Conflict of interest
How politicians and even federal judges get away with 'insider' trading
Nancy Pelosi, hedge fund manager
Have you been noticing that a lot of finance meme accounts have been posting about Nancy Pelosi recently? That’s because many in the twitter-sphere are responding to how she’s been able to invest in companies while at the same time voting on policies that can affect them.
Pelosi has become a regular feature on the biggest financial meme pages such as Litquidity and Parik Patel and investing TikTok accounts are getting tens of thousands of views on clips about Pelosi's moves in the market. But why?
How it all began
Central to the story of how Pelosi became the biggest meme on Wall Street is US legislation that forces lawmakers to disclose their and their family's trading activity. It means the general public can view Pelosi's - or, more specifically, Pelosi's husband's - often highly successful trades.
Pelosi has reported many stock trades carried out by her husband, Paul, over the last few years. But his trading activities shot into the news in July, when he made a cool $5.3 million by exercising call options that let him buy 4,000 shares of Google parent company Alphabet GOOGL 0.00.
The trade was highly controversial. That's because it came just before the House Judiciary Committee voted on antitrust regulation, which ultimately wasn't seen as a big threat to the tech titans.
Spokespeople for Speaker Pelosi told media outlets at the time that she had no knowledge of the purchases and that she owns no stock herself.
Although she didn't break any rules, the trades were seen as fishy by many, and two memes based around Pelosi quickly sprung up. One is that the 81-year-old is a high-rolling, risk-taking star trader. Another is that she's making the big bucks off of insider information.
Insider trading and politicians
Insider trading, or the act of buying or selling investments based on nonpublic information, is against the law. At its core, insider trading unfairly enriches privileged parties at the expense of the investing public. It's stealing, and it has been illegal since 1934 – at least for corporate insiders.
So what does insider trading have to do with politicians?
Well, Congress' investment returns showed that trading on insider information on Capitol Hill has likely been a problem for decades. Cited in a 2010 University of California, Los Angeles report, "Insider Trading Inside the Beltway," U.S. senators outperformed the broader market by about 12% per year between 1993 and 1998.
The only brake on congressional stock trading is the Stop Trading on Congressional Knowledge Act of 2012 — a.k.a. the Stock Act — which prohibits members of Congress and their employees from making financial trades as a result of information they gleaned via their jobs, and demands that they reveal their trades within 45 days. (Paul, it should be noted, violated this law. A spokeswoman said his earlier failure to report was an oversight.)
The very idea that members of Congress and their spouses could trade stocks without eventually running into trouble, even unintentional trouble, is so ludicrous, only a nation with a high tolerance for political corruption would permit it. The problem is basic: It is almost impossible for federal legislators, if they’re investing in individual stocks, to not, at some point, at least look as if they’re engaging in insider trading.
The potential conflict of interest is blatantly obvious. Lawmakers should focus on the most efficient legislation and not what might best serve their financial interests. Sure, some laws achieve both, but voters shouldn't have to worry if their Washington representatives' stock portfolios would benefit from, or influence directly, their decisions as lawmakers.
It seems like common sense to insist that, in return for serving in Congress, members either put their portfolios in a blind trust or, even better, do what millions of Americans do and place their investments in funds that mimic indexes such as the S&P 500. One incentive: A number of them would most likely come out ahead.
The Stock Act might not have stopped members of Congress from stock trading, but at least one study, published in 2019, found that after its enactment the benefits of their doing so all but vanished. Another paper reported that members of Congress, like many short-term traders, ultimately do worse actively managing their portfolios than if they’d simply put the money in an index fund.
But the issue, obviously, is bigger than the Pauls. According to a survey conducted by the Pew Research Center late last year, two-thirds of Americans believe most politicians are corrupt. In Western European countries such as Britain and France, fewer than half of those surveyed said the same.
Trust is clearly not there.
Can’t beat’em, join’em
So what do you do when the market is experiencing tremendous volatility and it seems that politicians have the inside scoop? Do what they do it seems.
Young investors have a new strategy: watching financial disclosures of sitting members of Congress for stock tips.
So far this year, Senate and House members have filed more than 4,000 financial trading disclosures — with at least $315 million of stocks and bonds bought or sold. That's according to Tim Carambat, who in 2020 created and now maintains two public databases of lawmaker financial transactions — House Stock Watcher and Senate Stock Watcher. He says there is a significant following for his work.
"I knocked out a very, very simple version of the project in like a couple of hours. And I posted it actually to Reddit, where it gained some significant traction and people showed a lot of interest in it," Carambat said.
Dinesh Hasija, an assistant professor of strategic management at Augusta University in Georgia, has been studying whether the market moves based on congressional disclosures. His ongoing research suggests that it does.
"Investors perceive that senators may have insider information," he said. "And we see abnormal positive returns when there's a disclosure by a senator."
In other words, Hasija's research shows that after the disclosures are published, there's a bump in the price of stocks bought by lawmakers.
At least one financial services consultant, Matthew Zwijacz, is planning to set up a financial instrument that automatically tracks congressional stock picks, because, in his view, lawmakers are "probably privy to more information than just the general public."
Both investors and government watchdogs are interested in these trades because of the possibility that lawmakers could use the private information they obtain through their jobs for money-making investment decisions.
"If the situation is that the public has lost so much trust in government that they think ... the stock trades of members are based on corruption, and that [following that] corruption could benefit [them]. ... We have a significant problem," said Kedric Payne, senior director of ethics at the Campaign Legal Center.
A surge of interest following congressional financial disclosures came near the beginning of the COVID-19 pandemic, when a flurry of reports indicated that lawmakers sold their stocks right before the financial crash.
NPR reported how Senate Intelligence Committee Chairman Richard Burr privately warned a small group of well-connected constituents in February 2020 about the dire effects of the coming pandemic. He sold up to $1.72 million worth of personal stocks on a single day that same month.
There's a deep cynicism that forms the foundation of a trading strategy based on mimicking the stock picks of lawmakers and their spouses: the notion that politicians are corrupt and that you can't trust them not to engage in insider trading — so if the information is public, you might as well trade what they're trading.
Judge’s land in hot water
Conflicts of interest don’t just exist with politicians, they also apply to federal judges as well.
A Wall Street Journal investigation has found that 131 federal judges oversaw 685 court cases in the last decade involving companies in which they or their families owned stock.
Federal law since 1974 has prohibited judges from hearing cases that involve a party in which they, their spouses or their minor children have a ‘legal or equitable interest, however small.’ That law and the Judicial Conference of the U.S., which is the federal courts’ policymaking body, require judges to avoid even the appearance of a conflict.
About two-thirds of the identified judges ruled in favor of their financial interests when deciding contested motions and the judges were appointed by Democratic and Republican presidents. So you can’t give me that BS about how one side is better than the other in this instance.
Fifty-six of the judges contacted by the Wall Street Journal because of stock conflicts said they planned to notify parties in 329 lawsuits that they should have recused themselves.
That means new judges might be assigned, potentially upending rulings.
The judge with the most conflicts was Judge Rodney Gilstrap, chief of the U.S. District Court for the Eastern District of Texas. The Wall Street Journal found 138 cases assigned to him involving companies in which he or his wife held an interest.
Judges offered a variety of explanations for the violations. Some blamed court clerks. Some said their recusal lists had misspellings that foiled the conflict-screening software. Some pointed to trades that resulted in losses. Others said they had only nominal roles, such as confirming settlements or transferring cases to other courts, though there is no legal exemption for such work.
Some judges also said they had thought—wrongly, it turns out—that they didn’t have to recuse because stocks were held in accounts run by a money manager.
Clearly, they are wrong in this instance and if politicians weren’t creating enough buzz to this topic, this sure as hell added fuel to the fire.
You can read the full Wall Street Journal article here and if you don’t have access to it, I would recommend listening to the Wall Street Journal podcast episode on Spotify.
There need to be changes made. There is literally no excuse for members of congress, the house, or federal judges to have such conflicts of interest when it comes to stocks.
Black and white. Will regulation happen? Probably not. Put in another way, you’re basically asking a home burglar to create rules that would make it harder for him to break into the very house he’s trying to rob.
Ain’t gonna happen.
I know this is a different kind of article than what I normally publish but it’s something that just blew my mind and I had to share. I hope you enjoyed it and we’ll be going back to your normal paid programming.