The Fine Line Between Political Intelligence and Insider Trading

Life in Washington is all about information – who will support or oppose an initiative, how will an agency address an issue in its rules, and when will a decision be announced. The pervasive role of the government in the economy makes that information particularly valuable to investors. And that can lead some to get a jump on the market if they learn about changes in policy before others.

“Well-timed” trading before a public disclosure of material information has all the hallmarks of insider trading. The problem is that the imprecise rules governing insider trading are an ineffective means to regulate how political intelligence firms gather, analyze and selectively disseminate such information to their clients.

Political intelligence has become a hot topic these days because of its potential to move markets. Last week, The Wall Street Journal reported about an investment firm in Washington that correctly predicted a decision by the government about reimbursement of Medicare costs; that information led to a jump of more than 6 percent in the shares of health insurers before the close of trading.

While that certainly looks questionable, trying to regulate firms that seek government information is difficult because of the lack of a definition of what constitutes “political intelligence” that would distinguish it from the ordinary analysis of governmental operations. A report issued by the Government Accountability Office points out just how hard it would be to try to adopt workable rules for the industry whose sole purpose is to gather such information.

Congress mandated the report as part of the Stock Act – for Stop Trading on Congressional Knowledge – passed last year in response to reports that some legislators were reaping outsize gains on their investments. The law made it clear that Congress and its staff members must obey laws that prohibit insider trading, something that wasn’t clear before last year. A Senate proposal to mandate disclosure by political intelligence firms was scuttled in favor of the Government Accountability Office report, a classic means of burying an issue.

In conducting interviews with firms dealing in government information, the Government Accountability Office found that “the prevalence of the sale of political intelligence is not known and is therefore difficult to quantify,” and that it can be “especially difficult to make a determination that a sale of nonpublic information has occurred.”

In addition to the difficulty in identifying what constitutes political intelligence, the report discusses the many hurdles that the Securities and Exchange Commission would face if it wanted to pursue an insider trading case based on information disclosed by a political intelligence firm to its clients (particularly if the firm itself does not trade directly on the information).

Political intelligence is a mix of public information and tidbits gleaned from interactions with government officials. Particular information may be incorporated into a broader discussion of political developments that is sold to a number of clients — not all of whom are engaged in stock market investing. The analysis often involves opinions about where the government might be leaning on a particular issue, so it might be hard for the government to determine what is nonpublic information and what is just an opinion about future government conduct.

The product sold as political intelligence deals with broad factors that affect an industry or segment of the economy, and rarely would the focus be on a specific company because legislation and administrative rules usually do not reach that level of detail. That makes the information quite different from what is usually seen in insider trading cases, which mostly involve nonpublic data about an individual company.

A crucial element in any insider trading case is proving the information received was both material and confidential. When dealing with political intelligence, the S.E.C.’s ability to prove each could be problematic.

So what constitutes “material” information? Broadly, it is data that a reasonable investor would consider important in deciding whether to act. The more general the information, the less likely it can be considered material.

Political intelligence may not meet the standard of “material” information when it is about broad trends in government policy. For instance, whether the Federal Reserve will continue to keep interest rates low would be difficult to link to a particular company’s prospects. And when confidential information is mixed with publicly available data, it becomes even harder to prove a political intelligence report met the required materiality standard.

A greater challenge would be showing that the information was confidential. Washington is rife with leaks, some of which are even planned as a means of sending up a so-called trial balloon to gauge public reaction to a new policy. So it might be difficult to show where the information came from or that a government official disclosed it in breach of a fiduciary duty in order to aid insider trading by the recipient.

In fact, it is questionable whether insider trading laws would even apply to the bulk of the analysis provided by political intelligence firms. In Dirks v. Securities and Exchange Commission, the Supreme Court noted that the role “analysts in general can play in revealing information that corporations may have reason to withhold from the public is an important one.” The same could be said about the disclosure of information about the government when its policies have a much greater impact on the public than any individual company.

Thus, the insider trading laws are a weak means of policing firms that specialize in gathering government information. The prohibition on insider trading is not crafted to deal with cases in which information about a broad segment of the economy could influence a decision about what type of investment to make.

Senator Charles E. Grassley said that he planned to introduce legislation to require political intelligence firms to register and disclose their contacts with government officials, highlighting the report about Medicare reimbursement as an example of the need for greater regulation. Increased disclosure by political intelligence firms might provide a number of benefits, if Congress can come up with a workable definition of what constitutes political intelligence that would not impact how journalists and other analysts scrutinize government policy.

The insider trading prohibition, however, would be ill suited as a means to police how these firms operate because of the many hurdles to proving a violation.