Insider trading inside the beltway.

• Author: Bainbridge, Stephen M.
• Position: Government employees and legislators trading with nonpublic knowledge

1. INTRODUCTION II. CURRENT LAW A. The Doctrinal Sources of the Insider Trading Prohibition B. The Classical Theory 1. The Legal Standard 2. Application to Members of Congress and Other Government Employees C. The Misappropriation Theory 1. The Legal Standard 2. Application to Members of Congress and Other Government Employees D. Summation III. POLICY A. Should Members of Congress be Allowed to Inside Trade? 1. Perverse Incentives 2. Unfairness 3. Summary B. Who Should Enforce the Prohibition? 1. A Constitutional Barrier? 2. Prudential Considerations IV. THE STOP TRADING ON CONGRESSIONAL KNOWLEDGE ACT A. The Prohibition on Trading and Tipping B. Reporting Provision V. CONCLUSION A 2004 study of the results of stock trading by U.S. senators during the 1990s found that senators on average beat the market by 12% a year. In sharp contrast, U.S. households on average underperformed the market by 1.4% a year and even corporate insiders on average beat the market by only about 6% a year during that period. A reasonable inference is that some senators had access to--and were using--material nonpublic information about the companies in whose stock they trade. Under current law, it is unlikely that members of Congress can be held liable for insider trading. The proposed Stop Trading on Congressional Knowledge (STOCK) Act addresses that problem by instructing the Securities and Exchange Commission to adopt rules intended to prohibit such trading.

   This Article analyzes present law to determine whether members of Congress, congressional employees, and other federal government employees can be held liable for trading on the basis of material nonpublic information. It argues that there is no public policy rationale for permitting such trading and that doing so creates perverse legislative incentives and opens the door to corruption. The Article explains that the Speech or Debate Clause of the U.S. Constitution is no barrier to legislative and regulatory restrictions on congressional insider trading. Finally, the Article critiques the current version of the STOCK Act, proposing several improvements.

1. INTRODUCTION

   The common stock investment portfolios of U.S. senators beat the market by 12% a year, on average, between 1993 and 1998, according to a study by economist Alan J. Ziobrowski and his collaborators. (1) In sharp contrast, the common stock investment portfolios of U.S. households as a whole underperformed the market on average by 1.4% a year during the relevant period. (2) Even more striking, corporate insiders investing in their own company's stock only beat the market by about 6% a year on average during that period. (3)

   The Ziobrowski study's results strongly imply that some members of Congress are using nonpublic information to make trading decisions. Over time, even professional investors do not systematically beat the market. (4) This basic premise of efficient capital markets theory has been confirmed by many academic studies. (5) The only important exception to the rule is corporate insiders trading in their own corporation's stock. (6) The obvious and generally accepted explanation for insiders' ability to beat the market is their access to and use of material nonpublic information about their company. (7)

   It seems unlikely that U.S. senators as a group have such unique investment skills that they can outperform not only the market as a whole but also corporate insiders over an extended period. Instead, it seems more reasonable to assume that the superior returns found by Ziobrowski result from senatorial access to--and use of--material nonpublic information about the companies in whose stock they traded:

   Looking at the timing of cumulative returns, the senators also appeared to know exactly when to buy or sell their holdings. Senators would buy stocks just before the shares suddenly would outperform the market by more than 25%. Conversely, senators would sell stocks that had been beating the market by about 25% for the past year just when the shares would fall back in line with the market's performance. The researchers say senators' uncanny ability to know when to buy or sell their shares seems to stem from having access to information that other investors wouldn't have. "I don't think you need much of an imagination to realize that they're in the know," says Alan Ziobrowski, a business professor at Georgia State University in Atlanta and one of the four authors of the study. (8) Congressional access to nonpublic information and the potential for the misuse thereof is hardly a new phenomenon. Over 40 years ago, Henry Manne observed that "the federal government is the largest producer of information capable of having a substantial effect on stock-market prices." (9) Not only does the government itself generate such information, vast amounts of information must be disclosed to the federal government before it becomes public. (10) Congressmen are especially well-positioned to receive information from these sources, Manne argued. (11) In addition to their direct interactions with nongovernmental information sources, they are also "focal points for receiving information produced or learned in all the various executive departments and agencies" that report to them. (12)

   More recent circumstantial evidence that at least some Members of Congress are "in the know" comes from a June 2010 Washington Post report, which found that "a host of [congressional] committee chairmen and ranking members ... have millions invested in business sectors that their panels oversee." (13) The reporters explained that their findings with respect to committee chair and ranking member investments are especially significant because it is those members of Congress who have the most power "to raise questions, hold hearings and push through targeted legislation that in some cases governs the industries in which they have investments." (14) As such, they not only have better access to nonpublic information, they also have the power to control the timing of legislative events so as to maximize their trading profits (e.g., delay a bill until they buy more stock). The report continues:

   Steve Ellis, vice president of the nonpartisan Taxpayers for Common Sense, said there has been a long-standing suspicion, difficult to verify, about committee assignments: that lawmakers tend seek out certain committees to suit their own interests. "It is part of the problem with the committee system. People try to get on the committees in which they have a vested interest," said Ellis, whose group closely tracks congressional activity. "Committees can have a huge impact on the sectors of the economy under their jurisdiction, and they're going to know more about what's going on in those sectors than the average lawmaker." "By being on a committee with a particular jurisdiction, they're in a better position of influencing the performance of their investments," he said, "or at least appearing to have that ability." (15) To be sure, there are not many known cases of improper trading by members of Congress. (16) Even so, however, the Ziobrowski study concluded that "trading with an informational advantage is common among Senators." (17) This conclusion rested on evidence that "the prices of common stocks bought by Senators tended to stagnate prior to purchase, soar after purchase, and then stagnate again after sale.... The prices for common stocks sold by Senators tended to increase dramatically just before the sale, followed by no further increases." (18) Taken together, these findings provide the study's "most robust evidence for Congressional insider trading." (19)

   Senators and members of the House of Representatives are not the only government officials who have access to inside information, of course. Congressional staffers, and employees of the Executive Branch and federal agencies all potentially could come into possession of material nonpublic information on which they could make trading profits. (20) In May 2009, for example, press reports indicated that two Securities and Exchange Commission (SEC) attorneys were under investigation for allegedly trading on the basis of information they learned on the job. (21) In several earlier cases, government employees were charged with tipping material nonpublic information to persons who used that information to trade in government securities. (22)

   Part II of this Article provides a doctrinal analysis of the legality of insider trading by both elected officials and government employees. It concludes that congressional staffers and other government officials and employees could be prosecuted successfully for insider trading under the federal securities laws, but the quirks of the relevant laws almost certainly would prevent members of Congress from being successfully prosecuted. (23) Part III sets out the policy justifications for extending those laws to include members of Congress. Part IV describes The Stop Trading on Congressional Knowledge Act (the "STOCK Act" or "Act"), (24) introduced by Congressmen Louise Slaughter (DNY) and Brian Baird (D-WA), which, if adopted, "will prohibit Members of Congress and their staff from using nonpublic information they are able to obtain through their official positions to enrich their personal portfolios." (25) Part IV then critiques the STOCK Act's approach to banning congressional insider trading.

2. CURRENT LAW

   The phrase "insider trading" is properly understood as a term of art, because it is in fact a misnomer in two significant ways, both of which are relevant to the analysis of the legality of such trading by government employees. First, the federal securities laws' prohibition of so-called "insider" trading encompasses many corporate outsiders. (26) Accordingly, congressmen, their staffers, and other government officials and employees are not exempt from liability for trading on the basis of material nonpublic information simply because they are not corporate...