If this spirit is ever corrupted to the point that it will tolerate a law which does not apply to both the legislature and the people, then the people will be prepared to tolerate anything but liberty.
—FEDERALIST
NO. 57
Nearly all men can stand adversity, but if you want to test a man's character, give him power.
—ABRAHAM LINCOLN1
THERE IS SOMETHING inherently wrong with a professional athlete gambling on his own game. It's unethical because he can influence the outcome of the game and profit from his manipulation. Such gambling is banned in every major sport since it threatens the integrity of the game and runs against our sense of justice.
Very few of us are professional athletes—I have enough problems on the treadmill—but all of us are governed by laws, codes, and rules concerning conflicts of interest.
In the financial world these regulations are everywhere. If you are an investment adviser, for example, you are required to disclose not just actual conflicts of interest, but also potential conflicts of interest. It you own stock in a company and you recommend that stock to others, you had better tell them that you stand to gain if they take your advice. Failure to do so can land you in a lot of legal trouble. If you are a bank regulator, you are not allowed to conduct so much as a simple bank examination if you happen to own any stock in that particular bank.
If you are a federal judge, the law requires that you recuse yourself from cases involving any company in which you own more than $30 worth of stock. If you don't, it's a felony.
On the U.S. Supreme Court, justices recuse themselves all the time for this very reason. Sometimes there is no direct conflict, yet propriety causes members of the court to be extra-careful. In May 2008, for example, four justices recused themselves from considering a case that involved compensation on behalf of citizens of South Africa from more than fifty American companies that were doing business in the country. Apparently the justices believed even the appearance of a remote link with any of the companies might raise concerns. When a case involving Disney World was brought for review before the Supreme Court in March 2008, Justice Samuel Alito recused himself because he owned Disney stock.2
The ancient Roman symbol of justice, the goddess Justitia, was often portrayed carrying scales and a sword and wearing a blindfold. These objects are meant to symbolize fairness, justice, and impartiality.
The executive branch of the federal government follows similar ethics rules and laws. If you work for a government agency like the Federal Communications Commission "you may not have a financial interest in any company engaged in the business of radio or wire communication."3
Don't even consider actively trading stocks based on executive-branch knowledge. The Securities and Exchange Commission recently launched investigations into two of its own employees who may have traded stock based on inside information. One of the employees, an SEC attorney, sold all of her shares in a large health care company two months before an investigation of that firm was opened. She also sold all her shares in an oil company two days before a colleague began an inquiry into that firm. Another attorney allegedly "traded in the stock of a large financial services company" while the SEC had an ongoing investigation into the firm.4
Conflict-of-interest laws are not limited to the federal government. School superintendents across the country are expected to make financial decisions that are to the benefit of their districts—not themselves. If they fail to do so, they can be charged with violating state laws. This applies even if they receive only an indirect financial benefit from their actions. Award a school contract to a relative's company and you will get in trouble.5
Even nonprofit organizations are required by the IRS to comply with conflict-of-interest laws. Failure to do so is a punishable offense. And certainly in the private, for-profit sector every large corporation has rules on conflicts of interest. If you use corporate resources for your personal benefit it is generally considered fraud, and you may find yourself in legal trouble. If you don't believe me, just ask former Tyco CEO Dennis Kozlowski. He was convicted in 2005 of accepting millions of dollars in unauthorized bonuses, among other improprieties, and he is serving a jail sentence as a result.
If you work for a major accounting firm, you are asked not to own stock in the companies you are auditing. An accountant must swear a professional oath to "hold himself or herself free from any influence, interest, or relationship in respect to his or her client's affairs, which impairs his or her professional judgment or objectivity."6
Corporate executives and officers are expected to reveal conflicts of interest and recuse themselves from decisionmaking that might personally benefit them. They are required by law to report to the SEC any transactions involving corporate stock within forty-eight hours of the transaction.
Many companies have codes of conduct for all employees that prohibit owning shares in a competing firm or supplier, or working for a competing firm or supplier. The conflict of interest is obvious.
If you work for a reputable news organization, chances are that conflict-of-interest rules quite clearly guide your portfolio. The New York Times has a strict policy on stock ownership. "No staff member may own stock or have any other financial interest, including a board membership, in a company, enterprise or industry about which she or he regularly furnishes, prepares or supervises coverage. This restriction extends beyond the business beat. A book editor may not invest in a publishing house, a health writer in a pharmaceutical company or a Pentagon reporter in a mutual fund specializing in defense stocks." The fear is, of course, that reporters might slant their reporting because of their personal investments.7
These kinds of corporate policies are developed to comply with federal and state laws. The Securities and Exchange Commission has actually gone after reporters who trade on their knowledge for personal gain. In the 1980s, Wall Street Journal reporter Foster Winans was the subject of a probe for taking money in exchange for stock tips. He was passing information in not-yet-published columns to a broker who traded on the information. Winans reportedly made less than $30,000 on the scheme. Nonetheless, the SEC said the reporter "violated [the law] by reason of his failure to disclose to readers of his column his financial interest in the securities about which he wrote and his intent to profit from the rise or fall of the market in such securities following the publication of the column in the [Wall Street] Journal." Winans spent eight months in jail.8
There has been a proliferation of ethics rules in the decades since Watergate, beginning with the Ethics in Government Act of 1978. At the same time, Congress, the SEC, and the Supreme Court have strengthened insider trading laws. So it is perplexing that, despite all the ink spilled to address ethics in government and insider trading, members of Congress and their staffs have floated above the fray. Politicians understand both the specific issue of insider trading and the larger issue of conflict of interest—when it suits their purposes. When U.S. District Judge Martin Feldman ruled to overturn the Obama administration's six-month moratorium on deep-water drilling in the Gulf of Mexico, six senators asked for an investigation. Judge Feldman owned stock in Exxon at the time.9 In another instance, senators went after medical researchers who were given government grants for pharmaceutical research while also receiving research money from drug companies. The senators questioned the ability of the researchers to be impartial. Of course, these senators said nothing about their colleagues (or themselves) trading these very same stocks while writing energy or health care policy.10
When it comes to lawmakers applying the conflict-of-interest standard to themselves, everything changes. Congress writes the laws and polices itself. Or doesn't, as the case may be.
The U.S. Constitution gives authority to the House and Senate individually to "determine the rules of its proceedings, punish its members for disorderly behavior, and, with the concurrence of two thirds, expel a member."11 Congress has taken this paragraph and run with it. A 2011 ethics report prepared for Congress begins by boldly stating that the House and Senate each have "sole authority to establish rules ... punish and expel Members."12
They have legislated themselves as untouchable as a political class.
Members of Congress and their staffs are effectively considered exempt from many of the laws they define for the rest of us, and from executive-branch regulation. We ask our legislators to share power with the executive branch, and that means we do not let the latter rule over the former. Thus the Securities and Exchange Commission has a Division of Enforcement to go after private-sector insider trading (among other crimes), but the SEC cannot touch members of Congress. A former senior counsel with the SEC's Enforcement Division says of congressional insider trading, "It may be unethical, and it may be unseemly, but it's not illegal."13 The four- and five-hundred-page House and Senate ethics manuals are silent on the matter of insider trading. The idea of using market-moving, inside-government information and trading stocks based on that information is simply not mentioned. (The senate manual does have an entire chapter on the use of the mail and Senate stationery for personal purposes, however.)14
The Senate pretends to take conflicts of interest seriously. When Senator Tom Coburn of Oklahoma was elected to the Senate in 2004, he asked to be able to continue to serve as a family physician, part time, on the side. The Senate Ethics Committee ruled that this would pose a conflict of interest and told him to shut his office down. God forbid we should have a senator making a little money as a doctor.15
The House ethics manual notes that there may be cases when legislation may affect the price of stock shares owned by a congressman, but adds that a member should not necessarily recuse himself from a vote, since by doing so he might be "denying a voice on the pending legislation."16
In other words, when a member of Congress trades stock based on information not yet shared with the public but revealed to him as part of congressional business, it is legal. It is even deemed "ethical." It can also be very, very lucrative.
Some economists argue that insider trading laws should be abolished. Professor Henry Manne, for example, makes this argument in his classic book Insider Trading and the Stock Market. Manne contends that insider trading gives corporate executives "positive incentives" to increase stock values. Whether you agree with Manne or not, however, not even he believes that such latitude should be extended to politicians. In an e-mail to the website Procon.org, Manne writes: "In my 1966 book I said unequivocally that insider trading by any government official on information received in the course of their work should be outlawed. We do not want them to receive extra compensation or outside compensation for doing their job. And, of course, all too frequently their access to this information is merely another form of a bribe, and that sure as hell is not legal."
In Manne's mind we have it exactly backward in our current laws: corporate executives can't do it, but politicians can.
In fact, politicians and their staffers not only can trade on inside information they passively receive, they can do the equivalent of an athlete betting on his own game. They can and regularly do introduce legislation and then buy or sell stock in companies that will be affected by that legislation.
"It is difficult to imagine a more obvious betrayal of the public trust," writes Andrew George, discussing this practice in the Harvard Law and Policy Review. "It is even more difficult to imagine that such behavior could be completely legal."17 As Stephen Bainbridge, a law professor at UCLA, puts it, "Congressional insider trading creates perverse legislative incentives and opens the door to serious corruption. Yet, both Congress and the SEC have turned a blind eye."18 Congresswoman Louise Slaughter adds, "Congress and the federal government are now so enmeshed in the operations of our financial markets that the potential for abuse by members of Congress, congressional staff and federal employees is staggering."
So are there any limits on this bad behavior by our lawmakers? If you ask a member of Congress, he or she will insist that financial disclosure requirements are sufficient. Politicians must disclose their financial transactions once a year for the previous year. In practice, however, as we have seen, it's nearly impossible to link their trades with contemporaneous legislative activity at such a distance. They can, and often do, file for extensions, meaning that their disclosures come, in some instances, eighteen months after they traded shares. Transactions are also reported in broad general ranges, making it difficult to establish volume price and profitability. Then there is the added problem that many politicians submit incomplete forms, obscuring either the dates or the amounts of their transactions.
Disclosure statements may actually encourage conflicts of interest and embolden politicians who believe that since they report a certain transaction, it becomes okay to do it. Indeed, several studies by behavioral economists demonstrate that disclosures may make things worse, by producing "perverse incentives": once politicians sign a form, they may believe they are free and clear to do what they want.19
***
So much for insider trading. What about broader conflicts of interest?
There are conflict-of-interest rules that apply to everyone in the executive and judicial branches of government, from the file clerk to the truck driver to judges to the secretary of defense. They are supposed to apply to the President too, and when it comes to personal finances, it does. But it is not illegal for a President to put fundraisers in charge of dispersing grants and loans to contributors and friends. Were a school superintendent to do this, he or she would be charged. But for a President? That's okay.
But these rules do not apply to legislators. They have their own. For the U.S. Senate, when it comes to raising conflict-of-interest concerns, the bar is set amazingly low: as long as a senator can prove that at least one other person besides himself benefits from a particular decision, he can pretty much use taxpayer money to enhance his own financial interests. The House rules are even worse. There is no such requirement.20
What this means on a practical level is that politicians can and often do use taxpayer money to help their own businesses and enhance the value of their own real estate. They can procure federal funds to develop a site where they own a sizable chunk of real estate. As long as it also benefits a neighbor, this is entirely acceptable. A member of Congress can secure federal transportation money and extend a light rail transit system right in front of her own commercial building and it is acceptable. Were a corporate executive to do this with corporate funds, she would more than likely be in trouble.
If you work anywhere in America—a corporation, the government, or the nonprofit sector—there are whistleblower laws to protect you if you report financial crimes. In 1989, federal ethics rules protected whistleblowers from retaliation if they exposed financial corruption in government. The Sarbanes-Oxley Act of 2002 extended those same protections to corporate America and nonprofit organizations. If you see your boss engaging in insider trading or fraud, you can report him to the authorities and you will be protected from retaliation. But Congress conveniently exempted itself from those requirements. Its members are effectively the only group of powerful people in America who can retaliate against whistleblowers who expose their financial crimes.
Another example: extortion, a crime defined as a person getting or attempting to get money, property, or services from someone through coercion. That coercion may include the threat to harm someone, physically or otherwise.
When ordinary Americans engage in extortion, they get arrested. Consider the case of a Bradenton, Florida, businessman who owned a tanning spa. One customer claimed that she was burned by his tanning lamps, and she sued him. The case was settled by his insurance company. The businessman was upset, however, and after the settlement he sent a letter to her two attorneys demanding $5,000 from them or else he would send complaint letters to local and state agencies, the state bar association, and the attorney general's office. The attorneys called the police. The businessman was arrested for attempting to "extort money" from the lawyers.21
Politicians have the power to extract wealth and favors based on their ability to help or harm people. While not as explicit as the extortion by the tanning spa owner, congressional extortion goes on regularly in Washington. When they want campaign contributions or preferential treatment, members of Congress may threaten businesses or individuals with harmful legislation. There is a name for this type of coercion: "juicer bills" or "milker bills," designed to "juice" and "milk" campaign contributions and favors from businesses and industries. Professor Fred McChesney, who teaches law at Northwestern University, says this is nothing short of "political extortion." Politicians threaten to tax something or regulate something in order to extract a campaign contribution, or even for personal financial gain.22
How powerful is this weapon? The mere threat of adverse legislation can affect a company's stock price. Two academics looked at thirty cases in which businesses were threatened with political action and the threats were later retracted. The study found that those threats "significantly" affected the stock prices of companies.23
Milker bills are often introduced in the area of taxes, says McChesney. Members of Congress threaten to impose a new tax and then withdraw the bill after campaign contributions flow in. Of course, the contributions were the point in the first place.
In the summer of 2006, Senate Majority Leader Harry Reid announced that he wanted a tax hike on hedge funds. At the time those funds were taxed at the capital gains rate of 15%. Reid declared that Democrats would put at the top of their agenda taxing hedge fund profits as regular income rather than as capital gains, meaning rates of 25% or higher. So they began working on legislation.
In late January 2007, shortly after the Democrats had captured both houses of Congress, Senator Charles Schumer sat down to dinner with a number of top hedge fund managers at Bottega del Vino in Manhattan. The net worth of the managers at the table totaled more than $100 billion. As the New York Times recounted, hedge funds up to this point had spent very little money on lobbying and campaign contributions. They were quite content to be left alone by Washington. But Schumer, who headed the Democratic Senatorial Campaign Committee, wanted to change that. And with the threat of a tax increase, suddenly the hedge funds became very generous. According to the Federal Election Commission, over the course of the next eighteen months, hedge funds dumped nearly $12 million into campaign accounts—with 83% of the money going to Democrats. John Paulson, one of the most successful hedge fund managers, held fundraisers for the Democratic Senatorial Campaign Committee. James Simons, a hedge fund manager who made $1.7 billion in 2006 alone, donated $28,500 to the DSCC, and Schumer raked in $150,000 for his campaign chest. Bain Capital and Thomas H. Lee Partners, both Boston-based investment houses with hedge funds, gave generously to Senator John Kerry.
PAY UP, OR ELSE
The political class also profited indirectly, because the hedge funds hired lobbyists, often the friends and former aides of politicians, to fight the bill. The Blackstone Group, which manages a huge hedge fund, had previously spent $250,000 a year on lobbying. Now Blackstone hired a number of Democratic Party lobbyists, including Schumer's former staff counsel, and spent more than $5 million on lobbying in 2007 alone. The Managed Funds Association, a lobbying group for hedge funds, also hired Democratic Party lobbyists, including a firm that employed Schumer's former aide for banking issues. Overall, dozens of former Democratic congressional staffers were hired with lucrative contracts to fight the bill.
Then, in the late fall of 2007, Senator Reid and his colleagues suddenly changed their tune. The Senate schedule, it seemed, was just too crowded to deal with the issue. The threat of a tax increase for hedge funds was withdrawn.
Politicians are so good at throwing their weight around that the banking industry had to lobby for legislation that would prohibit banks from lending to congressional candidates during election time. Why would they do that? Presumably out of fear that politicians would pressure them for special deals.
In our system of government, the legislative branch polices itself and the President is allowed to skirt conflict of interest laws because, well, he's the president. It is time for that to change.