Beyond Dirks: gratuitous tipping and insider trading.

Author:Nagy, Donna M.
Position:IV. Legislative Developments B. Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA
  1. Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA)

    Four years after ITSA, Congress reaffirmed its view that "[i]nsider trading damages the legitimacy of the capital market and diminishes the public's faith" and expressed its continued support for a robust civil and criminal enforcement program. (235) But that congressional support need not be merely inferred from the House Committee on Energy and Commerce's Report or the floor debates leading up to the passage of ITSFEA. Instead, the Act itself contains express statutory findings that reflect Congress's ratification of the federal insider trading prohibitions arising under Rule 10b-5 and Rule 14e-3. Specifically, Congress declared a finding that "[t]he rules and regulations of the Securities and Exchange Commission under the Securities Exchange Act of 1934 governing trading while in possession of material nonpublic, information" satisfy the statutory command that they be "necessary and appropriate in the public interest and for the protection of investors." (236) Congress further declared that the SEC has "enforced such rules and regulations vigorously, effectively, and fairly." (237) As Professor Steve Thel has observed, "[g]iven the heat of the debate over how much power Congress has given the SEC to regulate insider trading, it is remarkable that a statute directly addressed to that issue has been ignored for all practical purposes." (238) Because that debate has only intensified in the 19 years since the Court decided O'Hagan, the Salman case provides an important opportunity for it to acknowledge ITSFEA's findings as well as Congress's essential role in the development of insider trading jurisprudence.

    ITSFEA contained several important provisions that amended the Exchange Act by: raising the maximum criminal penalties under Section 32(a) from a fine of $100,000 and/or five years in prison, to a fine of $1 million and/or ten years in prison; (239) modifying ITSA's penalty provision to clarify that tippers may be subject to civil penalties for any tipping activity that involves a violation of the law, irrespective of the tippee's liability; (240) extending the civil penalty provision to "controlling persons" who recklessly disregard the likelihood that an employee or agent is engaging in illegal tipping or trading; (241) requiring that broker-dealers and investment advisers establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material, nonpublic information; (242) initiating a "bounty" program giving the SEC discretion to reward informants providing valuable information in insider trading cases; (243) and establishing an express private right of action for investors who traded contemporaneously with a person found to have violated an Exchange Act provision or rule by "by purchasing or selling any security while in possession of material, nonpublic information," (244) or for unlawfully communicating such information to a person who uses it to trade. (245)

    The express right of action for contemporaneous traders, which ITSFEA codified at Section 20A of the Exchange Act, reflected another determination by Congress to depart from the fiduciary principle at the core of Chiarella and Dirks. As the House Report explained, Section 20A was "specifically intended to overturn court cases which have precluded recovery for plaintiffs where the defendant's violation is premised upon the misappropriation theory." (246) The House Report pointed in particular to the Second Circuit's decision in Moss v. Morgan Stanley Inc. (247) which, notwithstanding the prior criminal convictions of the defendants for illegal insider trading and tipping, affirmed a district court's dismissal of a Rule 10b-5 damage action brought by former shareholders of a tender offer target. ITSFEA's drafters clearly disagreed with the Second Circuit's conclusion that such contemporaneous traders should not be able to ride "'piggyback upon the duty owed by defendants'" to their investment bank employers who were advising the acquiring companies. (249) Notably, Section 20 A embodies the position that Chief Justice Burger articulated in his Chiarella dissent: that a person who misappropriates information owes by virtue of that fact an affirmative duty of disclosure to the parties on the other side of his securities transactions. (250)

    As with ITSA, the period leading up to the passage of ITSFEA evidences Congress's serious consideration of the costs and benefits of adding into the bill an express statutory prohibition against trading securities on the basis of material nonpublic information. Over the period from 1986 to 1988, Congress held four sets of hearings devoted to the topic of insider trading regulation and considered multiple proposals for statutory definitions. (251) But while ITSFEA's drafters continued to be "cognizant of the importance of providing clear guidelines for behavior which may be subject to stiff criminal and civil penalties," (252) they ultimately concluded that the legal principles were "well-established and widely-known," and that "a statutory definition could potentially be narrowing, and in an unintended manner facilitate schemes to evade the law." (253)

    Along the way, however, when the misappropriation theory appeared in jeopardy of being struck down by a possible five-justice majority, (254) the movement for an express statutory prohibition picked up steam. Consensus in the Senate began to build around a proposed bill entitled the "Insider Trading Proscriptions Act of 1987." (255) The bill, as it was later reconciled with an alternative version submitted by the SEC, proposed adding a new Section 16A to the Exchange Act, making it unlawful:

    [F]or any person, directly or indirectly, to purchase, sell or cause the purchase or sale of, any security, while in possession of material, nonpublic information relating thereto (or relating to the market therefor), if such person knows (or recklessly disregards) that such information has been obtained wrongfully, or that such purchase or sale would constitute a wrongful use of such information. (256) However, when the Court's 4-4 affirmance in Carpenter v. United States left the misappropriation theory intact, (257) the apparent need for a statutory definition subsided. (258) Congress and the SEC soon returned to the view that insider trading jurisprudence could better develop through interstitial lawmaking in the context of civil and criminal prosecutions for violations of Section 10(b) and Rule 10b-5, as well as Section 14(e) and Rule 14e-3 in cases involving tender offers.

  2. The Stop Trading on Congressional Knowledge (STOCK) Act of 2012

    The SToCK Act codified for the first time an explicit legislative recognition that the Exchange Act encompasses insider trading prohibitions that arise under Section 10(b) and Rule 10b-5. (259) The Act also reflects Congress's recent judgment that interstitial lawmaking by federal courts continues to be an effective means of regulating the misuse of material nonpublic information in connection with securities trading--whether that information emanates from inside or outside of the government.

    The momentum that fueled the STOCK Act's landslide votes of 96-3 in the Senate and 417-2 in the House (260) grew out of a claim in a 60Minutes broadcast that congressional insider trading was "perfectly legal." (261) To quell the public's outcry, Congress quickly held hearings on proposed bills seeking to ban the purported practice, (262) and in the span of a few short months, passed legislation that President Obama signed into law in April 2012. As the Senate Report reflects, although the STOCK Act's drafters recognized that a federal court could theoretically apply misappropriation theory analysis if it were presented with a prosecution involving congressional insider trading, they were uncertain as to whether "the unique nature of an elected office of Congress ... [would] give[] rise to a fiduciary-like duty owed ... to anybody." (263) The STOCK Act addressed this uncertainty by adding new provisions to the Exchange Act--Section 21 A(g) and Section 21A(h)--which provide that "solely for the purposes of the insider trading prohibitions arising under this Act, including section 10(b) and Rule 10b-5 thereunder," all federal officials, including members of Congress, owe "a duty arising from a relationship of trust and confidence" to the United States government and its citizens with respect to material nonpublic information obtained in connection with their government service. (264) Prior to these amendments to the Exchange Act, the federal insider trading prohibitions arising under Section 10(b) and Rule 10b-5 had been rooted solely in a judicially implied claim. Thus, the STOCK Act made explicit what Congress had previously ratified through its enactment of ITSA and ITSFEA.

    But the STOCK Act's amendments to the Exchange Act are important for a second reason: they reinforce insider trading law's collaborative nature by expressly "incorporat[ing] the fiduciary duty approach reflected" in Chiarella, Dirks, and O'Hagan. (265) Prior bills leading up to the legislation had sought to resolve the controversy by amending the Exchange Act to include an outright statutory proscription against congressional insider trading. (266) But the STOCK Act's drafters ascribed to the "duty of trust and confidence" approach as a means of ensuring "that the insider trading prohibitions apply to Members of Congress in the same way that they apply to everyone else" and to leave unaltered "the construction of the antifraud provisions of the securities laws [and] the authority of the SEC or DOJ under those provisions." (267) Although Congress could have used the 60 Minutes-generated controversy to enact an express statutory prohibition of insider trading and tipping that would apply to the entire investing public (including its own members)...

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