The possibility of insider trading by Congressional officials is capturing headlines again — this time prompted by an academic study finding that Members of the House of Representatives had stock portfolios that outperformed those of average investors by about 6 percent annually.
This recent revelation comes in the wake of a 2004 study by the same four business school professors that found even greater, seemingly uncanny investment performances by Senators (about 12 percent annually). A front-page Wall Street Journal report in 2010 likewise raised questions about dozens of trades by legislative staffers.
Each of these studies appears to substantiate the well-worn claim that Congressional officials are immune from federal insider trading law. At least that is the conclusion drawn by many pundits, editors and journalists. Proposed legislation that has lain dormant for more than four years in the House — the Stop Trading on Congressional Knowledge Act (H.R. 1148, dubbed the STOCK Act) — is being heralded as the only way to prevent Congressional officials from using nonpublic Congressional knowledge to enrich their personal portfolios.
It is a specious claim. The conventional wisdom that there is some type of legal loophole for Congressional insider trading is simply wrong. Any Member of Congress or legislative staffer who trades securities on the basis of material nonpublic information obtained through Congressional service is already doing so in violation of existing federal securities law.
Congress has never actually enacted a federal securities law that explicitly defines or prohibits anyone from insider trading. Rather, Congress has been content to allow the offense to be prosecuted as a violation of Rule 10b-5 of the Securities Exchange Act of 1934, a general anti-fraud rule that prohibits deception “in connection with the purchase or sale of any security.”
The notion — accepted much too easily — that Congressional officials are not already prohibited from trading securities on the basis of Congressional knowledge is rooted in twin misconceptions.
Those are based on a lack of regard for the broad and sweeping duties of entrustment that attach to public office and an unduly restrictive view of the Supreme Court’s precedents, which have interpreted Rule 10b-5 to impose liability whenever a person trades securities on the basis of material nonpublic information in violation of a fiduciary-like duty of trust and confidence owed either to the issuer’s shareholders (the “classical theory” of insider trading) or to the source of the information (the “misappropriation theory”).
The (un)lawfulness of Congressional insider trading therefore turns on whether these officials owe duties of trust and confidence to others who would be deceived and defrauded by the self-serving use of nonpublic Congressional knowledge.
This question can be answered with a resounding yes.
Legislative staffers owe duties of trust and confidence to the Members of Congress who employ them. And Senators and Representatives stand in fiduciary-like relationships with the citizen-investors they were elected to serve. For proof, one need only consult the Constitution’s repeated references to public offices being “of trust.”
Consider also that Members of Congress have been imprisoned for bribery and kickback schemes that deprived the public of its right to receive honest services. Such convictions under the federal mail- and wire-fraud statutes presuppose that Congressional loyalty is a positive right and enforceable interest.
If a Member of Congress or legislative staffer were to purchase stock in a company based on Congressional knowledge (e.g., the award of a highly lucrative, but not-yet-publicly-announced, defense contract), the Securities and Exchange Commission could prosecute that official under Rule 10b-5 for defrauding the federal government and its citizens.
Congressional information constitutes government property that, like federal funds and tangible property, rightfully belongs to the citizenry. The entrusted information on which trades were based need only be material and nonpublic. It needn’t be explicitly confidential pursuant to a statute, internal rule or other specific mandate.
While constitutional protections such as the Speech or Debate Clause may hamper the collection of evidence supporting liability, they are not insurmountable obstacles.
If Congressional officials find the vicissitudes of a fiduciary-focused anti-fraud prohibition too vague and unsettling, Congress could expressly define and prohibit “insider trading” and unmoor the offense from Rule 10b-5. New legislation along that line would be a welcome development.
But unless and until Congress acts to clarify insider trading law for everyone, the classical and misappropriation theories — with their emphasis on duties of entrustment — can function just as well for Congressional officials as they do for all other investors who trade securities in the capital markets.
Donna M. Nagy, the C. Ben Dutton professor of law at the Indiana University Maurer School of Law, is the author of “Insider Trading, Congressional Officials, and Duties of Entrustment,” an article published in the Boston University Law Review, which can be accessed via the Social Science Research Network.