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A Glaring Omission in the Senate's Insider Trading Bill: Fair Disclosure

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Poor Raj Rajaratnam. He's the billionaire hedge-fund manager who in October was sentenced to 11 years in prison for trading stocks on nonpublic information obtained from corporate insiders. If only his sources had been members of Congress or their staff and the nonpublic information had concerned pending legislation likely to affect certain stock prices, he would still be in business.

For it is perfectly legal for lawmakers and other federal officials to divulge information that, if made public, would be market-moving and thus gives anyone who trades on it a lucrative advantage over other investors. In fact, large hedge funds -- important donors to political campaigns -- aggressively seek such information, with some success, in private meetings with legislators and other officeholders.

For example, the Wall Street Journal recently reported that, in a December 2009 meeting with key lawmakers, a small group of hedge funds learned -- hours before it was announced -- that Senate Democrats had eliminated a proposed government-run insurance plan from the health-care reform bill. Although the hedge funds would not say how they used the information, the Journal notes that the news "was potentially worth millions of dollars to the investors," since it would boost shares of major health insurers, with whom the government plan would have competed.

Similarly, in January 2010, as the Senate debated the Dodd-Frank bill, which tightened financial services regulation, several hedge-fund managers met with Senator Dodd and discovered that, contrary to prevailing opinion, he did not favor capping fees on debit-card purchases. The expectation of a fee cap had been a drag on shares of Visa and Mastercard, since it would hurt their revenues. This material (or market-moving) news of Senator Dodd's position garnered by the hedge funds remained nonpublic for weeks.

Even though such activities are legal, it's hard to see them as ethical. From a moral point of view, they are no different from a kind of insider trading prohibited by law. In both cases, people whose positions in economically significant organizations give them access to market-moving, nonpublic information selectively pass it on to others who then carry out unfair market trades with counterparties ignorant of the traders' covert advantage.

The legal difference is that, unlike government officials, when corporate executives give inside information to others who trade on it, they violate a fiduciary duty to serve the best interests of their companies' shareholders. It is the breach of that legal duty that makes both the disclosure and the use of inside information criminal acts.

Congress appears ready to address this disparity. Last week, the Senate passed the Stop Trading on Congressional Knowledge (STOCK) Act, which declares that members of Congress and thousands of other federal workers are legal fiduciaries. Whereas corporate managers' fiduciary duty is to their stockholders, these government officials would have an analogous duty to Congress, the government, and all U.S. citizens. Ostensibly, if this provision becomes law, it will be illegal for covered officials to share material, nonpublic information with others they know are likely to trade on it.

But even if the bill is enacted in its current form, it almost certainly will not keep members of Congress and their aides from disclosing high-value information to hedge funds in private conversations. For one thing, what prosecutor could plausibly argue that a government official has the very same duty of "trust and loyalty" that a corporate manager has? The nature of federal officials' relationships with their institutions and fellow citizens is radically different -- in numerous ways -- from that of a business executive to her firm's shareholders. In any event, it is preposterous to think it would ever be Congress's intent that a law it passed prevent its members from consulting with investors for fear of revealing nonpublic information on which the investors might trade.

If there is an ethical disconnect here, what can be done about it? In the late 1990s, the Securities and Exchange Commission came under pressure from "Main Street" investors and shareholder advocates to stop public corporations from giving advance releases of earnings forecasts and other material information to favored investors before making it public. The SEC responded by adopting Regulation Fair Disclosure (Reg FD), which stipulates that, when a corporation provides market-moving information to any investors, it must make it available to all investors at the same time.

In approving Reg FD, the SEC argued that it is inherently unfair for only a few investors to receive material information and that the practice undermines the public trust in the fairness of financial markets. Clearly, if these arguments justify Reg FD, then they warrant a parallel requirement on government officials.

Of course, legislators and regulators need to discuss public policy matters with investors, including hedge funds. But why should members of Congress and other federal insiders be excepted from the same demand for fair disclosure the government has imposed on corporate officials?

Perhaps that's a question voters should be asking Senate and House candidates.

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