Within a couple of weeks of the COVID-19 outbreak in the United States, the Securities and Exchange Commission issued a warning to corporate executives and the wider public about trading on insider information.
“Corporate insiders are regularly learning new material nonpublic information that may hold an even greater value than under normal circumstances,” the commission said. “Given these unique circumstances, a greater number of people may have access to material nonpublic information than in less challenging times.”
In the SEC’s view, more material insider information plus stocks bouncing around like a super pinky ball equaled temptation. (Several Congressional representatives were already being investigated for allegedly ditching stocks after getting classified briefings on the threat of COVID-19.) It was also somewhat surprising, since in fiscal year 2019, the SEC brought 21 fewer insider trading cases than the year before (see chart below).
The SEC’s warning was one that most finance chiefs took seriously: CFOs often manage or help manage the corporate trading window and approve or reject proposed trades when employees possess material nonpublic information (MNPI). But there’s another reason for CFOs to be hyper-cautious: Some legal experts and attorneys are pushing for a reform of insider trading law, and some of the proposed revisions could make it easier for prosecutors to bring cases and convict violators.
There’s been much discussion over the need for reform since the Bharara Task Force on Insider Trading published a report in January 2020 recommending ways to improve and clarify existing statutes and case law.
“Our nation’s insider trading laws have for too long lacked clarity, generated confusion, and failed to keep up with the times,” Preet Bharara, chair of the task force and former U.S. attorney for the Southern District of New York (SDNY), said at the time. “This lack of clarity and certainty, in this important area of law and our securities markets, has benefited no one.”
Specifically, the task force concluded that a legislative solution, in the form of a new statute expressly setting out the elements of an insider trading offense, would be the best vehicle for change. But not everyone sees the necessity for an overhaul.
Insider trading is illegal trading of a company’s stocks or other securities by individuals with access to confidential or nonpublic information about the company, according to the Legal Information Institute at Cornell Law School. Taking advantage of this privileged access to information is considered a breach of an officer’s or director’s fiduciary duty. Illegal insider trading includes tipping off others to MNPI so they can trade on it, a common occurrence in famous insider trading cases.
The primary criticism leveled at U.S. insider trading law is that it is premised on decades of judicial decisions predicated upon the general antifraud provisions of the Securities Exchange Act of 1934, rather than a precise statutory framework, says John Sylvia, co-chair of the securities litigation practice at Mintz.
“This approach has resulted in inconsistent standards within the circuit [courts],” says Sylvia, particularly with respect to liability for insiders who tip others and for those who receive the tips. That inconsistency has made it more difficult to pursue these “downstream actors” who trade on shared material nonpublic information (MNPI), he adds.
For example, in 2017, professional golfer Phil Mickelson avoided being charged with insider trading after receiving second-hand information about Dean Foods. Prosecutors could not charge him with a crime because they could not find any evidence that Mickelson knew his tipper had inside information or knew that the tipper benefited in any way from passing that information along to Mickelson — a quirk in existing insider trading law.
Other aspects of insider trading law need clarity also. For example, courts have gone back and forth on whether the law requires that the tipper receive a personal benefit in exchange for disclosing MNPI to someone else. They have also differed on what precisely constitutes a personal benefit, says Greg Baker, a partner in white collar defense at Lowenstein Sandler.
Indeed, the Bharara Task Force recommended that the “personal benefit” requirement of existing law should be eliminated. It also recommended changes to the “knowledge requirement” that was key in Mickelson’s case.
While it is unlikely, given the coronavirus pandemic, that Congress will make headway on insider trading law in 2020, there is legislation in the pipeline. H.R. 2534 (the Insider Trading Prohibition Act) passed the U.S. House of Representatives in December 2019 and was then referred to the U.S. Senate Committee on Banking, Housing, and Urban Affairs.
The bill addresses some of the nagging problems in insider trading law. For purposes of establishing a violation, for example, it says “that it is not necessary for [a person who receives a tip] to know specifically how MNPI was obtained or whether a personal benefit was paid or promised” — the issue in the Mickelson case. The standard would be whether the person who received the tip was “aware, consciously avoided being aware, or recklessly disregarded that such information was wrongfully obtained.”
The bill also addresses questions that have arisen in the digital era, such as if a cyberthief who steals corporate data and then trades on that information violates insider trading laws.
Instead of a strict breach of duty or “intent to defraud” standard, H.R. 2534 uses a “wrongfully obtained” standard. “Wrongfully obtained” is defined to include MNPI obtained by: (i) theft, bribery, misrepresentation, or espionage (or other electronic means);” (ii) “a violation of any Federal law protecting computer data or the intellectual property or privacy of computer users;” (iii) “conversion, misappropriation, or unauthorized and deceptive taking of such information;” or (iv) “a breach of any fiduciary duty, a breach of a confidentiality agreement, a breach of contract, or a breach of any other personal or other relationship of trust and confidence.”
Some experts and attorneys think H.R. 2534 is dangerous and unnecessary. “Merely because the SEC becomes displeased with the direction of judicial interpretation of the law does not mean that Congress must provide a legislative bailout,” says Jacob Frenkel, securities enforcement attorney at law firm Dickinson Wright. While the bill on its face appears to provide clarity, “greater confusion and more aggressive prosecutions are the likeliest results,” Frenkel says.
He says “the zones of uncertainty” in the bill outweigh what is currently a relatively understandable prohibition under the antifraud provisions of the securities laws. For example, says Frenkel, “establishing express liability for trading derived from cyber intrusions easily could be a valuable amendment to existing cybercrime statutes.”
Other attorneys disagree on whether the reforms would result in more cases or convictions. Says Baker: “The broader scope of the ‘wrongfully obtained’ and ‘recklessness’ standards, if approved, presumably would result in a greater number of insider trading prosecutions … This is particularly true insofar as the statute envisions liability for information obtained by theft or espionage.”
Mintz’s Sylvia sees a more complex outcome: a well-defined standard would lead to more informed prosecutorial charging decisions regarding tippers and tippees, he says, and likely would lead to more convictions. (Prosecutors and the SEC presumably would not charge cases that did not fit squarely within the statutory framework.)
“But the overall number of cases charged under current standards presumably would decline, as questionable cases would be rejected or charged as civil — and not criminal — violations,” says Sylvia.
Any changes in insider trading law, obviously, could potentially affect finance chiefs and other corporate executives. “H.R. 2534 would potentially make it easier to prosecute corporate executives who communicate MNPI in breach of a duty, because the proposed bill expands upon the types of duties [a breach of a confidentiality agreement, a breach of contract, or a breach of any other personal or other relationship of trust and confidence] … that ultimately give rise to liability,” Baker says.
Certainly, H.R. 2534 could make current law clearer. But it also may make things harder for CFOs and corporate attorneys monitoring employees’ compliance.
A CFO at almost all times is in possession of some material nonpublic information, Frenkel says. “The issue is, how ‘material’ is that information? By eliminating the requirements that the person trading acted with an intent to defraud or had a duty not to use the information for personal benefit, any public company CFO trading stock could potentially be in the SEC’s or [Department of Justice’s] cross-hairs.”
With the SEC watching closely the next few quarters, the best advice is to say informed.
Bob Violino is a freelance writer based in Massapequa Park, N.Y.