Ever since the U.S. Court of Appeals for the Second Circuit issued its landmark decision in United States v. Newman, debate has raged about whether the court has sanctioned insider trading or has appropriately restrained the Government’s efforts to prosecute innocent market conduct – and whether the judiciary, rather than Congress, should be defining and outlawing insider trading in the first place. Some members of Congress have now stepped into the act.
Last week, U.S. Senators Jack Reed and Bob Menendez introduced the Stop Illegal Insider Trading Act (S.702). The Reed-Menendez bill would make it illegal to (1) trade securities on the basis of material information that a person knows or has reason to know is not publicly available or (2) knowingly or recklessly communicate material information that a person knows or has reason to know is not publicly available when it is reasonably foreseeable that such communication is likely to result in the unlawful purchase or sale of securities.
The Reed-Menendez bill is a direct response to Newman, which, according to the bill’s sponsors, “has contributed to greater confusion in the legal system.” In Newman, the Second Circuit held that, to sustain a conviction for insider trading under section 10(b) of the Securities Exchange Act, the government must prove that a tippee who trades on the basis of material, non-public information knew that the tipper had breached a fiduciary duty by disclosing the confidential information – that is, the tippee knew the information was confidential and had been divulged for a personal benefit to the tipper. The Newman court also appeared to narrow the scope of what constitutes a personal benefit, explaining that “the mere fact of friendship, particularly of a casual or social nature,” is insufficient to meet the standard under the insider-trading laws.
The Reed-Menendez bill would essentially sidestep the constraints imposed by Newman (and by the Supreme Court’s decision in Dirks v. SEC) by creating an alternative cause of action for insider trading under a new section 10(d) of the Exchange Act. Section 10(d) would eliminate (1) the requirement that a tipper receive a personal benefit for disclosing confidential information and (2) the requirement that a tipper disclose confidential information in breach of a fiduciary duty to the source of the information.
In addition, the bill might expand the definition of insider trading to include trading on all sorts of informational advantages. As presently drafted, the bill prohibits communicating or trading on material information that is “not publicly available.” Although the term “not publicly available” excludes “information that the person has independently developed from publicly available sources,” the phrase “publicly available sources” is otherwise undefined. This language could potentially implicate information developed from a variety of seemingly legitimate sources that nevertheless might not have been disseminated widely enough to satisfy this vague standard.
The Reed-Menendez bill is not the only legislative response to Newman. Last month, U.S. Representative Stephen Lynch introduced the Ban Insider Trading Act of 2015 (H.R.1173). Like the Reed-Menendez bill, the Ban Insider Trading Act would also create a new section 10(d) that eliminates the requirement that a tipper have received a personal benefit for disclosing confidential information. The bill is currently pending before the House Financial Services Committee.
The Lynch bill is perhaps narrower than the Reed-Menendez bill, because the Lynch bill seems to preserve the current understanding that insider trading requires the use of nonpublic information that is obtained (i) “illegally,” (ii) “directly or indirectly from an issuer with an expectation of confidentiality or that such information will only be used for a legitimate business purposes [sic],” or (iii) “in violation of a fiduciary duty.” The Reed-Menendez bill, in contrast, appears to focus only on “material information that the person knows or has reason to know is not publicly available,” seemingly without regard to whether the information was used or obtained “illegally,” in breach of an expectation of confidentiality, or in violation of a fiduciary duty. The Reed-Menendez bill thus moves closer toward the parity-of-information rule that the SEC has advocated (unsuccessfully) for decades.
Practitioners will want to keep a close eye on both bills as they make their way through the committee process. Either bill, if enacted, would significantly alter the law of insider trading as it exists today – and even as it existed before Newman.