TCS Daily


Insiders on the Hill

By Stephen Bainbridge - March 30, 2006 12:00 AM

Imagine you're a United States senator. You own a lot of stock in a big defense contractor. In a confidential briefing from the Pentagon, you learn that a major weapon system being built by that contractor is about to be cancelled. When the decision is made public, the contractor's stock will drop significantly. You're tempted to pick up your phone, call your broker, and sell the stock so as to avoid the loss. Would you?

A study of stock trading by senators found that many of them routinely succumb to that temptation. As the Securities Litigation Watch blog reports:

... the authors of the study conclude that these results "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...." The study adds that it is as if "senators knew appropriate times to both buy and sell their common stock." The article quotes [one author] as stating in a recent interview that "there is cheating going on, at a 99 percent level of confidence."

The W$J reports that two members of Congress are finally trying to clean up this mess:

Two Democrat lawmakers plan to introduce today a bill that would block trading on such inside information. Current securities law and congressional ethics rules don't prohibit lawmakers or their staff members from buying and selling securities based on information learned in the halls of Congress. ... In addition to banning trading on inside information, the proposal would require that lawmakers and their top aides disclose within 30 days any stock trades. Congressional rules now require lawmakers to disclose their trades once a year. The bill also would require that companies register with Congress if they sell information about congressional activity to Wall Street investors.

A few thoughts:

1. Stock trading by Congressmen and their staffs presents a double-edged conflict of interest. They may vote on the basis of their trading plans or trade on the basis of their voting plans. As Larry Ribstein observes:

Congress's insider trading is bad because it gives our lawmakers the wrong incentives. Do we really want to give Congress more reasons to hurt and help particular firms?

In fact, Congress's trading is worse than trading by corporate insiders, which at least might be rationalized as a way to let employees cash in on their productive efforts. It's far worse than the usual trading on non-public information by outsiders without any breach of duty, which may encourage socially productive investigation and monitoring, as Bruce Kobayashi and I have argued.

2. Congress has lots of access to confidential information, but one key source is its power to investigate. Do we want Congress "investigating" companies so that members or staffers can get stock tips?

3. Congressional insider trading is a real problem. As I reported on my blog last year, a study of trading by US Senators found that they were earning rates of returns from stock trading that would make Warren Buffett proud. The study's authors found that "the senators also appeared to know exactly when to buy or sell their holdings. Senators would buy stocks just before the shares suddenly would outperform the market by more than 25%." As every investor knows, you can't do that sort of thing routinely without having access to nonpublic information.

4. Much Congressional trading based on nonpublic information may not violate the securities laws. As I explain in my online primer on insider trading, there are two basic ways in which persons can be held liable for insider trading.

First, an insider of the company -- i.e., a person in who is an agent or fiduciary of the company or otherwise a person in whom the company has placed its trust and confidence -- may not trade in the company's stock on the basis of material nonpublic information about the company. Obviously, this basis of liability will rarely apply to Congressmen or the staffers, who will rarely have an employee or other inside relationship with the company.

Second, under the so-called misappropriation theory of insider trading, the defendant need not owe a fiduciary duty to the investor with whom he trades. Nor does he have to owe a fiduciary duty to the issuer of the securities that were traded. Instead, the misappropriation theory applies when the inside trader violates a fiduciary duty owed to the source of the information. But how often will the Congressman or his staffer owe such a duty? Typically, one suspects, the Congressman or staffer will be in an arm's-length relationship with the source of the information, as where it is learned in the course of an investigation. (The misappropriation theory might apply to staffers, if the Congressman for whom they work is deemed the source of the information. In that case, the staffer would have breached a duty to his boss by using the information and thus be liable.)

Effective regulation of problematic Congressional trading thus requires a broader prohibition than the securities law definition of insider trading. Fortunately, the proposed legislation apparently recognized the problem, as the Journal reports that the proposed bill would "prohibit lawmakers and their aides from trading based on information obtained in Congress that is not yet public. And it would prohibit lawmakers and staff from giving that information to others for investment purposes."

5. Congressmen and their staffs currently have to report their trading activities only once a year. Under the proposed legislation, they would have to report trades every 30 days. In contrast, when Congress passed the Sarbanes-Oxley law in 2002, they gave corporate insiders only two days in which to report their stock transactions. Is there any good reason Congress shouldn't have to do likewise?

Congress often exempts itself from laws that apply to everybody else. In most cases, we might infer that it is the laws in question that are a bad idea. In this case, however, it is the Congressional exemption that is the bad idea. This gaping conflict of interest needs to be staunched.

Unfortunately, the bill may well get tied up in partisan bickering. The bill's authors are both Democrats and some Hill observers view it as a slap at Bill Frist, whose HCA stock trades have been questioned, and at Tom DeLay, whose former staffer Tony Rudy has engaged in some questioned trades. The problem, however, is a bipartisan one and a legislative fix deserves bipartisan support.

Stephen Bainbridge teaches law at UCLA and writes a weekly column for TCSDaily.com.

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4 Comments

Do we need more examples that Congressmen and Senators are better than us?
We should thank our folks in government for the privilige to earn a living, trade things we own and basically live. Of course all those annoying rules we have do not apply to our more intelligent, gifted and more moral benefactors.

blind trusts
All members of congress, their staffs, and all senior level govt officials should be required to do all their investments through blind trusts.

Or at a minimum through mutual funds in which they have no knowledge of the individual stocks that make up the fund.

Eye opening
What a great way for them to profit from their insider knowledge and votes. It is troubling to see that the Democrats are out in front on this. The GOP needs to wake up and get ahead of some of these issues instead of being so reactionary like Newt did in the 90s.

Sausage Laws Can be Tasty
Maybe Hill Insiders Make Sausage We all Enjoy

Professor Stephan Bainbridge, I thank you for a most enlightening article. I have always pondered the dangers lawmakers face when they take bribes, extort favors, or conspire for profit, and wondered about their extent, as well as the methods used, to avoid these dangers. Now I see how, since the inception of corporations in Queen Elizabeth’s time, lawmakers have been making a killing, rendering all prior corporate and business related legislation suspect.

Setting aside idealism, the love of contest, and ego, it never seemed to me that mere campaign contributions were sufficiently large bribes or extortion payoffs to warrant running for a seat and reelection as a lawmaker when obviously so many could do so much better in private life.

Lawmakers have the ability to take bribes and to extort all sorts of favors from business, corporate or not. But obviously, representatives of big businesses, the corporations, pay best, since they represent the deepest pockets, use other people’s money, and thus are more willing and able to pay the most. I understand that insurance is number one and pharmaceuticals number two in terms of lobbying presence in D.C.

The recent Medicare Part D legislation granted both great favors. Congress as well as the big pharmaceutical and insurance corporations, their executives and lobbyists, had an opportunity to make truly obscene amounts, the largest payoff ever, and all at the cost of the market, not the corporations. And yet investors, representing the market, will no doubt also benefit. Is this a free ride all around, except for the 46.5% who pay taxes, and perhaps not even for many of them, considering medical benefits and the boost to GNP, jobs, and the market given by the legislation? In light of the low demand by seniors for a Part D program, and the high cost to government requiring much new borrowing, the stench of conspiracy is obvious. Of course, communication in conspiracies as in most agreements is by sign language and other commonly observed events.

All that is needed to make conspiracy operative is common motivation (enough greed) amongst the co-conspirators. Most perfectly ordinary legal oral contracts work much the same way. University educated people, as Enron et al. shows, are experts at rationalizations that allow unethical if not criminal behavior to be committed without a twinge of conscience. It is the essence of political correctness.

The 3/31/06 NY Times Business Day section had a front page article entitled A Benefit For Insurers – Medicare Drug Plan Feeds More Profitable Managed Care, by Mild Freudenheim. It show how the new Medicare Part D prescription drug program enabled three major health insurers, Humana, Wellpoint, and UnitedHealth Group to upgrade Part D enrollees to other Medicare linked policies, such as Medicare Advantage. Medicare now pays Medicare Advantage private insurers an average of 15% more to take a patient than it spends on patients in a traditional program.

Representative Pete Stark of California claims the Part D program law “was written by insurance company lobbyists with the help of pharmaceutical company lobbyists.” He was just saying the obvious.

The government pays the insurer $900 to $2,000 a month for providing a full Medicare Advantage health policy to a patient, beyond whatever premium the patient pays, if any. The increased revenues yield 3% to 5% profit margins.

“The government’s real gift to the insurers was 6.4 million low-income people om Medicaid or other publ8ic-assistance programs who were automatically assigned to Part D or Medicare Advantage plans. They were allocated among insurers ready to meet Part D rates, with most going to those who had Medicare Advantage plans throughout the United States.

“Under this allocation, the government gave UntedHealth 1.2 million Medicaid assignees; the nest biggest were Humana and Wellpoint, which each got 600,000.

“The insurers can be sure of collecting 100 percent of the premium for the lowest income enrollees, and they are paid a sliding scale if the enrollees are eligible for other state assistance.”

The insurance industry is said to have a potential revenue opportunity of more than $50 billion a year , near doubling the revenue of the managed care industry.

God only knows what Part D does for the drug industry, but likely somewhat comparable to what the new law does for the insurance industry. Which means we are looking at a half to a $ trillion a year total. Yes this is real money. The money to be made in stock appreciation is staggering. And no doubt thousands if not tens of thousands of individually profited by insider knowledge of this legislation.

Of course, some might say there are benefits to seniors. And for some there are. But not all, perhaps not even the majority, considering drug side effects risks and the ignorance reflected in reliance by both doctors and patients on often questionable establishment health care methods and procedures. Personally, at 74, I have avoided doctors like the plague, not having seen a doctor in the last 20 years and yet having constantly improving mental and physical health. Although I have researched health problems since 1960 and diligently applied what I have learned, Providence has no doubt been more than a little help.

Not to be too negative. We ignore how sausage is made because, while the process is ugly, the end result is usually great. Perhaps we should do the same with Part D legislation. One can see how near everyone benefits from this Part D legislation in different ways, and some far more so than most. Still, there are benefits all around.
Politics, after all, is the art of the possible.
Again, many thanks for this most enlightening article.



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