exemptions from the new insider trading ban.
However, the bill would provide an affirmative defense for persons who enter into Exchange Act Rule 10b5-1 trading plans. A separate provision in the bill would require the SEC to review and make conforming amendments to Rule 10b5-1 within six months after enactment of the Insider Trading Prohibition Act.
In January, the House passed by a vote of 413-3 the Promoting Transparent Standards for Corporate Insiders Act (H.R. 624), sponsored by Rep. Waters, which would direct the SEC to reconsider and revise Rule 10b5-1. Senator Chris Van Hollen (D-Md) has introduced a companion bill (S. 573). Although the Waters and Van Hollen bills are more prescriptive in stating precisely what items the SEC should consider in studying Rule 10b5-1 than is the Insider Trading Prohibition Act, all three bills direct the SEC to make amendments to Rule 10b5-1. However, it is at least arguable that the Insider Trading Prohibition Act’s authority in this regard may be somewhat narrower ("necessary or appropriate because of the amendment to the Securities Exchange Act of 1934 made by this Act"—emphasis added) than the authority contained in the Waters and Van Hollen bills ("consistent with the results of such study").
Lastly, the Rules Committee Print of the Insider Trading Prohibition Act included a rule of construction providing that Exchange Act Sections 10(b) and 14(e), and any judicial precedents established under these sections, would continue to apply to insider trading cases if they are not in conflict with the new insider trading ban. The McHenry amendment eliminated this provision from the House bill.
Need for clarity. Representative Himes was one of several lawmakers in the 114th Congress to introduce similar legislation (H.R. 1625) shortly after the Second Circuit's 2104 Newman decision appeared to make it more difficult for the government to bring insider trading cases. Senator Jack Reed (D-RI) and Rep. Stephen Lynch (D-Mass) (S. 702 and H.R. 1173, respectively) also had introduced insider trading legislation. In the years since Newman, the Second Circuit has perhaps raised as many questions as it has answered through its application of insider trading principles in its amended Martoma opinion (See original Martoma opinion). The Supreme Court also has reaffirmed key principles announced in its Dirks opinion, which still undergirds much of the Supreme Court’s conception of insider trading, including the personal benefit requirement.
Prior to the House Financial Services Committee’s May 2019 vote to approve the bill, Rep. Himes told members the bill would do two things: (1) make sure that elected officials instead of unelected judges make insider trading law; and (2) end the series of reversals in insider trading cases within the Second Circuit brought about by the Newman decision. Representative Himes noted that the bill was largely uncontroversial, although some commenters objected to its treatment of automated stock sales plans. Still, Rep. Himes said he had spoken to SEC Chairman Jay Clayton about some technical issues and that remaining differences could be settled as the bill moved to the House floor.
Ranking Member McHenry said at that time the bill was imperfect but that there was a commitment from Chairwoman Waters and Rep. Himes to work out some details before a vote by the full House. Representative McHenry had indicated that the remaining issues involved the bill's personal benefit provision and its treatment of downstream tippees.
Other noteworthy proposed amendments. It is briefly worth mentioning two proposed amendments that were ultimately withdrawn. The first one, submitted by Rep. Robin Kelly (D-Ill) and supported by Rep. Bill Foster (D-Ill), chairman of the House FSC’s Task Force on Artificial Intelligence, would have required the SEC to report to Congress on the SEC’s use of artificial intelligence and machine learning tools to detect insider trading. The SEC could have omitted from the report any information that would undermine its ability to enforce insider trading laws.
Under another proposed amendment, submitted by Rep. Anthony Brown (D-Md), the SEC would have been required to study and report to Congress on how online platforms impact markets and on the application of insider trading rules to such platforms. "Online platform" would have been defined to mean "any public-facing website, web application, or digital application (including a social network, ad network, or search engine)." In one respect, the provision would have addressed issues that several Congressional committees and other potential legislation might address regarding the economic power of major technology and social media firms. It is also possible that the definition could have brought token exchanges into the study. The SEC previously issued statements on the operation of online platforms and on the trading of digital asset securities.
Industry comment, reaction. The House FSC’s Subcommittee on Investor Protection, Entrepreneurship and Capital Markets held a hearing in April at which members considered a group of securities bills, including a discussion draft of the Insider Trading Prohibition Act. John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and one of the bill’s drafters, said the bill would clarify the personal benefit aspect of insider trading law, which has been the focus of much concern ever since the Second Circuit’s decision in Newman.
According to Coffee, however, three changes would further clarify the bill’s scope. First, Coffee urged a rewrite to clarify that there is no personal benefit requirement; the discussion draft, Coffee said, could be read to implicitly retain this requirement. (The McHenry amendment would later clarify that the personal benefit requirement was still part of the bill.) Second, Coffee noted the absence of a good faith defense to derivative liability under the discussion draft of the bill (i.e., controlling person liability) in contrast to Exchange Act Section 20(a), which has a good faith defense. Coffee urged an amendment to add a good faith defense to the bill (as an aside, the "profit from" language in the discussion draft that Coffee also had cited for his concern about the lack of a good faith defense was dropped in the later Rules Committee Print of the bill).
Third, Coffee urged an amendment to the Insider Trading Prohibition Act to grant the SEC rulemaking authority not just to curb liability under the bill but to also expand liability as the market place and modes of committing fraud evolve. This authority, Coffee said, should be included to put the proposed insider trading ban on par with the more expansive SEC authority under Exchange Act Section 14(e), which states: "The Commission shall, for the purposes of this subsection, by rules and regulations define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative." By contrast, the proposed bill limits the SEC’s authority to exempting a person, security, or transaction (or any of these in the plural form) from the proposed insider trading ban on terms or conditions the Commission considers necessary or appropriate in furtherance of the purpose of this title.
Melanie Senter Lubin, Maryland Commissioner of Securities and a board member of the North American Securities Administrators Association, observed that "no statute or SEC rule explicitly prohibits insider trading." Lubin explained that current law relies on Exchange Act Section 10(b)’s and Rule 10b-5’s general antifraud authority to address "deceptive device[s] or contrivance[s]." Lubin characterized the discussion draft of the Insider Trading Prohibition Act as a "major step forward" in codifying a clearer definition of insider trading.
Remington A. Gregg, counsel for civil justice and consumer rights at Public Citizen, said that, on a societal level, unlawful insider trading can magnify income inequality by allowing corporate executives to profit from trading activities that ordinary investors could not engage in. More specifically, Gregg voiced concerns about the personal benefit requirement. "We believe the personal benefit test unjustly limits the boundaries of what should be illegal insider trading," said Gregg.
Tom Quaadman, executive vice president of the Center for Capital Markets Competitiveness at the U.S. Chamber of Commerce, told lawmakers the group has some "concerns" about the bill, although it "strongly opposes any form of insider trading." For example, Quaadman said the bill, as drafted, could become "under-inclusive and over-inclusive" simply from the process of codification of many existing insider trading principles; Rep. Huizenga would later make this point on the House floor. As for the required mental state, Quaadman said the bill could lessen or eliminate the scienter requirement. Quaadman said the Chamber also was concerned that the bill leaves existing Exchange Act Section 10(b) intact such that prosecutors might have a choice between using Section 10(b) or the proposed new insider trading provision (this issue did not materialize during floor debate on the bill in the House). Moreover, Quaadman said the bill could have the unintended consequence of limiting the use of Rule 10b5-1 plans.
Commenting in the Harvard Law School Forum on Corporate Governance and Financial Regulations blog in the months after the introduction of the Insider Trading Prohibition Act, Rahul Mukhi, Shannon Daugherty, and Destiny D. Dike, all of Cleary Gottlieb Steen & Hamilton LLP, opined that the bill could expand insider trading liability by using a "wrongfully obtained" standard and that the bill could result in confusion over whether it imposes a mental requirement based on recklessness or willfullness. (Coffee had addressed this issue in his testimony on the discussion draft of the bill and posited that Exchange Act Section 32(a) would still require a willfulness standard for criminal violations.).
More recently, the Council of Institutional Investors reiterated that it "generally supports" the Insider Trading Prohibition Act while noting that all four of the witnesses at the April House FSC hearing on the bill voiced similar "general support." The CII also said that although the bill could allow for more insider trading prosecutions, it would appropriately clarify that a tippee can be prosecuted even if they did not pay for a tip or they lacked specific knowledge of where a tip came from. The CII also had expressed support for the Insider Trading Prohibition Act in a prior letter published at the time of the House FSC’s May markup of the bill.