Part Two: Everything You Ever Wanted To Know About Insider Trading
Trading activity by members of Congress early in the pandemic, as well as by executives whose companies are involved in vaccine development, has once again resulted in a lot of public chatter about insider trading. Plus, the recent imbroglio involving the skyrocketing (and later plummeting) GameStop stock price— something I addressed a few days back — often devolves into online arguments about insider trading (which, let’s be clear, is pretty much entirely unrelated).
Insider trading is one of those subjects everybody feels completely comfortable talking about, even though many have little idea what it means. Hell, I spent more than a decade investigating insider trading cases for the SEC, and half the time even we didn’t know what it was. Why? Because there’s no law against insider trading. Rather, federal law simply prohibits securities fraud — and the courts and the regulators have spent the past 50 years struggling to squeeze a square peg into a round hole.
Given all the attention, you may be tempted to wade into online arguments about insider trading. Which is great. But here’s a little background that should help.
What Exactly Is Insider Trading?
Again, there is no law specifically defining insider trading, but here’s the general framework developed by the courts.
First, it is illegal to buy or sell stock using “material, nonpublic information.” “Nonpublic” is the easy part — the information must be confidential, something that hasn’t previously been reported to the public. And “material” means that the information is something an ordinary investor would find important in deciding to trade the stock. Examples of material information can include a company’s financial performance, a merger agreement, or a major product development (such as having a new vaccine approved by the FDA).
Second, the law forbids trading on inside information by anyone with a legal duty to keep the information confidential. Who has such a duty? Company insiders, of course. And not just executives, but anyone who works for the company. Whether you’re the CFO preparing the press release announcing quarterly earnings, or the IT intern who sees the draft press release sitting on the server, you’re equally forbidden from trading the company’s stock before the release is issued to the public. Other people who receive the information in confidence are also prohibited from trading. An outside lawyer, accountant, or banker helping the company prepare for a possible acquisition cannot trade the company’s stock; by the same token, if the CFO confides in her husband or her psychologist she’s worried about losing her job after the merger, they can’t trade, either.
Finally, those with a duty not to trade are also prohibited from tipping others. If you tell your college buddy, or your mom, that your company plans to announce a cure for COVID-19 and they might want to run out and pick up a few shares, not only will they get in trouble for trading, but you’re on the hook even you don’t personally trade and don’t see a penny of their profits.
Are Members of Congress Exempt?
Insider trading cropped up in the news last year on the heels of well-publicized trades by certain members of Congress. This invariably leads to angry tweets proclaiming, “Congress exempted themselves from insider trading laws!” Please stop saying this; it’s silly. True, there had been some ambiguity in the law, but in 2012 President Obama signed the STOCK Act, which expressly states that legislators (and most federal employees) have a legal duty not to trade based on information they learn on the job.
The problem with the STOCK Act is that it’s incredibly hard to enforce. Among other things, the information to which Congress has access doesn’t fit neatly into traditional inside information. If the CEO of Exxon learns they just had a massive oil spill and sells Exxon stock before word gets out, that seems like an easy call. But if a Senator is considering environmental legislation which may (or may not) impact various oil and gas companies, it is far less clear that this is “material nonpublic information” that would preclude them from selling Exxon shares.
In fact, there has yet to be a single case brought against a member of Congress under the STOCK Act. The SEC and Department of Justice did recently charge former GOP Congressman Christopher Collins with insider trading, but Collins had traded on information he learned in his position as a director of a public company, not through his official congressional duties. (Fun fact: Trump pardoned Collins on his way out the door.)
So does this mean the legislators we’ve read about are in the clear? It’s hard to say. Several GOP Senators (Loeffler, Burr, and Perdue) alleged to have sold stock following a confidential COVID-19 briefing last year have reported that the Justice Department has moved on, but we don’t know if the SEC is still investigating. If the intelligence briefing contained significant information unknown to the public at the time which could have impacted particular companies, there could be a viable insider trading case, but we don’t know what information was shared. (And it’s possible that the trades were made through a blind trust beyond the control of the particular Senator.) More recently, House Speaker Nancy Pelosi got flack for investing in Tesla shortly before President Biden signed an executive order encouraging federal agencies to procure zero-emission vehicles; but since this initiative was a visible part of Biden’s campaign platform, it would be tough to argue she was trading on nonpublic information.
Of course, the difficulty in establishing STOCK Act violations doesn’t mean we are left to eternally wonder whether legislators are improperly lining their pockets. Several Democrats have drafted bills which would prohibit lawmakers from trading individual stocks while in office and/or require all securities be held in a blind trust so that the official would have no say in managing their investments. Such a law would avoid the need to establish that the legislator had material nonpublic information at the time he or she traded; more importantly, a blanket trading ban would lessen the taint of Congress members taking actions that could benefit their stock portfolios, which is at heart more an ethical issue than a question of insider trading.
Yeah, But If They Could Lock Up Martha Stewart …
Just a bit of a side-note here, but for some reason it seems everyone tweeting about congressional trading feels obligated to throw in, “Martha Stewart went to prison for insider trading, why not these people?” So let’s clear something up: Martha Stewart did not, in fact, go to prison for insider trading.
Nearly 20 years ago, the SEC and DOJ alleged that Stewart sold about $200,000 of a pharmaceutical company’s stock based on an improper tip from her broker, avoiding about $45,000 in losses when the company announced bad news and the price cratered. The DOJ ended up not pursuing insider trading charges, instead charging her with lying to investigators about the reason for her stock sale (and altering some handwritten notes). A jury found her guilty of making false statements and obstruction of justice, and she served a few months in prison. She later settled civil insider trading charges with SEC, paying monetary penalties and agreeing to limitations on serving as a public company officer or director.
Arguably, the case stands for the opposite of what people seem to think, demonstrating that it can actually be quite difficult to prove insider trading (at least criminally). The case also exemplifies the advice that lawyers like myself always impart upon clients: lying to authorities and destroying records can get you in a lot more trouble than the underlying misconduct they’re investigating.
And Then There Are Those Greedy Pharma Execs!
There was also a lot of static over the past year about pharmaceutical executives cashing in as their companies announced progress towards a working COVID-19 vaccine. But let’s think back on our lessons above: was anyone trading based on nonpublic information? Some of these execs were selling after announcing the good news. At this point, the information was public — and therefore not insider trading. If you’re a company insider holding a lot of stock and the price skyrockets on good news, selling some of your shares is not just legal, but probably a good idea from a diversification standpoint. (Whether a pharmaceutical exec cashing in in the midst of a pandemic makes for good PR is another thing entirely.)
Of course, if insiders had bought stock before announcing the good news, that would be insider trading. Or if it later turned out that the companies’ public statements were overly rosy and their vaccine didn’t work, then the executives’ decision to unload their shares before the truth got out could be used as evidence that they were aware of fraud. But there is no indication at this point that this was the case.
Oh, and one other thing. Sometimes these stories about executive stock sales make reference to “trading plans” (also known as 10b5–1 plans). SEC regulations provide a defense to allegations of insider trading where the sales are part of a pre-existing trading plan. Given that senior executives are almost always in possession of material nonpublic information about the company, it can be difficult for them to sell their shares, which is a problem if a large part of your compensation is tied up in stock options. So they can draft a plan to, say, automatically liquidate 10% of their holdings each quarter. Such plans, however, won’t keep the executive out of trouble if he’s using it to game the system. For example, if the CEO learns the company’s hot new drug just failed some clinical tests, he can’t just write up a new plan to dump a bunch of stock the day before the company announces the bad news.
Uh-oh, Elon Musk Just Tweeted About Some Company
Every now and then, you’ll read about Elon Musk or some other big name talking up some pet company, raising a question of whether someone with enough cachet to move markets would be breaking the law by trading. Once again, while it may be unseemly, it’s generally perfectly legal.
This time the issue is one of duty. If Warren Buffett announces that he is a huge fan of ABC Co., and it turns out he loaded up on ABC Co. stock knowing that his public statement would goose the stock price, did he breach a duty of confidence he owed to anyone? Not ABC Co.; he’s not associated with them, and didn’t get any information from them. Of course, many people, such as journalists or stock analysts, likely have confidentiality agreements with their employers prohibiting them from trading stock of the companies they discuss publicly. But a bigwig with a megaphone is, like it or not, pretty much free to trade the stocks they chat up (which is why you might want to take what they say with a grain of salt given their potential profit motive).
That said, the speaker could still get in trouble if they’re making false statements. If some Instagram influencer corners the market in ABC Co. stock, publicly proclaims that ABC Co. is the greatest investment on the planet, and promptly dumps their ABC Co. stock once they’ve driven up the stock price, this could be a form of fraud — after all, if they truly believed their statement that the company was a good investment, why would they be selling off their shares?
Sounds Like A Big Ol’ Mess, So Maybe I’ll Just Make A Small Trade
Given so many legal complexities, and allegations involving big names, you may be thinking to yourself, they’re not gonna bother with a small-timer like me, may as well do a little insider trading. Alas, most insider trading cases are pretty straightforward, and the SEC routinely brings cases even where there were relatively small profits.
The stock exchanges have sophisticated systems for identifying trades placed shortly before market-moving events, regularly turning over to the SEC lists of people who made suspiciously well-timed trades. If the SEC launches an investigation and determines you traded on inside information, they will seek to recover not just your trading profits, but significant financial penalties, and they can also bar you from serving as an officer or director of a public company or working in the securities industry. (Plus, all SEC enforcement actions are public, meaning their case against you will forever be the first thing that pops up when someone googles your name.)
Even worse, the SEC can refer egregious cases to the Department of Justice, which, unlike the SEC, has the ability to put people in jail for insider trading.
So, hey, let’s just not go there.