1 Comment 
Print 
E-Mail Tweet 1 Comment Print E-Mail Tweet
Preet Bharara is Chair of the Bharara Task Force. This post is based on a report authored by the Task Force whose members are Preet Bharara (NYU School of Law), Hon. Joseph A. Grundfest (Stanford Law School), Joon H. Kim (Cleary Gottlieb Steen & Hamilton LLP), Melinda Haag (Orrick, Herrington & Sutcliffe), John C. Coffee, Jr. (Columbia Law School), Joan E. McKown (Jones Day), Katherine R. Goldstein (Milbank), Hon. Jed S. Rakoff (United States District Court for the Southern District of New York). Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation by Jesse Fried (discussed on the Forum here).
For too long, insider trading law has lacked clarity, generated confusion, and failed to keep up with the times. Without a statute specifically directed at insider trading, the law has developed through a series of fact-specific court decisions applying the general anti-fraud provisions of our securities laws across a broadening set of conduct. As a consequence, the law has suffered—and continues to suffer—from uncertainty and ambiguity to a degree not seen in other areas of law, with elements of the offense defined by—and at times, evolving with—court opinions applying particular fact patterns. The rules of the road have been drawn and redrawn around these judicial decisions, and not always consistently across the country or over time. Although there have been attempts in the past to codify the law to bring greater certainty and clarity to the offense of insider trading, none has succeeded. This has left market participants without sufficient guidance on how to comport themselves, prosecutors and regulators with undue challenges in holding wrongful actors accountable, those accused of misconduct with burdens in defending themselves, and the public with reason to question the fairness and integrity of our securities markets.
The Bharara Task Force on Insider Trading (“Task Force”) has brought together a group of experts on insider trading—from academia, private practice, and the judiciary as well as former Department of Justice (“DOJ”) and Securities and Exchange Commission (“SEC”) officials—to review and assess the current state of insider trading law and to explore proposals to improve it. This Report reflects the culmination of the Task Force’s work and the unanimous conclusions of its members.
After studying the history and current state of insider trading law, reviewing the different legislative proposals that have been presented over the years, and receiving input from various interested groups, the Task Force has reached the following conclusions.
The Task Force believes that new legislation applying these principles would help eliminate areas of uncertainty and confusion in insider trading law and provide greater clarity for courts, practitioners, and market participants. Applying these principles, the Task Force has drafted certain proposed language that could be used as a template for potential legislation.
The rationale for prohibiting insider trading is straightforward—protecting the fairness and integrity of our securities markets and holding wrongdoers accountable. Most agree that there is something fundamentally unfair about insiders with special access to secret corporate information making a profit from trading on such information, at the expense of the rest of the market. However, insider trading law—as developed by the courts over time—is not built around a notion of fairness in trading. The Supreme Court rejected the “parity-of-information rule” that would entitle the counterparty to a trade to know all that an insider knows. Instead, in applying Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”)—which prohibits “manipulative or deceptive device[s]”—courts have focused, not on the harm to the counterparty or the other market participants, but rather on the idea of fraud or deception committed against the holder of the information.
We recognize that a small number of economists and commentators have touted purported benefits of allowing insider trading, arguing that it would enhance the market’s efficiency. This argument ignores, among other things, the critical importance of the ownership interest in the inside information. Confidential corporate information belongs to the corporation and its shareholders. And the use of such information for non-corporate personal purposes—such as trading for personal gain— amounts to theft or “misappropriation.” Claims of market efficiencies (the impact of which are likely to be nonexistent or negligible at best) cannot—and should not—be allowed to justify what amounts to theft of corporate information.
Nor do they justify the perverse incentives that would be unleashed from allowing insiders to profit from confidential corporate information, including the wholesale discrediting of the principle of fairness in the U.S. markets.
Courts have recognized that information ownership provides the underpinning of insider trading law. As Task Force member Judge Jed Rakoff noted in a recent decision:
[I]nsider trading is a variation of the species of fraud known as embezzlement, which is . . . ‘the fraudulent taking of personal property with which one has been entrusted, especially as a fiduciary’ . . . . Insider trading occurs when someone to whom this property has been entrusted pursuant to a fiduciary or similar relationship secretly embezzles, or ‘misappropriates,’ the information in order to take advantage of its securities-related value.
But over the years, a number of quirks and uncertainties have emerged in the development of insider trading law. Courts have had to confront questions that lacked clear answers under existing common law precedent. These questions included:
Under the current legal regime, these types of recurring questions have not always had clear answers. Courts have faced challenges in consistently applying the law to each new set of facts presented before them. Prosecutors have seen convictions overturned as a result of changes in the interpretation of the case law. Defense counsel and compliance professionals have struggled to explain to their clients the difference between illegal insider trading and acceptable market research and intelligence gathering. The public has been left to question the fundamental fairness and integrity of the markets.
The purpose and focus of this Task Force has been to study these challenges and to propose reforms that could help clear up the uncertainty and modernize insider trading law.
The development of insider trading case law has also been accompanied over the years by attempts at legislative reform and SEC rulemaking.
In the 1980s, a decade that saw a number of highly public insider trading prosecutions, as well as a number of the important court decisions discussed above, including Chiarella and Dirks, the SEC promulgated a new rule lowering the bar to insider trading prosecutions in the tender offer context, and Congress enacted legislation that increased civil and criminal penalties for insider trading. Legislative efforts to codify insider trading or otherwise change or clarify the substantive elements of the offense, however, failed.
Rule 14e-3(a)
Around the same time the Supreme Court decided Chiarella, holding that insider trading required a breach of a duty owed to shareholders, the SEC promulgated Rule 14e-3(a) under Section 14(e) of the Exchange Act. Rule 14e-3(a) removed the fiduciary duty requirement in the context of tender offers, making it unlawful for a person to trade on the basis of material nonpublic information concerning a pending tender offer. The SEC noted that the Chiarella decision made the rule necessary, emphasizing the importance of protecting information relating to tender offers because of the detrimental impact such trading has on “tender offer practice, shareholder protection and the securities markets.” In 1997, the Supreme Court held in O’Hagan that the SEC had not exceeded its rule-making authority in adopting Rule 14e-3(a) without requiring “a showing that the trading at issue entailed a breach of fiduciary duty[.]”
Insider Trading Sanctions Act of 1983 (ITSA)
Following the Supreme Court’s decisions in Chiarella and Dirks, Congress enacted stronger penalties for securities law violations. The Insider Trading Sanctions Act of 1983 (H.R. 559) (“ITSA”) amended the Exchange Act to increase the amount of civil penalties that could be imposed on a violation—up to “three times the profit gained or loss avoided as a result of such unlawful purchase or sale”—and to increase maximum criminal fines from $10,000 to $100,000. Significantly, in passing legislation to increase penalties for trading in securities “while in possession of material nonpublic information,” Congress did not define “insider trading” or provide greater clarity regarding the elements of the offense in ITSA, opting instead to continue to rely on existing common law, even though Congress was contemporaneously discussing proposals to change the substantive law of insider trading (including a parity-of- information bill presented by Senator Alfonse D’Amato).
Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA)
Following a number of high profile insider trading prosecutions, including those of well- known financiers Ivan Boesky and Michael Milken, Congress responded with stiffer penalties in the Insider Trading and Securities Fraud Enforcement Act of 1988 (H.R. 5133) (“ITSFEA”). Congress reacted to the “dramatic increase in insider trading cases, including cases against some of the most prominent officials in Wall Street investment banking firms,” which occurred despite the enactment of ITSA several years earlier. In the view of the House Committee considering the bill, “the scandals of the last two years demand[ed] a legislative response.”
In discussing the bill, Congress again considered whether to include a definition of insider trading in the legislation, before ultimately deciding against it. The House Report on ITSFEA acknowledged its decision not to include an insider trading definition, stating:
While cognizant of the importance of providing clear guidelines for behavior which may be subject to stiff criminal and civil penalties, the Committee nevertheless declined to include a statutory definition in this bill for several reasons. First, the Committee believed that the court-drawn parameters of insider trading have established clear guidelines for the vast majority of traditional insider trading cases, and that a statutory definition could potentially be narrowing, and in an unintended manner facilitate schemes to evade the law. Second, the Committee did not believe that the lack of consensus over the proper delineation of an insider trading definition should impede progress on the needed enforcement reforms encompassed within this legislation. Accordingly, the Committee does not intend to alter the substantive law with respect to insider trading with this legislation.
Accordingly, ITSFEA focused on deterrence, which included increasing criminal penalties, both by raising the maximum sentence from five to ten years’ imprisonment and by increasing the $100,000 maximum penalty adopted in ITSA to $1,000,000. ITSFEA also authorized the SEC to pay up to 10 percent of all amounts recovered to whistleblowers who provided information leading to the imposition of such penalties.
Insider Trading Proscriptions Act of 1987
At the same time ITSFEA was being presented in the House, the Senate considered a new insider trading bill, the Insider Trading Proscriptions Act of 1987 (S. 1380). Several prominent securities lawyers, including Harvey Pitt, the former General Counsel (and future Chairman) of the SEC, and John Olson, the Chairman of the ABA’s Task Force on Regulation of Insider Trading, drafted the legislation, which was sponsored by Senators Donald Riegle and Alfonse D’Amato. The Insider Trading Proscriptions Act went a step further than ITSA and ITSFEA by actually defining insider trading. The bill would have amended the Exchange Act to prohibit any person from trading on material nonpublic information when the trader knew or was reckless in not knowing that the information had been obtained “wrongfully.” The proposed bill defined “wrongfully,” as being the result of “theft, conversion, misappropriation or a breach of any fiduciary, contractual, employment, personal or other relationship of trust and confidence.” Although the bill was introduced in the Senate, it did not progress outside committee.
In October 2000, the SEC formally adopted three new rules affecting the offense of insider trading: Regulation Fair Disclosure (“Reg. FD”), Rule 10b5-1, and Rule 10b5-2. Several years later, in 2006, Congress introduced the Stop Trading on Congressional Knowledge Act (“STOCK Act”).
Regulation Fair Disclosure (2000)
Reg. FD provides that when “an issuer, or any person acting on its behalf, discloses any material nonpublic information” to securities market professionals or other enumerated persons, it must make public disclosure of that information. Reg. FD was created in response to the growing practice at the time of issuers giving advance warning of earnings results and other nonpublic information to select institutional investors and analysts.
Rules 10b5-1 and 10b5-2 (2000)
Rule 10b5-1 addresses the issue of when insider trading liability arises in connection with a trader’s “use” or “knowing possession” of material nonpublic information. The rule focused on defining what constitutes trading “on the basis of” material, nonpublic information and attempted to address arguments that sought to require the government to prove “use” by providing that a trade is “on the basis of” material, nonpublic information when the trader is “aware” of such information. The rule also provides a number of affirmative defenses, including the use of information barriers (so-called “Chinese walls”). Rule 10b5-1 also allows company insiders to set up a predetermined trading plan to sell company stock without running afoul of insider trading law.
Rule 10b5-2 was adopted to “provide greater certainty and clarity” on the issue of when, under the misappropriation theory, a breach of “trust or confidence” arises, in particular in the context of a family or other non-business relationship. The SEC passed the rule following a number of cases that explored the nature of familial and other relationships. The Rule provides that a duty of trust or confidence exists in certain enumerated circumstances, including when the parties have agreed to maintain information in confidence or they have a “history, pattern or practice” of sharing confidences.
The STOCK Act (2012)
In 2006, Congress introduced the STOCK Act. The bill was proposed following insider trading investigations by the SEC and the DOJ into Senate Majority Leader Bill Frist in 2005, in connection with his sale of stock of a hospital company founded by his father. The bill was reintroduced several times before becoming law in 2012. The STOCK Act prohibits members of Congress from making a private profit from nonpublic information acquired by virtue of their official positions. The Act further provides that members and Congressional employees are not exempt from the securities laws, including the Exchange Act and Rule 10b-5, and as such, they owe a duty that arises from the relationship of trust to Congress, the U.S. government, and
U.S. citizens.
In the wake of Newman, and in the midst of another era of vigorous insider trading enforcement in the hedge fund industry and elsewhere, various members of Congress introduced bills seeking to define and update insider trading law. These included “The Ban Insider Trading Act of 2015” (H.R. 1173) introduced in 2015 by Representative Stephen Lynch, “The Stop Illegal Insider Trading Act” (S. 702) introduced in 2015 by Senator Jack Reed, and “The Insider Trading Prohibition Act” (H.R. 2534) (the “Himes Bill”) introduced in 2019 by Representative Jim Himes (following a similar predecessor bill introduced in 2015 (H.R. 1625)). Two of these bills (H.R. 1173 and S. 702) would have amended Section 10 of the Exchange Act, while the other (H.R. 2534) proposed a new Section 16A to follow current Section 16. Of the three, only the Himes Bill has gained any momentum, advancing out of the House Financial Services Committee on September 27, 2019, and passing through the House of Representatives on December 5, 2019 by an overwhelmingly bipartisan vote of 410-13.
All these proposed bills establish a separate cause of action that explicitly prohibits insider trading, but none would supplant Section 10(b). Two of these bills (H.R. 1173 and S. 702) remove the personal benefit requirement established by insider trading cases beginning with Dirks, a change that is not surprising given that the bills were largely proposed in reaction to Newman. The Himes Bill includes a “wrongfully obtained” standard that is similar to the standard proposed by the Insider Trading Proscriptions Act of 1987. And while the initial version of the Himes Bill removed the personal benefit requirement, just before the vote by the full house, language was added to retain the personal benefit requirement, at least in cases where the information was “wrongfully obtained” due to a breach of duty.
The passage of the Himes Bill in the House just last month by an overwhelming and bipartisan vote—at a time of extreme political partisanship—reflects the broad consensus that has developed over the need to clarify and modernize our insider trading laws. The Himes Bill has progressed far, in our view, because it includes several important improvements to the law. Most importantly, it sensibly shifts the focus to information that is “wrongfully” obtained as opposed to having to rely entirely on concepts of fraud or deception and fills a number of holes left ambiguously open by the current common law. However, the re-introduction of the “personal benefit” standard—the root, as we have noted, of much of the current confusion and ambiguity—undermines much of the improvement and simplification that the Himes Bill otherwise achieves and to which we believe a new insider law should aspire. In addition, should the Blaszczak decision (holding that Title 18 securities fraud does not require a showing of personal benefit) be left undisturbed, then alternative statutes like Title 18 securities fraud or wire fraud would, even after passage of the Himes Bill, present an even more attractive vehicle for prosecutors because of the absence of the requirement of proof of personal benefit. And the sought-after clarity in the Himes Bill could remain elusive.
In addition, on January 13, 2020, the House passed—by a vote of 384 to 7—the 8-K Trading Gap Act (H.R. 4335). The Act, if passed into law, would require public companies to establish policies, procedures, and controls to prohibit executives and directors from trading in equities in advance of the announcement, by Form 8-K, of certain corporate events.
After studying the current state of the law, including the extensive common law, prior attempts at legislation and rulemaking, as well as hearing from various interested constituencies (all of whom recognized the challenges created by the uncertainty and ambiguity in the law), the Task Force has concluded that reform that simplifies, clarifies, and modernizes insider trading law is indeed necessary and long overdue.
With that conclusion reached, the Task Force then asked itself what is the best form for such reform to take? Should it come through legislation in Congress or would SEC rulemaking be sufficient? Legislation allows for a clean slate upon which to write a new and sensible law, freed from any of the long-accumulated baggage of existing common law. It also carries with it the imprimatur of democratic legitimacy. The Task Force has concluded that because the SEC is bound in its rulemaking to existing Supreme Court precedent, it would be constrained by and unable to fully clear itself from many of the ambiguities and uncertainties that currently plague the legal regime. The SEC could seek to provide some greater clarity at the margins, but in the Task Force’s view, real and substantial improvement will need to take the form of new legislation.
In thinking about what such legislation should look like, the Task Force has distilled its conclusions into a number of general principles that it believes should guide efforts at drafting any new legislation.
Aim for clarity and simplicity.
Uncertainty and complexity in current insider trading law drives the need for reform. Thus, any efforts at new legislation should focus on providing greater clarity and simplicity. Any new statute should not simply replace one set of uncertainties and ambiguities with another. In line with this basic principle, the Task Force concludes that:
Focus on “wrongful” use of material nonpublic information, not exclusively on “deception” or “fraud.”
The Task Force believes any effort to improve upon the current legal regime should decouple the offense of insider trading from its exclusive reliance on concepts of “deception” and “manipulation,” and tie it instead to “wrongfully” obtained or communicated information. Much of the uncertainty currently present in insider trading law, as discussed above, stems from its grounding in common law interpretations of the “manipulative or deceptive device” language of Section 10(b) and Rule 10b-5. But insider trading is just as unfair and harmful when information is obtained through wrongful means not involving manipulation or deception. It should not matter, for example, if a cyber intruder seeking to trade on material nonpublic information accesses a company’s servers through deception or instead, through some other improper means. The law should clearly and expressly prohibit trading in securities based on any such “wrongfully obtained” material nonpublic information.
This is not an idea original to the Task Force. Indeed, as discussed above, legislation proposed in 1987 in the wake of another insider trading enforcement wave, proposed this change as a key element of its reform, as does the more recently- introduced Himes Bill. The Task Force agrees that a move from “deception” and “manipulation” to “wrongfulness” is a sensible change, particularly in view of technological advances that have affected the different ways in which information can be misappropriated. The concept of “wrongfulness” also captures the distinction—drawn in Dirks—between inside information used for illegitimate or self-serving purposes from that used for a “corporate or otherwise permissible purpose,” without necessarily forcing the analysis into the constricting framework of deceit or fraud. A new standard based on information “wrongfully obtained” or “wrongfully communicated” would also eliminate the distinction between “classical” and “misappropriation” cases, as well as the persistent questions surrounding how the elements of the offense apply to the two different theories. It would also treat separately—in a clearer way—the culpability of the tippee from the tipper.
In implementing this change, the Task Force recommends that “wrongfulness” for the purpose of insider trading be clearly and strictly defined, while capturing the variety of ways in which material nonpublic information can be obtained and communicated. It should be defined to include deception and misrepresentation, as well as breaches of duties of trust and confidence and agreements to keep information confidential, theft, misappropriation and embezzlement. In doing so, the definition of “wrongfulness” could encompass conduct from “classical” and “misappropriation” cases, as well as hacks and other unauthorized means of accessing corporate secrets.
In its discussions, the Task Force also considered whether an explicit exception should exist, in the definition of “wrongfulness,” for those who disclose information for the purpose of reporting a fraud, illegal acts, or other misconduct, as the corporate insiders did in the Dirks case. Although we recognized the challenges presented by the circumstances in Dirks—where the original tipper was motivated by a desire to blow the whistle on a fraud—in light of all the avenues now available to and protections provided for whistleblowers, the Task Force did not believe an express exception was necessary.
Eliminate the “personal benefit” requirement.
The “personal benefit” requirement originated with Dirks as a seemingly “objective” way of distinguishing between the self-serving use of corporate information (and thus the breach of duty), versus a legitimate corporate use. But over the years—and particularly with the Newman decision—it has generated a disproportionate share of confusion and uncertainty. In the last five years, for example, juries in different cases in the Second Circuit (where a vast majority of criminal insider trading cases are brought) have been instructed differently about the personal benefit element, in particular whether it requires the showing of a pecuniary gain. Investigation and litigation over what constitutes a cognizable personal benefit—even when the breach of a duty is otherwise clear—has taken on outsized importance and generated incongruent results. Pinning the personal benefit requirement on a jury’s finding of a “meaningfully close personal relationship” also has the potential to produce inconsistent and arbitrary results. One person’s best friend may be someone else’s distant acquaintance, and should that really matter for purposes of policing the integrity of the markets?
The necessity of proving “personal benefit” not only creates this type of confusion, but it also unduly narrows the way in which wrongful dissemination of inside information can be actionable. Because of the focus on “benefit,” the requirement can create the misimpression in the market (and in the courts, as we saw with Newman) that a pure gift of material nonpublic information, without any expectation of reciprocity, to someone who trades on that information might be allowed. The law should be clear on this point, and eliminating the “personal benefit” requirement and replacing it with a “wrongfulness” standard can help eliminate the uncertainty. Clearer rules and greater certainty benefit all involved—whether it be market participants who want to avoid investigation or sanction, or law enforcement seeking to aggressively enforce the law.
In advocating for a new insider trading statute that moves away from “deception” and “manipulation” and toward a concept of “wrongfulness,” and eliminates the “personal benefit” requirement, the Task Force recognizes that other fraud-based statutes will remain available to prosecutors. For example, although Section 10(b) historically has been the principal means through which insider trading has been prosecuted, prosecutors have occasionally turned to other statutes, including the mail and wire fraud statutes, as well as securities fraud under 18 U.S.C. U.S.C. § 1348, enacted as part of the Sarbanes- Oxley Act of 2002, to prosecute insider trading. Section 1348, which tracks language from the mail and wire fraud statutes, prohibits the obtaining of any money or property “by means of false or fraudulent pretenses, representations, or promises . . . with the purchase or sale of any commodity . . . or any security.” As noted above, in the Blaszczak decision last month, the Second Circuit held that prosecutions under Sections 1348 (securities fraud) and 1343 (wire fraud), even in the insider trading context, do not require a separate showing of “personal benefit” or other elements of a Title 15 insider trading charge. Thus, the continued availability of these other fraud-based statutes will leave some uncertainty even with the passage of a new statute. But because our proposed statute would not require a showing of personal benefit, it would be as attractive to prosecutors as Sections 1343 and 1348, and thus, prosecutors would be less likely to prosecute insider trading under other non-specific fraud-based statutes.
Moreover, a new insider trading statute would apply to both the DOJ and the SEC, as opposed to the Title 18 offenses that are available only to criminal prosecutors. In any event, it is not uncommon for multiple statutes to cover a range of overlapping criminal conduct, and with the introduction of a new insider trading-specific statute, we would expect that that would become the principal means of prosecuting insider trading offenses (as Section 10(b) has been historically).
Clearly and explicitly define the state of mind requirement for criminal and civil insider trading, as well as the knowledge requirement for tippees.
The differing standards between criminal enforcement by the DOJ (“willfulness”) and civil enforcement by the SEC (“recklessness”) have the potential to cause uncertainty and confusion in the market, as does the potentially differing knowledge requirements for tippers and tippees. Any proposed legislation should make the different state of mind requirements clear and explicit.
As a preliminary matter, the Task Force concludes that an important role exists for both criminal and civil enforcement of insider trading laws.
Proving the requisite criminal state of mind— willfulness—is difficult, as it should be. But it is doubly difficult in insider trading cases involving tipping chains (a common insider trading fact pattern), because it requires proving that a tippee had knowledge of the tipper’s breach of duty.
If limited to criminal enforcement, market participants could readily circumvent insider trading laws by ignoring or not inquiring about the origins of any inside information, so long as such steps do not rise to the level of criminal conscious avoidance. The SEC’s ability to pursue insider trading civilly, where market participants act recklessly, plays an important role in ensuring the integrity and fairness of the securities markets.
Any new legislation should expressly set forth the two different intent requirements for criminal and civil enforcement. In this regard, the proposed Himes Bill defines the relevant mental state as “aware, consciously avoided being aware, or recklessly disregarded,” without differentiating between criminal and civil states of mind.
Because such a formulation risks confusion about which standards apply to criminal and civil enforcement, the Task Force would propose defining the state of mind requirements clearly as willfulness for criminal violations and recklessness for civil violations. This would provide market participants with fair warning of the boundaries of criminal liability and at the same time leave room for civil enforcement to police less egregious offenses when appropriate.
In addition, considering the confusion that has emerged at times over the requisite state of mind for tippees versus tippers, particularly with respect to a tippee’s knowledge of the underlying breach of duty, any new legislation should expressly set forth a tippee’s knowledge or intent requirements. For criminal liability, the tippee should know that the tipper obtained or communicated information wrongfully, and for civil liability, the tippee should have at least recklessly disregarded that fact.
Applying the principles set forth above, the Task Force developed the following draft language that could be used in proposed legislation. While other variations in terms of language or format could also serve the principles discussed above, the Task Force concluded it would be useful to provide some model language that seeks to apply the general principles outlined above.
The complete report, including footnotes, is available here.
