Insider Trading and Congress: The Difficulties in Application

The Washington Post reported that Representative Spencer Bachus was under investigation by Office of Congressional Ethics.  According to the article: 

OCE investigators are examining whether Bachus violated Securities and Exchange Commission laws that prohibit individuals from trading stocks and options based on “material, non-public” inside information, said the individuals, who spoke on the condition of anonymity because of the sensitivity of the matter. The office also is investigating whether Bachus violated congressional rules that prohibit members of Congress from using their public positions for private gain.

The article provided one scenario that may have given rise to concerns about insider trading.  Congressman Bachus allegedly attended a "closed-door briefing" by high ranking government officials then traded options the next day.  As the article describes:

On Sept. 18, 2008, at the height of the economic meltdown, Bachus participated in a closed-door briefing with then-Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben S. Bernanke. At the time, he was the highest-ranking Republican member of the Financial Services Committee. According to a book Paulson would later write, the topic of the meeting was the high likelihood of decline across the entire economy if drastic steps were not taken.  The next day, Sept. 19, Bachus traded “short” options, betting on a broad decline in the nation’s financial markets, and collected a profit of $5,715.

Congressman Bachus, as the article makes clear, vigorously denies that any wrong doing occurred.  For one thing, he asserts that "no inside information provided in the briefing by Paulson and Bernanke." 

Nonetheless, the scenario provides a basis for a tutorial on the difficulties that can arise in applying the prohibitions on insider trading in these types of circumstances.  The difficulties, by the way, can be traced to poorly reasoned decisions by the Supreme Court (with Dirks and Chiarella the best examples). 

First, insider trading requires the use of material nonpublic information.  To the extent no such information was revealed at the briefing, there can be no insider trading.  

Assume, however, for sake of this tutorial, that Paulson and Bernanke presented nonpublic data that demonstrated a continued decline in the economy (perhaps statistical data or data on some of the companies at risk for collapse).  There is by the way nothing in the Washington Post article that in fact suggests this occurred and, as we have noted, the Congressman denies that there was any material nonpublic information disclosed at the briefing. 

To the extent any such data demonstrated that the economy was better or worse than anticipated, such non-public data could be material.  Materiality, however, is examined in the context of the "total mix" of available information.  To the extent the data merely confirmed what the market already knew (that things were getting worse), it might not change the "total mix" of available information.  In those circumstances, data about the economy might not be material. 

Alternatively, assume for sake of this tutorial that the briefing did not involve nonpublic data but did provide Paulson and Bernanke with an opportunity to express their pessimistic opinions on the direction of the economy.  Opinions and statements of belief can qualify as material information. See Va. Bankshares v. Sandberg, 501 U.S. 1083 (1991) ("We think there is no room to deny that a statement of belief by corporate directors about a recommended course of action, or an explanation of their reasons for recommending it, can take on just that importance.").

Moreover, the persons expressing the opinion matter.  Id.  ("Shareholders know that directors usually have knowledge and expertness far exceeding the normal investor's resources, and the directors' perceived superiority is magnified even further by the common knowledge that state law customarily obliges them to exercise their judgment in the shareholders' interest.").  With the information coming from two critically important financial regulators, reasonable investors may have viewed the opinions about the economy as material. 

But again, one must examine the "total mix" of available information.  It is also highly likely that the market knew that Paulson and Bernanke were concerned about a continued decline in the economy.  To the extent merely repeating these views at the briefing, the opinions are probably not material.  

Even assuming that the briefing involved the disclosure of material non-public information (which Congressman Bachus denies), this alone does not establish a violation of the prohibitions on insider trading.  Under the law of insider trading, it depends upon how the information was conveyed.  Dirks required that the information be told in breach of a fiduciary obligation.  For this to impoose a duty, it would have to be shown that those in Congress somehow had a fiduciary obligation with respect to the information received as a result of their positions.  As Robert Khuzami, the director of the Division of Enforcement at the Commission, noted in testimony:

There does not appear to be any case law that addresses the duty of a Member with respect to trading on the basis of information the Member learns in an official capacity. However, in a variety of other contexts, courts have held that “[a] public official stands in a fiduciary relationship with the United States, through those by whom he is appointed or elected."  Commenters have differed on whether securities trading by a Member based on information learned in his or her capacity as a Member of Congress 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.

Alternatively, it would need to be shown that the information was used in violation of a duty of trust and confidence.  One way for that to occur is to show that the information told at the briefing was intended to be confidential and that those attending understood and accepted this expectation.  In fact, there may have been no such expectation.  Indeed, Bernanke and Paulson may have expected (even wanted) the information to be disclosed to the public.  

On the other hand, the duty of trust and confidence could come from sources other than Paulson and Bernanke.  To the extent, for example, that Congress imposed on its members a duty of trust and confidence with respect to this type of information, its use would potentially violate the proscriptions on insider trading.  In any event, for insider trading to have occurred, a duty of trust and confidence (and a violation of that duty of trust and confidence) needs to be found somewhere.  As Robert Khuzami, the director of the Division of Enforcement at the Commission, noted in testimony:

Existing Congressional ethics rules also may be relevant to the analysis of duty for both Members and their staff. For example, Paragraph 8 of the Code of Ethics for Government Service provides that “Any person in Government service should . . . [n]ever use any information coming to him confidentially in the performance of governmental duties as a means for making private profit.”

Nonetheless, the area remains untested.  The legal uncertainty is, therefore, very high.  Indeed, the need for a duty explains the approach taken in the STOCK Act, the legislation designed to clarify the application of insider trading prohibitions to Congress.  As the legislation provides:

For purposes of the insider trading prohibitions arising under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 issued thereunder (or any successor to such Rule), section 602 affirms a duty arising from a relationship of trust and confidence owed by each Member of Congress and each employee of Congress to Congress, the United States Government, and the citizens of the United States.

Finally, even if there was a duty and even if the briefing involved material non public information, that may not be enough to establish insider trading.  To the extent the contents of the briefing were leaked or otherwise disclosed to the public, the information would be reflected in share prices.  Any trading that occurred thereafter would not constitute insider trading.  

All of this suggests that insider trading claims against those in Congress attending a government briefing on a subject widely known to the public will be very difficult to bring.  It is made infinitely more complicated by the duty analysis, something that the Supreme Court grafted onto the law several decades ago. 

J Robert Brown Jr.