Efforts to preserve wealth before the meltdown draw scrutiny

Patricia Foster and David Peartree
BridgeTower Media Newswires

Reports of trading activities by four senators in advance of the recent market meltdown didn’t exactly send shock waves through Washington, D.C. Senate Majority Leader Chuck Schumer (D-NY) has called for ethics investigations, a necessary but insufficient response. Without a more robust reaction from members of Congress, the call for internal investigations seems perfunctory. It reminds us of that famous scene from the 1942 film Casablanca in which Captain Louis Renault, the Prefect of Police in Casablanca, blurts out his famous line. While pocketing his gambling winnings for the evening, he declares with an absolutely straight face that he is “shocked, shocked” that gambling has been going on at Rick’s Café. The investing public will derive little comfort from internal congressional investigations. More intense scrutiny is required.
The inflection point occurred on March 11, 2020. By then, the World Health Organization had declared that the coronavirus (COVID-19) had become a global pandemic, and our domestic markets had plunged officially into bear market territory. Since then reported COVID-19 cases have risen dramatically and the markets have been volatile. As investment portfolios plummeted dramatically after an 11-year bull market, reports that some members of Congress had liquidated substantial portfolio holdings in advance of the precipitous downturn sparked outrage among investors. They wondered whether they or their financial advisors had missed important signposts. They wondered whether the worst was yet to come, and they also wondered whether members of Congress might be subject to different rules.

—————

Legacy of Rep. Louise Slaughter

The law of insider trading is complex. Currently, there is no express statutory definition of insider trading. For purposes of this column, we note that important touchstones relating to the prohibitions on insider trading are found in the anti-fraud provisions of the federal securities laws and in relevant case law. Prior to the passage of the STOCK Act in 2012, there were differing opinions as to whether it was illegal for members of Congress to trade on nonpublic information derived from their congressional activities. Because the anti-fraud provisions of the federal securities laws had not squarely addressed the issue, many legal scholars argued that the insider trading laws did not apply to Congress. Others argued that insider trading by members of Congress had always been prohibited because, under rules of both the House of Representatives and the Senate, members of Congress were subject to a duty of confidentiality regarding information learned through congressional proceedings.

Concerned that the federal laws prohibiting insider trading were not being applied to members of Congress, the late Rep. Louise Slaughter (D-Fairport) and Rep. Brian Baird (D-WA) introduced the Stop Trading on Congressional Knowledge (STOCK) Act in March 2006. The bill died in committee. And, although the bill was reintroduced several times over the next five years, it failed to gain traction. Academic studies concluding that the portfolios of U.S. senators beat the market by an average of 12% were presented during congressional hearings in 2009. Yet there was little appetite in Congress to advance the initiative.

The impetus for action did not occur until after a 60 Minutes broadcast aired on November 13, 2011. Steve Kroft’s interview of Peter Schweizer, then a fellow at the Hoover Institution of Stanford University, changed the trajectory. In a discussion about a new book that Schweizer was writing, Schweizer told Kroft that his current research project had been motivated by a desire to understand why some members of Congress had managed to accumulate significant wealth beyond their salaries and why they had become particularly adept at buying and selling stocks. He said that he and a team of eight student researchers had reviewed financial disclosure records of several members of Congress and had independently verified the results. During the interview, Schweizer provided multiple examples of suspect trading activity involving members of Congress who allegedly had obtained, and traded on, nonpublic, market moving information with no repercussions. Schweizer compared the trading abuses by members of Congress with the fate of corporate insiders who had been prosecuted for trading on material, nonpublic information. He pointed to hedge fund manager Raj Rajartnam, who had been prosecuted and sentenced to 11 years in prison for trading on material, nonpublic information. The results of Schweizer’s research were included in his 2011 book, Throw Them All Out.

The 60 Minutes interview shined a bright light on public corruption that had gone on undetected for decades. Shortly thereafter, more than 284 members of the House of Representatives signed up to co-sponsor the STOCK Act. The legislation was ultimately approved by both the House and the Senate, and was signed into law by President Obama on April 12, 2012. Kudos to the late Louise Slaughter, who was inducted posthumously into the Women’s Hall of Fame last year!

—————

The STOCK Act of 2012

The STOCK Act was designed to stop government officials and employees from trading in securities or derivatives based on information or knowledge derived as a result of their governmental positions. It accomplished that by amending the federal securities laws to impose an explicit duty on members and employees of Congress, as well as executive and judicial branch employees with respect to material nonpublic information. Although the STOCK Act does not define the term “nonpublic governmental information” for purposes of the prohibitions against insider trading it would be reasonable to conclude that members of Congress who had been privy to intelligence reports about the coronavirus and its probable impact on the economy were prohibited by the statute from trading on information derived from those reports.

The STOCK Act:

• Expressly states that members of Congress and other ­federal employees are not exempt from the federal securities laws that prohibit insider trading.

• Prohibits individuals from benefiting from nonpublic information acquired as a result of their governmental positions.

• Requires members of Congress to make public disclosures of certain financial transactions.

• Makes clear that members of Congress and their staffs owe a duty to the government and the United States not to misappropriate nonpublic information for personal profit.

Although the STOCK Act enhanced requirements for disclosure of transactions in stocks, bonds and other financial instruments, Congress voted to remove the transparency of transaction reporting in the year following its enactment.

—————

Will there be more scrutiny?

News reports have identified four senators who collectively sold millions of dollars worth of stock in the days and weeks before the impact of COVID-19 on the market was apparent to the investing public, presumably in an effort to avoid substantial portfolio losses. In response to media inquiries about these trades, each of the four senators has attempted to deflect attention. One senator has said that all of her assets are held in a blind trust. Another has said that neither she nor her husband has any discretion over their investments. Another, who did not support the STOCK Act, has said that he relied only on public news reports to guide his decision to sell amounts of stock whose market value was reportedly upwards of $1.72 million. He has requested an Ethics Committee review of his trading activities.

While we expect that the trading activities of these senators may be investigated by the Senate Ethics Committee, internal investigations alone will not convince the investing public that there is a level playing field in our domestic markets. More intense scrutiny is warranted. Members of Congress are subject to possible criminal and civil penalties for violations of the insider trading laws. Moreover, members of Congress who are convicted of felonies involving public corruption while serving as elected officials are barred from receiving federal pensions.

Will the Securities and Exchange Commission or the Department of Justice investigate? On March 23, the co-directors of the SEC’s Enforcement Division issued a stern reminder to those who may have access to material nonpublic information of their responsibilities under the federal securities laws: “The Enforcement Division is committing substantial resources to ensuring that our Main Street investors are not victims of fraud or illegal practices in these unprecedented market and economic conditions. The Enforcement Division is committed to protecting investors and maintaining confidence in the fairness and integrity of our markets.” While we hope that our government agencies will act, additional interviews with Peter Schweizer, currently president of the Government Accountability Institute, would once again shine a light on the importance of integrity in our trading markets.

—————

Patricia Foster is a securities law attorney whose experience includes representation of clients in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. This column is a collaborative work by Patricia Foster and David Peartree. David Peartree is a registered investment adviser offering fee-only investment and financial planning advice. The information in this column is provided for educational purposes and does not constitute legal or investment advice.