Illegal insider trading is the weird Barbie of securities regulation, a concept that, like the movie-version of the doll, has been pushed and pulled and misshapen over time. It started with the notion that trading securities of a company based on material, nonpublic information (“MNPI”) received from that company violated the antifraud provisions of the Securities Exchange Act of 1934.[1] It was subsequently limited to those traders who also had a duty to the shareholders of the entity whose securities were being traded.[2] It was further narrowed when the U.S. Supreme Court held that, to be liable, tippers must receive a personal benefit when sharing MNPI with one who trades on that information.[3] Insider trading liability was then elongated to encompass traders with no fiduciary duty to the company being traded but had an obligation to their source of the MNPI.[4] The legal doctrine is now poised to receive a new appendage called “shadow trading,” as the SEC recently filed a civil action asserting that trading in a company’s securities based on MNPI about an economically similar company constitutes insider trading.[5]

As I explain in my new article, given this history, it may be no surprise that the Securities and Exchange Commission has yet to file an action against a member of Congress for profiting in the stock market based on MNPI gleaned from their legislative duties. Research studies have documented the above-average returns that federal legislators generate when trading stocks. News outlets have reported a number of incidents of beneficial securities trading by these representatives in tandem with legislative activities relevant to the securities traded. Such incidents include Congress members selling off stock holdings in early 2020 after getting briefings on the impending economic downturn as the result of the pandemic. It was also reported that federal lawmakers traded profitably in bank stocks while navigating the failures of Signature Bank, Silicon Valley Bank, and First Republic Bank in early 2023. Lucrative trading by members of Congress has garnered so much attention that two exchange-traded funds were launched last year to imitate the trading patterns of the lawmakers.

A few well-intentioned members of Congress proposed a bill in 2004 (the “Stop Trading on Congressional Knowledge” or “STOCK” Act) to preclude members of Congress from trading based on nonpublic information; it was revised and reintroduced over a span of years but failed to gain traction until 2011, when investigative news broadcast 60 Minutes aired an episode on congressional insider trading. The episode asserted that the federal securities laws could not reach this offensive behavior because members of Congress were exempt from liability for insider trading. The public outrage at this was not quelled by technical explanations from the SEC and legal scholars that members of Congress could, in fact, theoretically be held liable for insider trading.

In response, Congress passed the STOCK Act in 2012.[6] The law affirms the fiduciary duty of members of Congress and their exposure to potential liability for insider trading. The STOCK Act also requires federal lawmakers to file electronic reports with congressional ethics committees reporting their stock trades within 45 days after the trades are made.[7] Even so, no member of Congress has been charged with fraud based on insider trading in nonpublic legislative information. Moreover, the lawmakers have recently come under fire for neglecting their obligation under the law to report their securities transactions in a timely manner.

Insider trading is an imperfect lens through which to view congressional trading. Clear perspective requires an honest reckoning with the power dynamic between members of Congress and publicly traded companies. Federal lawmakers regularly take or avoid action that could affects the success of corporations. These lawmakers are also vulnerable to being controlled by corporations, through lobbying and rent-seeking practices. In essence, legislators are in a control relationship with public companies. Precise instances of control are impossible to identify because much of Congress’ work occurs outside of the public eye, but the control relationship is well documented and therefore subject to the registration provisions of the Securities Act of 1933.

The Securities Act provides that it is unlawful to offer or sell securities outside of the registration process unless an exemption from registration applies.[8] This broad mandate encompasses both the initial sale of securities to the public and sales between investors in the secondary market. Investors selling securities in the secondary market are typically unaffected by the registration requirement of the Securities Act because they are covered by an exemption applicable to persons who are not issuers, underwriters, or dealers.[9] However, investors who are in a control relationship with a public company must proceed with caution when selling the company’s securities to other investors because the statute’s definition of underwriter includes anyone participating in a “distribution” of securities by a control person.[10] Thus, sales by a control person pose the risk that the transaction will trigger the registration requirement.

The definition of control is intentionally broad under the statute; it covers both exercised and unexercised ability to influence an entity. Whether a control person is engaged in a “distribution” under the statute is also unclear, but the SEC adopted Rule 144 under the Securities Act[11] to provide a safe harbor for secondary market sales by control persons. If the control person’s sales comply with the rule, no distribution will be deemed to have occurred and the parties involved in the sale need not register. Rule 144 mandates, among other things, that current information on the issuer of the securities being sold be available, and that the control person’s sales not exceed established maximums with respect to quantity and volume. In addition, the broker involved in the transaction must inquire into the circumstances of the sale to ensure no distribution is occurring. Further, the safe harbor requires that a form (Form 144) be filed with the SEC for sales within a three-month period that exceed 5,000 shares or $50,000.

Members of Congress currently rely on the typical investor exemption for sales not involving an issuer, underwriter, or dealer, but they do so at their peril. As explained above, the concept of control is broad and certainly encompasses members of Congress and the relationship of influence they occupy regarding public companies. As a result, they satisfy the broad definition of control person for purposes of the registration provisions and should seek the shelter of Rule 144 when selling their securities in the secondary market.[12] Congresspersons should be completing Form 144 for sales exceeding specified levels within a three-month period. The form would require the legislator to disclose details of the securities being sold, as well as the circumstances under which those securities were acquired.[13] Further, the brokers who facilitate sales on behalf of a member of Congress should be conducting an inquiry regarding such trades and ensuring that legislators file the form with the SEC on time. Finally, the Forms 144 should be completed, submitted, and viewable electronically, thanks to recent amendments to Rule 144 that remove the ability to file such forms with the commission on paper. Applying the registration provisions to congressional trading would improve the transparency of our markets by delivering information that is material to an investor’s decision. It leverages brokers to act as gatekeepers regarding congressional trades and improves public confidence in the ethical conduct of federal lawmakers.

Before rushing towards new solutions to combat congressional insider trading, it is worthwhile to consider the applicability of the existing, extensive regime of federal securities regulation. The Securities Act creates a system of monitoring and disclosure for control persons of issuers that must be applied to federal legislators, in light of their broad, deep, and often shrouded relationship of influence with corporate entities.

ENDNOTES

[1] SEC v. Texas Gulf Sulfur Co., 401 F.2d 833 (2nd Cir. 1968).

[2] Chiarella v. United States, 445 U.S. 222 (1980).

[3] Dirks v. SEC, 463 U.S. 646 (1983).

[4] United States v. O’Hagan, 521 U.S. 642 (1997).

[5] See SEC v. Panuwat, No. 4:21-CV-06322 (N.D. Cal. Aug. 17, 2021).

[6] Stop Trading on Congressional Knowledge Act of 2012, Pub. L. No. 112-105, 126 Stat. 291 (2012).

[7] The law was quietly amended in 2013 to remove the electronic reporting requirement.

[8] See 15 U.S. Code § 77e (mandating registration), 15 U.S. Code § 77c (exempting certain securities), and 15 U.S. Code § 77d (exempting certain transactions).

[9] See 15 U.S. Code § 77d(a)(1).

[10] See 15 U.S. Code § 77b(a)(11).

[11] See generally 17 C.F.R. § 230.144.

[12] While there is legal support for this conclusion, the author recommends that the definition of underwriter in the Securities Act be amended to expressly provide that members of Congress are control persons of any corporation in which they trade.

[13] See Table I of Form 144, which is available on the SEC’s website at https://www.sec.gov/files/form144.pdf.

This post comes to us from Professor Sarah J. Williams at Penn State Dickinson Law. It is based on her article, “Regulating Congressional Insider Trading: The Rotten Egg Approach,” forthcoming in the Cardozo Law Review and available here.