Insider Trading and Executive Overreach

The recent controversy over President Donald Trump’s use of his emergency authority to fund a wall on the U.S. southern border has awakened many Americans to the problem of executive overreach. Yet, what few may appreciate is that executive overreach can cause trouble in contexts far beyond immigration or border security. For example, consider U.S. securities regulation. Executive overreach was a major factor in creating confusion in the current U.S. laws against insider trading, and some reformers propose using new executive actions to correct the problem.

A recent op-ed by an SEC commissioner and a former U.S. attorney calls for making U.S. insider trading laws clearer and more coherent.[1] The authors imply that Congress is to blame for the current state of the law. But SEC officials blaming Congress for the incoherence of U.S. insider trading laws is like a drunk driver blaming a light pole for jumping into the middle of the road. The flaws in the law are better explained by the actions of 1960s SEC commissioners who were unwilling to wait for Congress to pass legislation prohibiting insider trading.

Federal prosecutions of insider trading are brought under the anti-fraud provisions of U.S. securities statutes, despite decades of state court decisions prior to 1961 that rejected insider trading as a form of fraud.[2] The history of state court decisions is important, because when federal statutes set out to punish common legal violations without redefining the violation, federal courts will generally look to state law to determine the scope of the activity in question.[3] This means that when Congress passes a law prohibiting fraud in securities transactions without redefining fraud, the state law definitions of fraud should control.

U.S. insider trading law punishes parties with special access to information for failing to disclose that information before trading. Before the 1960s, imposing liability for fraudulent nondisclosure in a business transaction required showing that the defendant intentionally withheld information that she had a duty to disclose to her counter party, and that her intent was to make the counterparty act in a specific way.[4] Because traders on stock exchanges cannot influence their counter parties’ decisions, state courts rejected the claim that insider trading was a form of fraud.[5] If you cannot make someone take an action, then you cannot be held liable for using deception to make that person act.

In its 1961 Cady, Roberts decision, without authority from Congress, the SEC originated the U.S. ban on insider trading by explicitly rejecting the state law definitions of “fraud” and “fiduciary duty.” In Cady, Roberts the SEC rejected the need to show that a defendant actually influenced the actions of his alleged victim, let alone that the defendant intended to influence the alleged victim’s trading decision.[6] In the same case, the SEC also redefined which parties had, and which parties were owed, fiduciary duties. The state law generally recognized corporate directors as having fiduciary obligations to the corporate entity itself, not to shareholders.[7] However, in the then radical Cady, Roberts opinion, the SEC asserted that under the federal antifraud provisions directors and many other insiders owe fiduciary duties of disclosure to everyone participating on securities exchanges—shareholders and non-shareholders.[8] The SEC described these dramatic changes in the scope of basic legal principles as necessary to prevent the “inherent unfairness” of allowing insiders to trade with parties who do not have access to the same information. Of course, executive-branch officials in the United States are not authorized to change the law based solely on a personal judgment about what is necessary.

The drastic interpretive choices of the SEC in Cady, Roberts make it obvious that the ambiguity in modern U.S. insider trading regulation is not a matter of happenstance or merely the result of Congress’ failure to pass clear legislation. Because we use words to define other words, the SEC’s redefinition of these basic legal concepts had follow-on effects, which led to confusion and contradictions in U.S. securities law. But to be fair to the current agency officials calling for reform, there is some validity to the concern that Congress has been lax in legislating clear insider trading rules. In the 1980s, Congress passed two bills increasing the penalties for violating the prohibition on insider trading and clarifying which civilians had standing to sue in federal court.[9] Congress chose not to define what constitutes insider trading in either bill. The failure of Congress to clearly define insider trading when it did pass insider trading legislation shows that executive overreach can be aided and abetted by legislative negligence. In the 1980s, Congress understood that targets of the ban on insider trading were facing years in prison and the confiscation of millions of dollars, and it still chose not to clarify the law.

Fixing the incoherence in regulation of insider trading requires keeping in mind that the problem began with executive overreach. This is important because the current self-appointed task force for reform takes for granted that the SEC itself has the authority to create new rules explicitly banning insider trading, which would mean no longer twisting the anti-fraud statutes beyond recognition. If the SEC did not have the authority to create rules prohibiting insider trading in 1961, and Congress failed to define the violation in the 1980s, then it is doubtful that the SEC now has the authority to create rules banning insider trading. If nothing else, the controversy over President Trump’s emergency declaration could help voters and law makers to recognize that the question of executive overreach stretches far beyond the funding of a southern border wall.

ENDNOTES

[1] Preet Bharara and Robert J. Jackson Jr., Insider Trading Laws Haven’t Kept Up with the Crooks, NYTimes.com, Published October 9, 2018. Accessed January 30, 2019.

[2] Bainbridge, Insider Trading Law and Policy, pages 11-17.

[3] See Chiarella v. United States, 445 U.S. 222, 233, 100 S. Ct. 1108, 1117, 63 L. Ed. 2d 348 (1980) (“Formulation of such a broad duty, which departs radically from the established doctrine that duty arises from a specific relationship between two parties, see n. 9, supra, should not be undertaken absent some explicit evidence of congressional intent.”) Also see Jordan v. Duff & Phelps, Inc., 815 F.2d 429, 436 (7th Cir. 1987) (In describing how the scope of fiduciary duties to disclose under Rule 10b-5 would be determined, Judge Easterbrook states that “[t]he obligation to break silence is itself based on state law…and so may be redefined to the extent state law permits.”) (Quotation marks omitted.) Also see United States v. Craft, 535 U.S. 274, 278, 122 S. Ct. 1414, 1420, 152 L. Ed. 2d 437 (2002) (“[W]e look initially to state law to determine what rights the taxpayer has in the property the Government seeks to reach, then to federal law to determine whether the taxpayer’s state-delineated rights qualify as ‘property’ or ‘rights to property’ within the compass of the federal tax lien legislation.”) (Citations and quotation marks omitted.)

[4] Restatement (Second) of Torts § 551.

[5] Goodwin v. Agassiz, 186 N.E. 659, 661–62, 283 Mass. 358, 363–65 (Mass. 1933) (“Every element of actual fraud or misdoing by the defendants is negatived by the findings. Fraud cannot be presumed; it must be proved…The stock of the Cliff Mining Company was bought and sold on the stock exchange. The identity of buyers and seller of the stock in question in fact was not known to the parties and perhaps could not readily have been ascertained. The defendants caused the shares to be bought through brokers on the stock exchange. They said nothing to anybody as to the reasons actuating them. The plaintiff was no novice. He was a member of the Boston stock exchange and had kept a record of sales of Cliff Mining Company stock. He acted upon his own judgment in selling his stock. He made no inquiries of the defendants or of other officers of the company. The result is that the plaintiff cannot prevail.”) Also see Bainbridge, Insider Trading Law and Policy, pages 13-17.

[6] In the Matter of Cady, Roberts & Co., 1961 WL 60638 at *5, 40 S.E.C. 907 (Nov. 8, 1961) (“Respondents further assert that they made no express representations and did not in any way manipulate the market, and urge that in a transaction on an exchange there is no further duty such as may be required in a ‘face-to-face’ transaction. We reject this suggestion. It would be anomalous indeed if the protection afforded by the antifraud provisions were withdrawn from transactions effected on exchanges, primary markets for securities transactions.”)

[7] Bainbridge, Insider Trading Law and Policy, pages 11-13.

[8] In the Matter of Cady, Roberts & Co., 1961 WL 60638 at *5, 40 S.E.C. 907 (Nov. 8, 1961) (“There is no valid reason why persons who purchase stock from an officer, director or other person having the responsibilities of an ‘insider’ should not have the same protection afforded by disclosure of special information as persons who sell stock to them. Whatever distinctions may have existed at common law based on the view that an officer or director may stand in a fiduciary relationship to existing stockholders from whom he purchases but not to members of the public to whom he sells, it is clearly not appropriate to introduce these into the broader anti-fraud concepts embodied in the securities acts.”)

[9] Bainbridge, Insider Trading Law and Policy, page 30.

This post comes to us from Kevin R. Douglas, a visiting assistant professor at George Mason University’s Antonin Scalia Law School.

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