STOCK Act Could Expand Insider Trading Laws And Restrict Investment Advisers' Use Of 'Political Intelligence'

Last month, the Senate Homeland Security & Governmental Affairs Committee passed the "Stop Trading on Congressional Knowledge Act," or "STOCK Act"1 and the House Financial Services Committee held hearings on similar legislation.2 The primary purpose of this Act is to close a loophole in the law that may allow Members of Congress to legally trade securities based upon nonpublic "political intelligence." However, the legislation could have significant, perhaps unintended, consequences for investment advisers and those in the financial services industry.

The current Senate and House versions of the bill differ significantly. The House version would expand insider trading laws to prevent any person – including investment advisers – from purchasing or selling securities while in the possession of material nonpublic "political intelligence" they received from certain federal sources. It would also regulate "political intelligence" firms and establish a disclosure regime for "political intelligence activities" similar to the reporting requirements now in place for federal lobbying activities. The Senate bill is narrower, and merely confirms that Members of Congress owe a duty of trust and confidence and calls for a study of political intelligence firms.

This article provides a brief overview of federal insider trading laws as they apply to "political intelligence" then describes the main provisions of the STOCK Act, highlighting the differences between the current Senate and House versions. It then analyzes the impact that the proposed legislation could have on investment advisers, including the use of political intelligence firms, lobbying shops and consultants by investment advisers to gather political intelligence. It closes by identifying several key issues investment advisers should keep an eye on as the proposed legislation makes its way through the Congress.

Depending on what provisions (if any) are ultimately enacted, the legislation could alter the way investment advisers conduct basic regulatory due diligence in connection with their investments. The legislation could weaken a key provision of Regulation FD, which confirms the "Mosaic Theory" defense to federal insider trading laws.3 It could also impact the way investment advisers use employees, expert networks, lobbyists and political intelligence firms to research federal legislative and political activities in connection with their investments. In fact, the legislation could fundamentally alter the way that investment advisers interact with federal employees, including Members of Congress.

Background on the STOCK Act – Insider Trading by Members of Congress

Although versions of the STOCK Act have been introduced in each of the past two Congresses, the bill has gained significant momentum over the past few months due to a new book,4 a '60 Minutes' report5 and numerous articles6 alleging that Members of Congress or hedge funds traded securities based upon inside information or "political intelligence."

These stories have created pressure on Congress to do something to ban this practice. Unfortunately, the demand for quick action increases the risk of unintended consequences.

Brief Overview of Insider Trading Laws

Insider trading laws generally prohibit an individual from purchasing or selling securities if such person possesses material nonpublic information and the purchase or sale of such securities would violate a duty of trust or confidence7 owed directly or indirectly to an issuer, an issuer's shareholder or the source of the information.

An employee of a corporation owes a duty of trust and confidence with respect to nonpublic material information concerning the company he or she works for. Thus, a corporate employee is generally prohibited from trading on such nonpublic material information or providing (tipping) the information to third parties so they may trade on it.8 Likewise, it is generally illegal for third parties (tippees) to purchase or sell securities while in possession of nonpublic material information they received (i) from a source who owes a duty of trust and confidence or (ii) where the purchase or sale of securities would violate a duty of trust and confidence owed to the source of the information.9

It is unclear whether Members of Congress, Congressional staff and other federal employees owe a duty of trust and confidence with respect to...