Blind trusts, inside information, and the ‘mosaic theory’: Why charging members of Congress with insider trading is so fraught

It’s the kind of controversy that gives further ammunition to those who believe Washington, D.C., is a self-serving swamp that should be drained.

As the U.S. economy continues to take a pounding from the coronavirus pandemic, it’s emerged that some lawmakers may have parlayed information from private congressional briefings on the threat posed by the virus into potentially lucrative stock trades. If true, it would mean that before the stock market tanked from its all-time highs and tens of millions of Americans lost their jobs to the ongoing economic lockdown, members of Congress took privileged information on the impending damage and used it to enrich themselves—in effect, an act of insider trading.

Two senators in particular—North Carolina Sen. Richard Burr and Georgia Sen. Kelly Loeffler—have drawn more attention due to the size and nature of stock transactions made in their names. While both lawmakers have denied the allegations, both the Department of Justice and the Securities and Exchange Commission (SEC) are reportedly investigating whether there was any wrongdoing. Spokespeople for the Justice Department, the SEC, Burr, and Loeffler all declined to comment.

Should authorities uncover misconduct, it could prove the biggest test to date for the Stop Trading on Congressional Knowledge Act. Better known as the STOCK Act, the law has seldom been put to action since President Obama signed it into effect eight years ago.

The bill came about after a 2011 60 Minutes exposé revealed how members of Congress, through stock trades (as well as other financial maneuvers), were profiting from information that they gleaned on the job and doing so without consequences. So the STOCK Act reiterated that congressional officeholders were not, in fact, exempt from federal securities laws prohibiting insider trading—a legal gray area dating back to the passage of the Securities and Exchange Act of 1934.

“Prior to the STOCK Act, it was a source of controversy whether the existing securities laws applied to members of Congress,” according to Robert Kelner, chair of law firm Covington & Burling’s election and political law practice. 

While it was “theoretically possible” to pursue insider-trading cases against members of Congress before the STOCK Act, such cases “were difficult to bring,” adds Barak Cohen, a partner at law firm Perkins Coie and a former Department of Justice prosecutor.

“The STOCK Act made it clear that there’s a fiduciary duty that members of Congress owe with respect to material, nonpublic information, and makes it possible to bring those kinds of insider-trading cases,” Cohen notes.

Despite that clarification, STOCK Act cases have proven few and far between in the years since the law’s passage. Some congressional ethics investigations—like that of former Wisconsin Rep. Tom Petri, who owned stock in a defense contractor that he was advocating for on Capitol Hill—failed to rear criminal charges. Even former New York Rep. Chris Collins, who was recently sentenced to 26 months in prison after pleading guilty to charges of insider trading, wasn’t indicted under the STOCK Act. (Collins sat on the board of the pharmaceutical company involved in his case, rather than acting on information learned in his capacity as a congressman.)

But that could well change depending on what investigators looking into Burr’s and Loeffler’s financial dealings find, according to securities attorneys and government ethics experts who spoke to Fortune.

“The simple fact of the matter is that if you have insider info and you go and use it [to trade securities], it’s not yours to use,” according to Thomas Gorman, a partner at law firm Dorsey & Whitney who formerly served as senior counsel at the SEC’s Division of Enforcement. “If you’re a corporate officer, it belongs to the company and is supposed to be used by the shareholders. And if you’re a legislator, it’s not for your use; it’s for the public, and you’re supposed to be doing the public’s business.”

Taking stock

At the heart of the matter are stock trades executed by, or on behalf of, Burr and Loeffler in the wake of private Senate briefings on the evolving threat posed by the coronavirus in late January and early February. 

After the briefings, on Feb. 13—the day after the Dow Jones Industrial Average closed at an all-time high of 29,551 points, and before it began its steep descent into bear market territory—Burr sold up to $1.7 million worth of stock holdings, including stakes in hotel companies that have been ravaged by the coronavirus outbreak, ProPublica first reported.

Likewise, freshman Sen. Loeffler—who is the wife of New York Stock Exchange chairman Jeffrey Sprecher and the wealthiest member of Congress with an estimated net worth of $500 million—unloaded up to $3.1 million worth of stock in the three weeks following a Senate Health Committee briefing on Jan. 24, the Daily Beast first reported. By contrast, Loeffler did not disclose a single stock transaction between the time she took office on Jan. 6 (as the governor-appointed successor to former Georgia Sen. Johnny Isakson, who resigned due to health issues) and Jan. 23.

While both politicians have vehemently denied allegations that they profited off nonpublic information, their reasonings differ. Burr claims that in divesting his stock holdings, he “relied solely on public news reports to guide my decision.” (He also asked the Senate Ethics Committee to open an investigation into the matter, in the interest of “full transparency.”)

Loeffler, meanwhile, counters that she had no knowledge of the stock trades whatsoever. “I do not make investment decisions for my portfolio,” she said last month—noting that such investment decisions “are made by multiple third-party advisers without my or my husband’s knowledge of involvement.”

Other senators whose stock dealings have drawn attention in recent weeks—including Dianne Feinstein of California and James Inhofe of Oklahoma—have also claimed that their portfolios are managed by third parties and that they themselves had no knowledge of trades made on their behalf. Additionally, neither Feinstein nor Inhofe attended the Senate Health Committee briefing on Jan. 24, they claim.

Richard Painter, a professor of corporate law at the University of Minnesota who served as chief White House ethics lawyer during President George W. Bush’s administration, says that the scale of and circumstances around Burr’s and Loeffler’s trades demand closer scrutiny than those of other lawmakers.

“I think both of them crossed the threshold where, if I was at the SEC, I’d investigate,” Painter tells Fortune, citing the senators’ divesting of hotel and travel stocks and Loeffler’s investment in software and cloud-computing firm Citrix, which produces teleworking software. “It just looks fishy. If I were in the SEC’s enforcement division, I’d want some more information.”

A tale of two defenses

Assuming authorities are scrutinizing the senators’ stock dealings, then the diverging defenses offered by Burr and Loeffler could be put to the test in different ways, legal sources told Fortune.

For Loeffler, things are relatively straightforward, given that she claims she had no knowledge of the trades made on her behalf until after the fact. If that’s proven to be the case, it’s almost certain that she would be exonerated. Otherwise, investigators would have to determine whether or not she informed investment advisers of any material, nonpublic information gained in her capacity as a senator before the transactions were made—circumstances that could be revealed by digging into Loeffler’s phone records and emails.

In the case of Burr—who acknowledges that he himself made the stock trades in question—the situation is more convoluted. The onus would fall on investigators to prove that the senator specifically acted on nonpublic information gained through his position. But that’s easier said than done, as Burr—a 25-year Capitol Hill veteran who has chaired the Senate Intelligence Committee since 2015—could hypothetically fall back on the so-called mosaic theory defense in claiming that his decisions were informed by a variety of factors and sources of information.

“The difficulty [in pursuing STOCK Act cases] is that people in the legislative and executive branches are privy to a lot of inside information from many different sources, and are typically able to defend themselves by referencing a ‘mosaic theory’ of receiving information,” Perkins Coie’s Cohen notes.

Painter adds that, in Burr’s case, “the government has to show that the nonpublic information itself was material” to the stock trades pursued by the senator, and that they weren’t transactions that Burr “would have done anyway.”

Covington’s Kelner also points to “carve-outs” in Section 10 of the STOCK Act that, while not very clear, are “intended to protect members of Congress in engaging in their constitutional duties.” While no legislators have yet been indicted under the STOCK Act, Kelner believes that “it’s predictable that they would defend themselves based on those constitutional carve-outs.”

In general, congressional insider cases “are not easy cases to prosecute as a criminal matter,” Kelner adds. “Like anything, it’ll depend on the clarity of the evidence available.”

A matter of trust

The STOCK Act’s effectiveness as a piece of legislation remains up for debate—both in terms of preventing members of Congress from unduly profiting from their positions and also protecting legislators from legal liabilities that could see them unfairly end up in hot water.

For some observers, the simplest way to deal with the entire matter is to prohibit members of Congress from owning individual stocks in the first place, and, instead, restrict them to holding investments in broad-based mutual funds and exchange-traded funds. Loeffler announced her intention to do just that earlier this month, in response to the uproar over her stock trades. 

“What [the STOCK Act] didn’t do is simply tell members of Congress to not invest in individual stocks—that they should invest in mutual funds [instead]. That would solve this conflict of interest problem,” Painter says. “Why should members of Congress who own medical device stocks decide whether to repeal the medical device tax?”

Painter notes that statutes prohibiting such conflicts for executive branch employees already exist. Under Title 18 Section 208 of the United States Code, it is a criminal offense for members of the executive branch (except for the President and vice president) to participate in government matters in which they or their immediate family has a financial interest.

“That’s why I told [former Goldman Sachs CEO] Hank Paulson that he had to sell his Goldman Sachs stock to become Treasury Secretary [in 2006],” Painter recalls of his time as the Bush administration’s chief ethics lawyer. But in addition to exempting the President and vice president, he adds, the law also “doesn’t apply to members of Congress.”

In order to comply with 18 U.S. Code 208, as it’s more commonly known, many executive branch members place their assets, including stock holdings, in a blind trust. While Loeffler claims to have had no knowledge of the stock trades made on her behalf by investment managers, her holdings are not in a blind trust—an arrangement in which she would have no way of knowing or intervening in how her assets are being managed.

“My advice to clients is typically, if they’re in office or in a position where these laws apply, that a blind trust is an excellent way to protect themselves from liability,” Perkins Coie’s Cohen says.

But blind trusts do come with a stigma. “The general thinking is that blind trusts don’t tend to be invested very well,” Covington’s Kelner notes. “There aren’t many people comfortable with the idea of having no idea what risks they are exposed to.”

There is also the option known as a Rule 10b5-1 plan, which establishes a predetermined plan for purchasing or selling select securities and is often used by corporate insiders to comply with insider-trading laws. Along with blind trusts, 10b5-1 plans are among the most viable “safe harbors” available to politicians seeking to insulate themselves from insider-trading scrutiny, according to Dorsey & Whitney’s Thomas Gorman.

In Gorman’s estimation, because neither Burr nor Loeffler chose to adopt any of the measures designed to protect lawmakers from accusations of self-dealing, “the government has to investigate them” to determine whether or not there was any wrongdoing.

Should investigators find such evidence, it would be the STOCK Act which, while little used thus far, would be deployed to hold those lawmakers accountable for their actions.

“Without the STOCK Act, I’m not sure any regulators would be looking at stock trading by members of Congress,” Kelner says. “The hurdles were higher before. It would have been difficult to bring a case.”

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