A Proposal for Abolishing Congressional Insider Trading

In a little under 10 months, Americans will head to the polls to elect 470-odd lawmakers (and one president) to represent their interests in Washington. But once these Mr. Smiths arrive in Washington, will they be representing your interests...or lining their own pockets?

Three months ago, a report on 60 Minutes sounded the alarm about the potential for widespread insider trading in Congress. Ever since, a little-known piece of legislation (albeit, one we've been talking up for the past 18 months) has gained momentum. It's called the STOCK Act, and its aim is to put an end to insider trading on Capitol Hill, and to ensure that Congress members play by the same rules as the rest of us.

Why is this law needed, and what specifically must be done to put an end to this practice? Eight years ago, Professor Alan Ziobroswki of Georgia State University conducted a study showing that U.S. senators and representatives significantly outperform other investors on their stock returns. Crunching the numbers, the professor concluded that "trading with an informational advantage is common" in Congress. The results of a second study out of MIT, while less damning, also left open the possibility that members of Congress are trading on insider information...or at least, that they did so in the past, when no one was looking (and might do so again).

Either way, though, most experts we've spoken with agree: There's no good reason not to pass a law stating clearly and unambiguously that insider trading is wrong. And more to the point, because the law prohibits others from trading on insider information, the same rule should hold true for the legislators themselves. Put simply, members of Congress should be subject to the same standards as the rest of us: They should not be able use congressional information for their own benefit, and, to assure compliance and legislative transparency, they should report their transactions in a timely and comprehensible manner, just like corporate officers and directors.

Now...what do we need to do to make this happen?

There ought to be a law
It's ambiguous whether insider trading involving members of Congress is prohibited. Ask one "expert" whether insider trading laws already apply to Congress, and you'll get a resounding "yes" in response (followed by 13 pages of footnotes trying to prove the point.) Ask another expert, he'll just as convincingly argue "no."

But regardless of how they interpret current law, just about everyone we've spoken with agrees that there's no reason why we shouldn't pass a law clarifying that Congress is banned from insider trading -- just like the rest of us. We entrust our elected representatives with nonpublic information so that they can do their jobs for the benefit of the people they represent -- not so that they can misappropriate this insider information for personal gain. To this end, we at The Motley Fool believe that the STOCK Act should contain a provision reading more or less like this (although we'll leave the drafting to the professionals):

Members must not use material nonpublic information that they receive by virtue of their congressional positions, or gained from performing their duties, for personal benefit.

How to enforce the law
Of course, even after the principle is in place, we still need a way to determine when a violation has occurred, and how to punish it. For Americans who do not happen to be members of Congress, the SEC has been honing the provisions of the Securities Exchange Act of 1934 and its rules for almost eight decades now. But by the same token, once a law is passed subjecting Congress to the insider trading prohibition, could it take another 80 years to work out all the kinks?

Probably not. Considering that a vast array of laws, regulations, court decisions, and commentary has already been written on insider trading, we see no need to reinvent the wheel. Instead, we believe that the simplest, most elegant solution is to make crystal clear that the rules the SEC and courts have worked out for the rest of us regarding insider trading apply to Congress, too. And the simplest way to do that is to make it clear that Congress has the same duty to protect confidential information as does anyone outside of Congress. If we were writing the law, we'd want to see something to the following effect:

Members owe a duty of trust and confidence to Congress, the United States government, and the American people. Consequently, their use or disclosure of congressional information is subject to the provisions of Section 10(b) of the Securities Exchange Act of 1934 and the SEC's Rule 10b-5.

Uttering the magic words "duty of trust and confidence" is more than just fancy legal language. Under current law, once this duty has been created, a violation of it (for example, by trading on insider information) can constitute securities fraud. Creation of this duty also implicates the prohibitions against "tipping" -- when someone who holds insider information passes it on for someone else to trade on, rather than trading on the information him- or herself.

As an added benefit, by extending the ban on tipping to Congress, the STOCK Act would curtail some of the more objectionable behavior by political intelligence firms that have been in the news lately.

Sunshine is the best disinfectant
The two clauses that we're recommending move toward banning bad behavior. Still, an ounce of paranoia is worth a pound of prosecution. While we're all in favor of locking up bad actors, we'd just as soon scare the bejeezus out of Congress so that they never dare trade on insider information in the first place.

How do we do that? By making them fess up in public to any trades they make, trusting that an unfettered free press and intrepid blogosphere will gamely dig into these disclosures and raise "uncomfortable" questions about any transactions that look suspect. Our suggestion for the law:

Members must report their transactions in publicly traded securities within 48 hours of executing each transaction. Congress shall develop a standard means of reporting such transactions electronically to ensure that this requirement not place an undue burden upon those who must report the transactions. This system shall require Members to accurately disclose the date of each transaction, its amount, and the security being traded.

We believe that including these three provisions will largely put an end to the practice of insider trading in Congress (if it is ongoing), ensure that it never gains traction (if it is not), and punish offenders (should they prove us wrong on points one and two).

Help Wanted: A congressional cop
Against the chance that an offense does take place, however, we believe that Congress should choose an appropriate body to police enforcement of the STOCK Act. The SEC is the logical agency for this, because it enforces the securities laws for everyone else. We are concerned, however (although we'd love to be proven wrong on this), that charging the SEC with this responsibility would place that agency in the untenable position of being asked to police the actions of the people who sign its paycheck. For this reason, we believe that the respective House and Senate ethics committees should also take an active role in policing their respective chambers. When suspicions of improper trading are brought to their attention, or when they formulate their own suspicions after review of disclosure forms, these committees should officially request the SEC to investigate and take all appropriate measures. Such invitations should alleviate the SEC's fears about political repercussions from investigating a lawmaker, although it would still retain its traditional role of enforcing the securities laws on its own.

An intelligent addition
We disagree with Sen. Joe Lieberman, D-Conn., who recommended that the recent phenomenon of political intelligence firms gathering nonpublic information for their (commonly hedge fund) clients on Capitol Hill requires further study. It is possible (and we hope) that creating a "duty of trust and confidence" and implicating the general rules against tipping will stop the more objectionable activities that the political intelligence firms are alleged to have engaged in. That said, there is no clear nexus between a senator (for example), the political intelligence firm he speaks with, and the (now twice-removed) client of that firm who may ultimately trade on illegally "tipped" insider information, especially as energetic firms may be able to piece together bits of confidential information into valuable "mosaics" with no obvious source. This lack of a clear connection stands in marked contrast to the situation where (again, for example) a senator tips a relative to material nonpublic information, resulting in a trade on congressional information.

To facilitate the monitoring of the flow of information from Congress, we therefore recommend the following addition to the STOCK Act:

Political intelligence firms, lobbying firms that engage in political intelligence-gathering activities, and organizations performing similar activities shall register with the SEC and provide detailed information on their identities, their focus of activity, their contact information, and corresponding information on their clients -- which data shall be updated annually, or in the event of a change of status of a client or former client, within 48 hours of such change occurring. All such disclosures shall be maintained in an up-to-date, publicly accessible electronic database.

That said, the other provisions are so important that we would not want a focus on political intelligence firms to delay or divert progress on the rest of the STOCK Act.

Foolish humility
We readily admit that the above suggestions are not cure-alls to the bad acts occurring in Congress generally, or trading on congressional knowledge in particular. The authorities will not always detect improper trading, and, to the extent that prosecutorial discretion is often the better part of prosecutors not-getting-fired-by-their-bosses, even a properly anointed regulator may not take aggressive action against any but the most egregious violations. Nevertheless, the provisions we recommend should go a long way toward treating congressional insiders as they ought to be -- subject to the same limitations on improper trading that apply to the rest of us.

At the time thisarticle was published Lawrence Greenberg is general counsel for The Motley Fool.Rich Smithis a Motley Fool contributor. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

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