New York, NY – The investigation into a potential leak of information from the Centers for Medicare & Medicaid Services regarding an important policy decision reversal announced early last month continues to be the topic of numerous newspaper articles last week. All this coverage has prompted many in the media to weigh in on these stories. However, amongst all this coverage, we have seen conflicting views about whether information obtained from Washington DC “insiders” can be considered MNPI and thus prompt an insider trading charge. The following is the start of a discussion on this topic.
Insider Trading Basics
Those of you who are regular readers of this blog know that the prohibition against “insider trading” is based on obtaining material non-public information or MNPI to either trade on or to pass along to others who then profit from this information.
Traditionally, insider trading was directly associated with the misuse of material non-public information about a public company or the market for a public company’s securities. However, in the past few decades, regulatory action and case law has expanded the definition of insider trading to other securities markets – including government bonds, commodities, and other public securities.
In addition, it has become clear that market moving information other than that directly associated with a public company, including government economic releases, or information about regulatory and legislative developments obtained from Washington DC insiders, could also be considered MNPI.
Is It Material?
Information is considered material if there is a substantial likelihood that a reasonable investor would consider it important in making a decision to buy or sell a security. In addition, material information, when disclosed, is likely to have a direct effect on the market price of a public security.
Examples of material information in the Washington context might be information that a merger was approved by Congress as happened in 1985 with the approval of the Standard Oil of California merger with Gulf Corp. to form Chevron. From 2004 to 2006, Congress considered creating a trust fund to cover medical costs and resolve asbestos-related lawsuits. During this period, the changing prospects for this bill had a direct impact on the stock price of companies like USG Corp., W.R. Grace & Co. and Crown Holdings. CMS’s recent reversal of a decision to cut Medicare Advantage payments was also information which, when released, had a huge impact on the price of a few healthcare stocks.
Of course, it must be noted that obtaining or trading on information that is solely material DOES NOT make it insider trading. In fact, most investors trade regularly on material information including the passage of certain key bills, the release of corporate earnings results, or the reporting of major economic releases. For material information also to be MNPI, it must meet a few other key thresholds.
Is It Non-Public?
Insider trading does not take place unless someone trades on (or passes along) information that is BOTH material and non-public. Information is non-public when it has not been disseminated in a way which makes it available to investors generally.
Information is public once it has been reported on a broadly distributed news source such as the Wall Street Journal, New York Times, or other widely disseminated publications. In more recent years, public dissemination of information has also included distributing it via the Internet. In fact, recently, the SEC admitted that a corporate executive did not violate Regulation Fair Disclosure by disseminating market moving company information on his personal Facebook page.
Besides being broadly disseminated via a news outlet or the internet, investors must then have a reasonable time to react to the information before it is considered “public”.
However, many in Washington argue that most of the information collected by policy research, political intelligence, or lobbyists on behalf of investors cannot be MNPI because a number of legislators, staffers, and lobbyists generally know about it and are discussing it. Unfortunately, this view is not consistent with the definition of “public information” that has historically been accepted by the courts.
In other words, the mere fact that two or three dozen people know about a development inside the beltway does not mean that is public knowledge. Therefore this information could be found to be MNPI if all other conditions are met.
Is It In Breach of a Duty?
Trading on or passing along information that is both material and nonpublic might not be considered to be insider trading unless one more rule is broken.
Under the “misappropriation theory” an individual is guilty of insider trading when they either provide or trade on “material non-public” information in violation of a “duty of trust and confidence” owed either to the company who the information is about, or the person who disclosed the information.
Traditionally, this fiduciary duty of trust applied to an issuer’s directors, officers and employees, investment bankers, underwriters, accountants, lawyers and consultants, as well as other persons who have entered into special relationships of confidence with an issuer of securities.
Historically, it was unclear whether there could be insider trading when it came to information collected from political insiders. Many argued that Members of Congress and their staff did not have a “duty of trust and confidence” to keep information private. Consequently, without a violation of this duty, there is no insider trading according to the misappropriation theory.
However, on April 4, 2012, this all changed when President Obama signed into law the Stop Trading on Congressional Knowledge Act (the STOCK Act). In Section 3 of the STOCK Act, the fiduciary duty required for insider trading liability under the misappropriation theory was established. The relevant language in this section said that:
“Each member of Congress or employee of Congress owes a duty arising from a relationship of trust and confidence to the Congress, the United States Government, and the citizens of the United States with respect to material, non-public information derived from such person’s position as a Member of Congress or employee of Congress or gained from the performance of such person’s official responsibilities.”
The Act also specifies that “Members of Congress and employees of Congress are not exempt from the insider trading prohibitions arising under the securities laws, including section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.” The Act further directs ethics committees in all three branches of government to clarify that insider trading violates their internal ethics rules.
Ultimately this means that information provided by a member of Congress or employee of Congress about a material nonpublic development that they learned while doing their job, might be considered a violation of insider trading law if it were traded on, or if it were passed on to someone else who traded on this information.
So what does this all mean? In our view, trading on or passing along information collected from political insiders, such as Members of Congress, their staff, or employees of Federal Agencies could run afoul of insider trading law if that information is deemed both material and generally not known. Consequently, we believe that investors who use this type of information need to assess it on the same basis as they would any other type of market moving information.
We also think that research firms that collect information from political insiders, whether as an input into their own research, or as direct intelligence for their clients, need to adopt a formal and rigorous compliance process to identify and potentially quarantine any information which they see as both market moving and broadly unknown. Unfortunately, our research shows that many research firms that engage in this type of information sourcing disregard this risk and don’t have great compliance controls in place.
Clearly the rules have changed and insider trading is now more possible than ever with information gathered from Washington political insiders.