By Dan Portnov
Not busy enough with impeachment in the run up to the holidays, the U.S. House of Representatives on December 5 passed a bipartisan bill to prohibit insider trading. The Insider Trading Prohibition Act passed by a vote of 410 to 13 and now awaits a Senate vote and then, if passed, a review by the President.
This is not the first time that Congress has sought to explicitly ban insider trading by statute. The bill still has a long way to go before it becomes law, but it does attempt to offer clarity to a body of law that has caused much hand-wringing from the defense bar over the past few years.
So, what does this bill say, and what would it mean to future insider trading prosecutions?
Insider Trading, A Very Brief History
Insider trading is not and has never been prohibited by statute. The Securities and Exchange Commission has its own standards for when insider trading is illegal and will bring civil or administrative enforcement actions against traders citing violations of Rule 10b-5 (promulgated under the Securities Exchange Act of 1934), in addition to violations other sections and rules. Where the insider trading conduct is flagrant and intentional, the local U.S. Attorney’s Office will get involved to prosecute the accused entities.
The first rule against insider trading was established by the Supreme Court in the 1909 case Strong v. Repide which stated that a director of a company must either disclose inside information or abstain from trading on it. However, SCOTUS did not address who would constitute an “insider.”
The first modern case involving insider trading was Chiarella v. United States where the Supreme Court held that there must be a confidential relationship, or fiduciary duty, between a defendant and the company about which confidential or nonpublic information is known.
The Present State of Insider Trading
There are two general theories of insider trading, the classical theory and the misappropriation theory. The classical theory posits that a Rule 10b-5 violation occurs when a corporate insider purchases or sells securities on the basis of material, nonpublic information. Corporate insiders may include non-officers or employees, including attorneys, accountants or consultants. The misappropriation theory holds that a party who trades on wrongfully obtained (e.g. stolen or hacked) information is liable for misappropriating that information.
Three recent cases have shown the evolution of insider trading jurisprudence while identifying the need for a consistent theory of culpability. First, in December 2014 the Second Circuit (home to a majority of insider trading prosecutions) ruled in United States v. Newman that it is not enough for the government to prove that a tippee (recipient of information) knew that an insider disclosed confidential information. Rather, the tippee must know that the insider disclosed that information for a benefit, i.e. something of value.
The Supreme Court weighed in two years later, in December 2016, in Salman v. United States. The Salman decision essentially pared back Newman, holding that giving a tip to a friend or relative, or someone with whom you had a “meaningfully close personal relationship,” without receiving anything in return, would still violate Rule 10b-5 if the tippee traded on the information. Thus, the warm and fuzzy feelings of doing your friend or relative a solid would effectively count as a benefit.
2017 brought Mathew Martoma’s appeal of his conviction to the Second Circuit. There, the court read Newman and Salman to obviate the need to prove a close relationship between tipper and tippee. It held that the government need only show enough to allow a jury to infer that the tipper only intended to benefit the tippee. Consequently, satisfying burdens of proof for the SEC and DOJ in insider trading cases has become easier.
The Current Bill and Its Impact
The Insider Trading Prohibition Act (ITPA), introduced by Congressmen Jim Himes (D-CT), contains several key provisions. The bill:
- Prohibits trading on “wrongfully obtained” material nonpublic information.
- Defines “wrongful” as obtained through “ “theft, bribery, misrepresentation or espionage, a violation of any federal law protecting computer data or the intellectual property or privacy of computer users, conversion, misappropriation or other unauthorized and deceptive taking of such information, or a breach of any fiduciary duty or any other personal or other relationship of trust and confidence.”
- Prohibits a person who wrongfully obtains material, nonpublic information to share that information when it is reasonably foreseeable that the tippee likely to trade on that information.
- Holds a tippee culpable so long as they were “aware, or recklessly disregarded, that the information was wrongfully obtained or communicated” (removing Newman’s knowledge of a tipper’s benefit requirement).
- Grants the SEC the right to exempt any person or transaction from liability.
If signed into law—a big “if” given lack of signaled bipartisan support in the Senate—the ITPA would shift focus on the source of inside information and the trader’s awareness of that source. Circumstantial evidence, such as concealment of communications might go further to proving the element of “wrongfully obtained.” And proving benefit to the tipper, the original Newman holding, would be unnecessary to find culpability (it would, however, help in proving damages and penalties).
Thus, the ITPA would fit with the current trend—the Martoma decision—of relaxing the burden of proof for criminal and civil enforcement of insider trading. But would the ITPA signal a sea change in insider trading prosecutions? The answer is: unlikely.
 The Supreme Court declined to hear the government’s appeal from the Second Circuit in Newman.