Background: Dirks, Tipping Liability and the Personal Benefit Test
In Dirks v. SEC,2 the Supreme Court established the legal framework for finding tipper/tippee liability under the Securities Exchange Act of 1934, as amended (Exchange Act), Section 10(b) and Rule 10b-5: when an insider breaches a fiduciary duty or misappropriates information by disclosing material nonpublic information to a tippee, the tippee inherits a duty to disclose or abstain from trading. Whether an insider’s disclosure is a breach of duty depends in large part on the personal benefit the insider received as a result of the disclosure.3
The Ruling: Blaszczak Differentiates Exchange Act Securities Fraud from Criminal Wire Fraud and Criminal Securities Fraud under Title 18
Blaszczak was a consultant and former employee of the Centers for Medicare & Medicaid Services (CMS) who received confidential government information from his former colleagues at CMS. Blaszczak then passed the information to two hedge fund managers who traded on the information, earning millions of dollars in profits. Federal prosecutors brought various charges, including securities fraud under the Exchange Act (referred to in the decision as “Title 15 securities fraud”),4 securities fraud under a criminal statute adopted as part of the Sarbanes-Oxley Act5 and wire fraud.6 Following trial in the U.S. District Court for the Southern District of New York, the jury acquitted all defendants with respect to the Exchange Act securities fraud offenses and found certain of the defendants guilty with respect to the wire fraud and Title 18 criminal securities fraud offenses.
One of the questions raised on appeal to the Second Circuit was whether the “personal benefit” test established in Dirks applies in Title 18 criminal fraud cases.7 The two judges in the majority — with no apparent disagreement on this issue by the dissenting judge — answered this question in the negative, declining to extend Dirks beyond the context of the federal securities laws. In reaching this position, the Second Circuit compared and contrasted the history and purpose of the securities fraud offenses codified in the Exchange Act and Title 18’s wire and securities fraud provisions. (Title 18 is the location of most criminal prohibitions under federal law, including these and other fraud provisions.) Each provision relates to schemes to “defraud,” and courts have found each of them to encompass embezzlement or misappropriation theories of fraud, that is, that the “undisclosed misappropriation of confidential information, in breach of a fiduciary or similar duty of trust and confidence, ‘constitutes fraud akin to embezzlement.’ ”8 However, the Second Circuit went on to characterize the Dirks personal benefit test as a “judge-made doctrine premised on the Exchange Act’s statutory purpose.”9 In Dirks, the Supreme Court stated that “a purpose of the securities laws was to eliminate ‘use of inside information for personal advantage.’ ”10 The Second Circuit thus concluded that the personal benefit test arises not from the embezzlement theory of fraud but instead from the purpose of the Exchange Act’s antifraud provisions.
While the wire fraud statute applies generally, with no particular focus on securities fraud, the Title 18 securities fraud provision does share that focus with the Exchange Act. However, the Second Circuit examined the legislative history behind the Title 18 securities fraud provision’s adoption and concluded that “Section 1348 was added to the criminal code by the Sarbanes-Oxley Act of 2002 in large part to overcome the ‘technical legal requirements’ of the Title 15 fraud provisions,” explaining that “Congress intended for Section 1348 to ‘supplement the patchwork of existing technical securities law violations with a more general and less technical provision, with elements and intent requirements comparable to current bank fraud and health care fraud statutes.’ ”11 Having concluded that the statutory purpose of the Title 18 securities fraud provision is broader than that of the Exchange Act securities fraud provision, the Second Circuit declined to “graft” the Dirks personal benefit test onto either of the Title 18 fraud provisions at issue.
Context: Tipping Liability and the Personal Benefit Test under the Exchange Act in Recent Years
The ability to prosecute insider trading under Title 18 without satisfying the Dirks personal benefit test may be particularly useful to the government because the relevant law under Section 10(b) of Title 15 has been in flux in recent years.12 The Supreme Court has held that a tipper breaches a fiduciary duty by making a gift of confidential information to a trading relative, on the theory that the tipper derived a personal benefit from the transaction as a result of the close relationship between tipper and tippee.13 However, uncertainty remains under the Exchange Act as to how close a nonfamilial relationship must be, or what other objective criteria of personal benefit must exist in the absence of a clear financial benefit or familial relationship, for a jury to infer that a tipper has derived a personal benefit from disclosing information to a tippee.
Blaszczak Finds that Information about Pending Regulations Is “Property” for the Purposes of Wire Fraud and Title 18 Criminal Securities Fraud
Both the wire fraud and Title 18 criminal securities fraud statutes require that the victim of the fraud be deprived of “property.” Blaszczak argued that on the facts of this case, CMS’s interest in the information about its pending regulatory changes was not the kind of “property” that either statute was intended to protect. CMS did not intend to use that information in any of the ways that a private party would use confidential information; its interest in the information was purely regulatory. However, the Second Circuit majority held that the information was “something of value” and the government had “the right to exclude” unauthorized persons from obtaining that information, which was sufficient to give CMS a property right in that information. Judge Amalya Kearse disagreed with this part of the majority’s holding and, for that reason, dissented from the majority’s decision. She argued that there was no conversion of anything that could be properly characterized as property. The fact that the decision was split increases the possibility that the Second Circuit might review the case en banc (which it does far more rarely than other circuits) or that the Supreme Court might accept an appeal of the decision, although in either event such review might be limited to the property question that split the panel.
Potential Impact of Blaszczak
In light of the absence of a clear framework regarding how a personal benefit may be established under Dirks, the Blaszczak ruling will likely result in the Department of Justice’s (DOJ) increased reliance on Title 18’s fraud provisions in prosecuting criminal insider trading cases involving tipping. There are several notable differences between the Exchange Act and Title 18 securities fraud provisions in addition to those discussed above. For example, while both civil and criminal charges may be brought under the Exchange Act, only criminal charges may be brought under Title 18. As a result, while the DOJ may bring charges under either provision, the Securities and Exchange Commission (SEC) can bring only civil charges under Exchange Act Section 10(b) and Rule 10b-5. It seems odd that DOJ could successfully bring suit to enforce insider trading laws in situations where the SEC (the expert agency) cannot.
In early December 2019, the U.S. House of Representatives passed the Insider Trading Prohibition Act with a huge bipartisan majority. The Insider Trading Prohibition Act would codify the law of insider trading under the Exchange Act — a body of law that has been largely judge-made over the past 60 years. The “personal benefit” issue was a notable bone of contention in the House; an early version of the bill (drafted with SEC input) would have abolished the “personal benefit” test. But an amendment on the House floor restored a version of a personal benefit requirement, although it is not clear exactly how the courts would interpret that requirement. If the Senate takes up the House bill (which is highly uncertain at this time), it remains to be seen whether it would keep a personal benefit test or whether it would apply its concepts to Title 18 criminal insider trading cases in addition to the Exchange Act.
- Expect more criminal prosecutions of insider trading cases, particularly tipping cases, under Title 18.
- The DOJ may be more likely to prevail on Title 18 charges than on Exchange Act charges.
- Companies and firms active in the securities markets should caution their management, board members, employees, contractors and affiliates that disclosure of material nonpublic information even to unrelated persons may create criminal risk for tippers and tippees in broad circumstances.
1 No. 18-2825 (2d Cir. Dec. 30, 2019).
2 463 U.S. 646 (1983).
3 Dirks at 647.
4 15 U.S.C. § 78j(b).
5 18 U.S.C. § 1348.
6 18 U.S.C. § 1343.
7 The other question raised on appeal was whether a government agency’s confidential nonpublic information relating to its contemplated rules may constitute “property” in the hands of the government for purposes of the wire fraud and Title 18 securities fraud statutes. See below for a discussion of this question.
8 Blaszczak at 27-28, quoting United States v. O'Hagan, 521 U.S. 642, 654 and citing United States v. Chestman, 947 F.2d 551, 566–67, 571 (2d Cir. 1991) (en banc).
9 Blaszczak at 28.
10 Dirks at 662, quoting In re Cady, Roberts & Co., 40 S.E.C. 907, at 912, n. 15 (1961).
11 Blaszczak at 31, quoting S. Rep. No. 107-146, at 6 and 14 (2002).
12 See, e.g., United States v. Newman, 773 F. 3d 438 (2d Cir. 2014); U.S. v. Salman, 792 F.3d 1087 (9th Cir. 2015); U.S. v. Martoma, 869 F.3d 58 (2d Cir. 2017) (Martoma I); U.S. v. Martoma, 894 F.3d 64 (2d Cir. 2018) (Martoma II).
13 Salman v. United States, 137 S. Ct. 420 (2016).
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