In the days leading up to Nov. 16, 2005, the stock prices and trading volumes of several companies with asbestos-related liabilities including USG Corp., W.R. Grace & Co., and Crown Holdings, began to spike up in an otherwise flat market. No publicly available news about these companies or the industry explained the increases in price and volume.
What the public did not yet know—but what was known to certain investors with political connections—was that on Nov. 16, Senate Majority Leader Bill Frist would deliver a speech announcing new legislation to relieve companies such as USG Corp. and others of their liabilities in asbestos-related lawsuits.
The asbestos legislation is an example of the effect that Congressional action can sometimes have on a stock’s price, and also of the potential for insider trading based on that knowledge of non-public information. Notably, and to the surprise of most people, no laws or regulations prohibit members of Congress (or their friends, staff, neighbors, or other acquaintances) from trading freely on such material, non-public information about a public company.
Indeed, members of Congress and their staff currently do not owe any “duty of confidentiality” to Congress and can’t be held liable for insider trading based on congressional knowledge under the current laws. Nor is there anything at this time that would prohibit Congressional staffers and executive branch employees from sharing inside information obtained from Congress with their friends—potentially allowing the recipients of such information to use it to make huge trading profits or prevent big losses. That means trading on inside knowledge of upcoming Congressional action is today one of the few forms of legal, repeatable insider trading (see my December 2008 column for a list of the others).
An academic study released in 2004, as well as some other more recent developments, indicates that this Congressional loophole to the insider trading laws isn’t just theoretical. Georgia State University professor Alan Ziobrowski released a study showing that during the 1990s, senators’ stock picks (which must be publicly disclosed periodically) beat the market by 12 percentage points a year on average. By comparison, corporate insiders only beat the market by about 6 percentage points a year, and U.S. households underperformed the market by 1.4 percentage points.
Ziobrowski and his colleagues concluded their findings “suggest that senators are trading stock based on information that is unavailable to the public, thereby using their unique position to increase their personal wealth …” Ziobrowski later was quoted as stating that, in his opinion, “there is cheating going on.”
There were also published reports in the wake of the study that the Securities and Exchange Commission had reviewed the findings, but decided not to pursue the issue because such cases would be difficult to prove. Critics, however, observed that a more cynical explanation for the SEC’s decision to do nothing might lie in the fact that the U.S. Senate is responsible for approving SEC commissioners and the agency’s budget.
It’s hard to come up with any compelling reason why trading based on Congressional knowledge should remain legal, and quite easy to build the case against it.
In September 2008, U.S. Rep. Spencer Bachus of Alabama, the ranking Republican on the House Financial Services Committee, drew criticism for his trading of short-term put and call options in 2007, including a single transaction on Dec. 10 that netted him $15,000. He’d held that particular investment for just two weeks, and sold it on the same day that the company’s stock price surged following its announcement that it would acquire a competitor. Bachus’ trading in 2007 reportedly allowed him to supplement his $165,200 annual congressional salary by $160,000 that year.
There’s more: Tony Rudy, a staffer for former House Minority Leader Tom DeLay, was suspected of consistently trading based on material, non-public legislative information. While a DeLay staffer, Rudy reportedly traded hundreds of thousands of shares of stock from his work computer in 1999 and 2000.
Failure and Reform
It’s hard to come up with any compelling reason why trading based on Congressional knowledge should remain legal, and quite easy to build the case against it. Still, despite a situation that cries out for legislation to end this loophole, recent efforts to pass a bill that would do just that have gone nowhere. In January, U.S. Reps. Louise Slaughter and Brian Baird introduced—for the third time—legislation intended to stop insider trading on Capitol Hill called the “Stop Trading on Congressional Knowledge Act” (the STOCK Act). Slaughter and Baird also introduced similar bills in 2006 and 2007, without success.
Slaughter and Baird have persisted, however, and Baird recently stated that he considers the legislation to be more important than ever as the government prepares to direct billions of dollars into the economy through the Troubled Asset Relief Program. The STOCK Act of 2009 (H.R. 682) would, among other things, amend Section 10 of the Securities Exchange Act and Section 4(c) of the Commodities Exchange Act to:
prohibit members of Congress, employees of Congress, or executive branch employees from buying or selling stocks, bonds, or commodities futures based on non-public information they obtain because of their status;
prohibit those outside Congress from buying or selling stocks, bonds, or commodities futures based on non-public information obtained from within Congress or the executive branch;
prohibit Congressmen and employees from disclosing any non-public information about any pending or prospective legislative action obtained from a member or employee of Congress for investment purposes; and
require members of Congress and employees to report the purchase, sale, or exchange of any stock, bond, or commodities future transaction in excess of $1,000 within 90 days.
It would also require firms that sell “political intelligence” and obtain their information directly from Congress to register with the House and Senate, and to make disclosures much like lobbying firms are now required to do.
There are arguments against the STOCK Act, but none strike me as particularly strong. One is that the law is unnecessary because congressmen already have a duty preventing them from trading on inside information that derives from some combination of common law relationships, agreements to maintain information in confidence, and a history of sharing confidences. But it’s difficult to see this ill-defined and never-before applied “duty” serving as the basis of a future insider trading case against a congressman.
Another practical limit on Congressional insider trading may lie in the concept of “democratically accountability”—that Congressmen must publicly disclose their trading activity, and their constituents will take note and vote them out of office if they appear to be engaging in insider trading. This, too, seems like a weak argument. If we really want to deter insider trading flowing from Congressional knowledge, legislation seems like a much more effective and direct means of doing so.
If anything, the more interesting arguments against the STOCK Act are that it isn’t strong enough. While the STOCK Act amends the rules of the House of Representatives to prohibit disclosure of material, non-public information to others, for some reason it does not similarly amend the rules of the Senate. In addition, while corporate executives must publicly disclose their securities transactions within just two business days under the Sarbanes-Oxley Act, the STOCK Act gives members of Congress the luxury of a full 90 days to do so.
Finally, the STOCK Act places greater restrictions on federal employee insider trading than on congressional insider trading: While it broadly prohibits federal employees from trading securities based on material non-public information relating to the issuer of the securities, it only prohibits insider trading by Congressmen with respect to “any pending or prospective legislative action relating to such issuer …”
In short, a loophole currently allows members of Congress and their “tippees” to engage in legal insider trading based on what they learn from their elected positions. The only way to close this loophole is for the very people that benefit from the loophole to close it themselves.
So far, however, the efforts of Representatives Slaughter and Baird to end this loophole have gone nowhere, and there is nothing to indicate that Round 3 of their attempt to “Stop Trading on Congressional Knowledge” will have any greater success. With hundreds of billions (if not trillions) of dollars of federal money poised to gush into the economy by the U.S. government, now seems like the perfect time to pass legislation such as the STOCK Act.
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