The following comes to us from Jeanne L. Schroeder, a Professor of Law at The Benjamin N. Cardozo School of Law, Yeshiva University.  This is a synopsis of Taking STOCK: Insider and Outsider Trading by Congress, 5 WILLIAM & MARY BUSINESS LAW REVIEW (forthcoming 2014). An earlier version of this article is available here.

The “Stop Trading on Congressional Knowledge Act of 2012″ or “STOCK Act” (available here) supposedly repealed an exemption from the federal securities laws that made insider trading by members of Congress “totally legal”. As every securities lawyer knows, however, there never was such an exemption. Representatives and Senators have always been subject to the same rules as the rest of us. It is just that insider-trading law is so incoherent that legal scholars sharply disagreed as to when, or even if, trading by government officials on the basis of material nonpublic information gleaned from their positions would be unlawful. It would not constitute “classic” insider trading, and it was not clear if it constituted “misappropriation” or “outsider” trading. Consequently, despite circumstantial evidence that such trading is not unusual, neither the Securities and Exchange Commission nor the Department of Justice has ever brought an insider trader action against a member of Congress.

The STOCK Act was, in fact, enacted to address a public relations problem – the common misperception that Congress exempted itself from the securities laws. It did not address the real legal problem – the chaotic state of insider-trading case law resulting from the fact that neither the securities laws nor the regulations promulgated under them expressly prohibit insider trading generally, let alone define what it might be. Rather, to be unlawful, insider trading must fall under the catch-all anti-fraud provisions of section 10(b) and rule 10b-5 of the Securities Act of 1934. It is unfortunate, therefore, that Congress ducked this golden opportunity either to amend the ‘34 Act in order to define insider trading or, at least, to give the SEC authority to do so. Consequently, we are left with the jurisprudential scandal that insider trading is largely a common law federal offense.

Even after the STOCK Act, it will continue to be difficult to curtail undesirable Congressional trading. First, the Act does not define unlawful Congressional trading. It merely states that “each Member of Congress . . . owes a duty arising from a relationship of trust and confidence to the Congress, the United States Government, and the citizens of the United States with respect to material, nonpublic information derived from such person’s position as a Member of Congress”. The phrase “duty of trust and confidence” does not track the Supreme Court’s insider trading law jurisprudence – which requires that a trader violates a “fiduciary or equivalent” duty to the source who owns the information. Rather it alludes to the language of Rule 10b5-2 promulgated by the SEC under section 10(b) in an attempt to restrain judicially imposed limitations on insider trading liability. Unfortunately, the legal status of this regulation is uncertain because its language is broader than the fiduciary language used by the Supreme Court. Ironically, the most important legacy of the STOCK Act might be that its adoption of the language of Rule 10b5-2 could be construed as an implicit endorsement of its application to other persons.

Second, the STOCK Act addresses a perceived evil that, although not inconsistent with, is nevertheless different from the concerns that animate insider trading law. The former is worried primarily about the integrity of governmental actors and the potential for corruption. In contrast, courts tend to describe the goals of the latter as preventing fraud and promoting market integrity. It is hard to see how caselaw developed to address these latter issues could be contorted to effectively address improprieties by governmental actors. Consequently, although the STOCK Act might clarify when Congressional trading would violate Congress’s internal ethical rules, it is still not be clear whether the SEC can successfully bring civil actions against, or the DOJ can prosecute, members and staffers under the securities laws.

Moreover, I agree with Stephen Bainbridge that insider trading law, as actually applied, is based on the allocation of property rights in nonpublic information. Both the classic and misappropriation theories analyze insider trading as a form of self-dealing in principal property by a disloyal agent – which is why the Supreme Court and the Second Circuit has limited restrictions on trading to persons who have a fiduciary-type duty to the source of the information.

This property analysis brings into question whether the STOCK Act will effectively ban Congressional trading. Congress’s decision not to define unlawful trading but merely to allude indirectly to the misappropriation theory, raises the issue of if or when Congress, the United States or the people have a proprietary right in nonpublic information that could be misappropriated.

Perhaps the most problematic element of an insider-trading action against a Congressional member or staffer would be the limitation announced by the majority in United States v. O’Hagan, 521 U.S. 642 (1997), that the material nonpublic information be of a sort regularly used in the trading of securities to reap risk-free profits. This is necessary to satisfy the element of section 10(b) and Rule 10b-5 that the fraud be “in connection with” the purchase or sale of securities. Unfortunately, Justice Ginsburg did not give much guidance as to what this might mean. The limited caselaw under the misappropriation theory is not much more helpful.

The type of non-public information traded on in the reported cases is almost always firm-specific (for example, earnings reports or mergers). Although much federal legislation can be expected to affect the price of securities, it is not often firm-, or even industry-specific. If broad, economy-wide information were to be considered “of a sort”, then the STOCK Act would seem to prohibit any and all trading in publicly issued securities by Congress and its staff. If this was Congress’s intent, wouldn’t it have been simpler merely to provide so directly by requiring all members to place their investments in blind trusts, as many of them do already?

Consequently, with respect to Congressional trading, it is another provision that may be more important as a practical matter. Section 6 of the STOCK Act will require members and staff to publicly report all trading in publicly issued securities. This might have some shaming effect that will discourage them from trading in corporations that would be affected by pending legislation or where there seems to otherwise be blatant conflicts of interest. Or to put this more gently, it might increase awareness that some securities trading by public officials, whether or not unlawful, is widely considered to be unseemly.