Myths and Facts on Congressional Insider Trading

This is required reading, from the website of Congresswoman Louise Slaughter, who has been a leader in pushing to ban congressional insider trading. The document below is from 2006, but as illuminating as ever.

SUMMARY of S.T.O.C.K. (Stop Trading on Congressional Knowledge) Act

• Prohibits members or employees of Congress from buying or selling stocks, bonds, or commodities futures based on nonpublic information about pending or prospective legislative action.
• Prohibits those outside of Congress from buying or selling stocks, bonds, or commodities futures based on nonpublic information about pending or prospective legislative action if that information is obtained from a member or employee of Congress.
• Prohibits members, employees, or persons with nonpublic information from disclosing information about any pending or prospective legislative action if they believe that information will be used to buy or sell stocks, bonds, or commodities futures.
• Requires members of Congress and employees to report the purchase, sale, or exchange of any stock, bond, or commodities future in excess of $1,000 within 30 days. Members and employees who choose to place their stock holdings in blind trusts or mutual funds are exempt from this reporting requirement.
• Requires firms that specialize in "political intelligence" and obtain their information directly from Congress to register with the House and Senate, much like lobbying firms are now required to do.

MYTH vs. FACT

MYTH:  Congressional insider trading is already a violation of current insider trading laws.

FACT:   Just as anyone else, Members of Congress and staffers are subject to current insider trading laws.  However, current insider trading laws do not apply to nonpublic information about current or upcoming congressional activity. 

EXAMPLE  1

The CEO of Company A is in a private meeting in the office of Congressman B.  During the meeting, Company A's CEO tells Congressman B that their recently-launched product is defective and that they are going to announce a full recall of the product next week.  This information has not been shared with the public.  After the meeting, Congressman B sells all of his stock in Company A.  THIS IS ILLEGAL

UNDER CURRENT INSIDER TRADING LAWS. 

EXAMPLE 2

Congressman B learns that the Chairman of the Appropriations Committee has decided to provide a multi-million dollar defense contract for Company A in the Defense Appropriations bill.  This information has not been released to the public, but will almost certainly drive Company A's stock price up when it becomes public knowledge.  Congressman B buys stock in Company A.  THIS IS NOT ILLEGAL UNDER CURRENT INSIDER TRADING LAWS, AND IS WHAT THE LEGISLATION ADDRESSES. 

Under current insider trading laws, there are two basic ways in which a person can be held liable for insider trading. 

First, an insider of the company may not trade in the company's stock on the basis of material nonpublic information about the company.  An insider of the company is anyone who is an agent or fiduciary of the company or someone who otherwise owes a duty of trust or confidence to the company. 

Second, under the misappropriation theory of insider trading, the person does not need to owe a fiduciary duty to the company.  However, to be held liable, the person must violate a fiduciary duty to the source of the information.  House Rules do not clearly imply that Members of Congress or their staffers have a duty of confidentiality to Congress and it would be difficult to conclude that there was such a duty.  The work of Congress depends on open lines of communication between Members and constituents and organizations.  For this reason, if we want this practice to be illegal, we must create a broader prohibition that does not require a duty of confidentiality. 

"If a congressman learns that his committee is about to do something that would affect a company, he can go trade on that because he is not obligated to keep that information confidential.... He is not breaching a duty of confidentiality to anybody and therefore would not be liable for insider trading."

-  Thomas Newkirk, a partner with law firm Jenner & Block and a former official with the SEC's   enforcement division, as quoted in Wall Street Journal, "Bill Seeks to Ban Insider Trading By Lawmakers and Their Aides" (3/28/06)

 "Effective regulation of problematic Congressional trading thus requires a broader prohibition than the securities law definition of insider trading."

-  Steven Bainbridge, Professor of Law at UCLA, who teaches or has taught Business Associations, Unincorporated Business Associations, Advanced Corporation Law, Corporate Finance, Securities Regulation, and Mergers and Acquisition, in "Insiders on The Hill" (http://www.tcsdaily.com/article.aspx?id=033006D

MYTH:  Even if congressional insider trading is not covered by current insider trading laws, congressional insider trading is illegal under other laws. 

FACT:  In 1958, the House of Representatives adopted the Code of Ethics for Government Service into its Ethics Rules.  Clause 8 of the Code of Ethics states that "Any person in Government service should...[n]ever use any information coming to him confidentially in the performance of governmental duties as a means for making a private profit."  However, this is a House Rule, enforceable only by the House Ethics Committee on an internal basis, and not a law under which a Member or staffer can be prosecuted.  Recent years have proven that House Ethics Rules are rarely, if ever enforced.  In those cases where they are enforced, Members receive little more than a slap on the wrist.  In addition, there is currently no mechanism in place within the House to track and monitor this.  If we want to put an end to this practice, we must develop a new law that can and will be enforced. 

In addition, the Code of Ethics for Government Service has not been adopted by the Senate and therefore does not apply to Senators or Senate staffers. 

Finally, House Rules do not have any effect on those outside of the House.  The Code of Ethics for Government Service has no impact on "political intelligence" firms who gather information from Members of Congress or their staffers and share that information with outside investors.  In addition to shutting down congressional insider trading by Members and staffers, the legislation will prohibit trading based on information gathered and sold by "political intelligence" firms. 

MYTH:  The legislation imposes onerous disclosure requirements on Members and staffers.

FACT:  If a Member of Congress or staffer otherwise required to make financial disclosures under House Rules holds his or her stocks in a blind trust or mutual fund, there are no new disclosure requirements.  However, if a Member or staffer trades stocks outside of a blind trust or mutual fund, and the value of a trade exceed $1,000, he or she will have to disclose the trade within 30 days.  Under current House Rules, Members and staffers have to report these trades once per year. 

30 days is the same length of time required for disclosure of privately-funded congressional trips.  In addition, this reported requirement is far less onerous that that imposed on corporate leaders who have to report within 48 hours.

MYTH:  This law will have no practicable effect because congressional insider trading is not a problem.

FACT:  In December of last year in an article entitled "Washington Whispers to Wall Street," BusinessWeek reported that the political intelligence business started with a couple of cottage firms in the early 1970's and has grown to an industry which is estimated to earn between $30 million and $40 million a year. Prominent players include the Washington research shops of Prudential, Lehman Brothers, and Stanford Washington Research Group, owned by Stanford Financial Group of Houston.

Banning Congressional Inside Trading: Not So Easy

The SEC's top enforcement official, Robert Khuzami, is all for stopping members of Congress from insider trading. But he wants Congress to tread carefully in enacting such a ban. As he said recently in testimony:

While trading by Members of Congress or their staff is not exempt from the federal securities laws, including the insider trading prohibitions, there are distinct legal and factual issues that may arise in any investigations or prosecutions of such cases. Any statutory changes in this area should be carefully calibrated to ensure that they do not narrow current law and thereby make it more difficult to bring future insider trading actions against individuals outside of Congress.

The Greedy Wife: Annabel McClellan's Insider Trading

Here's a nightmare scenario: You're a top corporate tax lawyer involved in mergers and acquisitions. You talk openly about the deals with your wife, who used to be in business herself but is now a part stay-at-home mom, part socialite, and part mobile phone app entreprenuer. 

Everything is going great: you're making tons of money, know lots of interesting people, and have a huge home in the hills of San Francisco that you and your wife have lovingly restored. You take trips abroad to places like London.

Then, one day, federal authorities show up and arrest you and your wife on charges of insider trading, a serious felony punishable by years in prison.

It turns out that your wife has been passing along tips about the deals you're working on to her sister and brother-in-law in London, and the brother-in-law -- an investor -- is making millions with the information.

This scenario is pretty much Arnold McClellan's recent life in a nutshell. At least as his wife Annabel McClellan tells the story. In pleading guilty to charges last week related to insider trading, McClellan claimed that she acted alone and that Arnold, now a former partner at Deloitte Tax LLP, was not involved.

As reported in Bloomberg Businessweek: “Annabel McClellan has apologized to the SEC and her husband, who had no knowledge of or involvement in her wrongdoing,” according to an e-mailed statement released today by Nanci Clarence, her lawyer. “She accepts that she will serve a sentence in prison, and takes full responsibility for what she has done.”

When this case was first revealed, Arnold McClellan's lawyers released a strongly worded statement. We see similar statements all the time by offenders who later plead guilty. But if Arnold is innocent, and it does look that way, you can understand the rage that was so thinly veiled in his lawyers' statement:

"Arnold McClellan denies the SEC's claims and will vigorously contest them," Elliot Peters and Christopher Kearney of Keker & Van Nest LLP said in a statement on behalf of McClellan. "He did not trade on insider information, and there will be no evidence that he passed along any confidential information to anyone." McClellan "had no financial incentive to commit the actions alleged," the lawyers added. "He is a conscientious, law-abiding professional with a 23-year unblemished track record of client service at Deloitte to prove it."

This guy must feel like his life was nuked out of the blue. I wonder whether he'll get his job back. I doubt it. As for his future with Annabel, well, best of luck for that marriage.

Update on Thursday, January 12, 2012 at 6:05PM by David Callahan

From the San Francisco FBI website, November 8, 2011:

Annabel McClellan was sentenced to 11 months in prison for obstructing and impeding the due and proper administration of the law, U.S. Attorney Melinda Haag announced.

On April 5, 2011, McClellan, 38, entered a guilty plea to one count of obstruction in violation of 18 U.S.C. § 1505 stemming from false statements she made to the SEC during its insider trading investigation. According to that plea, she corruptly influenced, obstructed and impeded the due and proper administration of the law under which a pending proceeding was being conducted before the United States Securities and Exchange Commission (SEC). . . .

McClellan was ordered to surrender to the Bureau of Prisons and begin serving her prison sentence on Jan. 2, 2012.

Insider Trading: A Crime for the Smart and Dumb, High and Low

The term insider trading conjures up images of sophisticated Wall Streeters or "expert networks" engaged in complex white collar crimes and pocketing millions. But often that is not the reality, and a surprising number of insider trading cases involve lower level people trying to make a few quick bucks. After all, insider trading is actually not so complicated: If you know something about earnings before the stock market does, you do pretty well.

Some of those snared in insider trading cases are, in fact, the antithesis of savvy high-rollers. They are morons at the bottom of the food chain. Fortunately, judges are smart enough to go easy on these people. Consider the case of Bonnie Hoxie. As reported in the Wall Street Journal:

A former Walt Disney Co. administrative assistant was sentenced to four months home detention Tuesday after admitting last year to engaging in a scheme to sell early access to the entertainment company's earnings.

Federal prosecutors in Manhattan alleged that Bonnie Hoxie, the former assistant to Disney's head of communications, gave her then-boyfriend Yonni Sebbag information about Disney's upcoming results before their public announcement last spring.

Mr. Sebbag then contacted dozens of hedge funds and investment companies anonymously last March in an amateurish insider-trading plot, offering to provide an early glimpse of Disney's results, prosecutors said.

"I trusted someone who I was not only romantically involved with, but also was a close confident of for over eight years," Ms. Hoxie said Tuesday. "I was blindsided by love in not making the correct choices."

Home detention sounds like the right punishment to me, even though I'm usually calling for tougher sentences.

And what happened to the boyfriend? Yonni Sebbag was sentenced to 27 months. That seems pretty harsh, but perhaps the judge slapped him with extra time for his stupidity. Consider these details from the case about how genuis Yonni marketed the info that Bonnie got:

A form letter was sent last March to more than 30 investment companies, offering access to Disney's earnings before their release last May and giving the companies a Gmail address to respond to, prosecutors said.

Federal Bureau of Investigation agents then began corresponding with Mr. Sebbag by email, posing as hedge-fund traders, prosecutors said. Mr. Sebbag agreed to share the inside information for $15,000 in cash, prosecutors said.

Mr. Sebbag was the "primary leader of this conspiracy," Assistant U.S. Attorney Julian Moore said Tuesday.

Three days before the release of earnings, Mr. Sebbag allegedly emailed a copy of "speaking points" related to the company's fiscal 2010 second-quarter earnings, prosecutors said.

I respect the feds who are busting insider traders. But calling Yonni Sebbag the "primary leader" of a "conspiracy?" Come on, now. Bonnie and Yonni sounds more like a Vegas act than a conspiracy.

If you want to know more about how two not-so-bright ordinary people with no criminal past can end up in a lot trouble, check out the details of Sebbag and Hoxie case in the SEC complaint below.

SEC Complaint Against Bonnie Hoxie and Yonni Sebbag

Light Punishment for Insider Traders Undermines Deterrence

The huge federal insider trading probe is said to be spreading terror in the investment world. But let's get some context here: insider traders rarely spend long stints in prison, even the most extreme offenders. While Michael Milken was indicted on 98 counts of racketeering and securities fraud in 1989, for instance, and was sentenced to 10 years after a pleading guilty to many fewer charges, he ultimately spent less than two years behind bars. Ivan Boesky, another storied figure in that scandal, also spent less two years in prison.

Not much has changed in twenty years. Prison sentences for inside trading tend to be light and many insider traders caught by the feds never go to prison at all. A recent analysis by Bloomberg Businessweek of cases in New York found that: "Almost half of the 43 defendants who were sentenced in Manhattan federal court in the past eight years for insider trading avoided a prison term, with many never seeing the inside of a jail cell because they cooperated with prosecutors."

The average defendent got a term of 18.4 months.

One reason for the light sentences is that many defendents cooperate with prosecutors the moment they are caught. This isn't the Mafia, after all. Educated and savvy criminals see the handwriting on the wall early on and get on board to help further investigations. That counts for a lot at sentencing time. Another factor is the amount of money involved. When inside traders make small profits, their sentences are shorter.

The 2007 case involving UBS banker Mitchel S. Guttenberg shows these patterns at work. The SEC charged 11 individuals in that case, which involved two separate insider trading schemes over a number of years. Besides Guttenberg, the defendents included: Erik Franklin, David Tavdy, Mark Lenowitz, Robert Babcock, Andrew Srebnik, Ken Okada, David Glass, Marc Jurman, Randi Collotta, and Christopher Collotta.

But only two people actually went to prison. Guttenberg, who pleaded guilty, was sentenced to 6.5 years, and David Tavdy -- who didn't cooperate with prosecutors -- got 63 months. 

Guttenberg's prison term was one of the longest in recent years, but Credit Suisse Group AG banker Hafiz Muhammad Zubair Naseem got a stiffer sentence: 10 years for leading a fraud that netted nearly $8 million. Joseph Contorinis, a former money manager at Jefferies Paragon Fund who also made big profits -- more than $7 million -- was sentenced last year to six years. 

These tough sentences are outliers. Many defendents get probation or home confinement. For instance, in the UBS case, Randi Collotta and Christopher Collotta (a former lawyer for Morgan Stanley and her husband), were both sentenced to home confinement for their role in an insider trading scheme. In that case, the government also went lightly because Mr. Collotta had health issues, a not uncommon occurrance. Prosecutors are allowed to take health isues into account in recommending sentences.

Home confinement sounds tough, doesn't it? Especially in cases involving wealthy defendents with palatial digs.

People on Wall Street like to complain that sentences for insider trading are too high -- that this is an insignificant crime and that the shame of arrest and loss of livelihood is enough of a deterrent. Well, the facts suggest otherwise. Not only are punishments quite light, but there is clearly not enough deterrence judging by how much insider trading goes on. Not only have prosecutors nailed dozens on insider traders in recent years, but experts agree that much insider trading never results in arrests.

Obviously the risk-and-benefit analysis remains favorable enough to draw many people to insider trading. And we're not talking about just anyone. We're talking about individuals who analyze risk for a living.