Insider trading is back in the news, although some would argue it never left. Last month, the U.S. House of Representatives passed the Insider Trading Prohibition Act, which seeks to create a new provision, Section 16A of the 1934 Securities Exchange Act, devoted to banning the trading of securities while “aware of material nonpublic information.” If the bill is enacted, it would represent the first time the phrase “insider trading” has been defined by congressional statute. Typically, charges of insider trading are brought under Section 10(b) and the SEC’s Rule 10b-5, which does not mention the term “insider trading” but instead broadly prohibits any device, scheme, or artifice used to defraud, as well as any untrue statement, or omission, of material fact in connection with the purchase or sale of any security.
With such a vague statutory standard upon which to establish liability for insider trading, the law of insider trading has been shaped almost entirely by common law, in the form of SEC administrative actions and judicial opinions. One of the reasons that regulation of insider trading is thorny is that it is not per se illegal to trade on inside information, especially in scenarios involving tippers and tippees. Pursuant to the foundational holding in Dirks v. SEC, in order to obtain a conviction for insider trading based upon a tipper-tippee theory, the government must prove that the tipper received a personal benefit for the tip, and that the tippee knew about that benefit.
The last five years of blockbuster insider trading cases have focused on this seemingly nebulous personal benefit test, and the Supreme Court has been unable to clear the muddy waters. For example, in 2017, the Supreme Court, in an unsurprisingly unanimous decision in Salman v. United States, reaffirmed the holding of Dirks, yet failed to elucidate the more problematic application of the personal benefit test in situations where the tippee is not a trading relative or friend. After Salman, the Second Circuit wrestled with the personal benefit test in Martoma, but remained faithful to the Dirks standard. The table gives a shorthand account of the arc of jurisprudence regarding the personal benefit test.
|Elements of Personal Benefit Test for Tipper-Tippee Liability
|Powell’s three examples of a personal benefit:
1. Pecuniary gain, OR
2. Reputational gain, OR
3. Presumption of benefit due to close friend or family relationship
|2d Circuit, 2014
|1. Relationship (Dirks’ #3) must be meaningful and close; AND
2. Include pecuniary gain, essentially folding Dirks’ #3 into Dirks’ #1.
|Abrogates Newman’s holding that Dirks’ #3 (relationship presumption) also requires pecuniary gain
|2d Circuit, 2018
|Reads Salman’s abrogation of Newman to mean that the relationship of Dirks’ #3 does not need to be close or meaningful. Any relationship will meet the Dirks’ #3 test.
|2d Circuit (NOT en banc), 2018
|Backtracks on previous holding that any relationship creates a presumption of personal benefit. Holding stands because court can find Dirks’ #1 (pecuniary gain) = harmless error
As a result of these and other decisions, the parameters and definitions of insider trading remain hard to pin down and often shift depending on the facts of the most recent case. Legislative proposals have faced similar challenges. Although the proposed Insider Trading Prohibition Act may seem to present a fix on its face, it would essentially codify existing common law without clarifying the definition of a personal benefit.
In a forthcoming article, The New Insider Trading, I suggest that the hubbub in the courts and legislatures over defining insider trading – sure to reach a fever pitch the next time a cert petition on the issue is granted or a new bill proposed – may be misguided. This is because there may be a simpler way to bring an insider trading case. Since the passage of Sarbanes-Oxley, there has been a somewhat sleepy provision of the criminal code that could present an end-around to the morass of insider trading precedents under Rule 10b-5. Under 18 U.S.C. §1348, the government can bring an insider trading case under the more general umbrella of securities fraud, which has scant jurisprudential precedent with regard to insider trading prosecutions.
The elements required to prove a charge under §1348 are similar to other fraud-based offenses such as mail and wire fraud, health care fraud, and bank fraud, and require only that the government prove the existence of a scheme or artifice to defraud, and the intent to defraud, in connection with the purchase or sale of a security. Practically speaking, this means that the heavily-litigated personal benefit test found in Dirks may not apply to a charge of insider trading under §1348.
A case argued in the Second Circuit last November and affirmed on December 30 highlighted this alternative method of charging insider trading. In United States v. Blaszczak, the defendant was acquitted of insider trading under the traditional Rule 10b-5 charge, but was found guilty under 18 U.S.C §1348. In other words, the jury awarded convictions for securities fraud only under §1348 and not Rule 10b-5, despite the charges emanating from the same set of facts and activity. The explanation for this outcome at the district court lies in the potentially problematic jury instructions. The jury instructions for Rule 10b-5 consisted of nearly 20 pages of transcripts and required the jury to address 10 specific issues related to whether the defendants had a duty of trust and confidentiality to the company, whether there was a personal benefit granted in the exchange of information, and whether the tippees knew of that personal benefit. In short, if the jury could answer “no” to any of the questions related to the elements of Rule 10b-5 and its interpretation under Dirks, it would acquit the defendants on that charge. And it did. In contrast, the jury instructions related to §1348 were sparser, and consisted of only four pages of transcript. The government only needed to show that there was a “scheme of artifice to defraud,” intent to defraud, and a connection to the purchase or sale of a security. Hence, a standard tipper-tippee insider trading case garnered a conviction only under §1348 and not Rule 10b-5.
The Blaszczak case and others like it raise significant questions about the regulation of insider trading. One major question is whether the definitions of insider trading, including personal benefit, should be imported from §10(b) precedents into §1348 cases. Under our current common law, conduct that constitutes Rule 10b-5 criminal insider trading under the tipper-tippee theory exists only if the elements of the Dirks test are met. If those definitions are not imported into the broader securities fraud regime of §1348, then §1348 ostensibly is creating a new scheme and definition of tipper-tippee insider trading.
Another fundamental issue is that proving the elements for §1348 likely is less burdensome than for proving those of §10(b), as evidenced by Blaszczak. The practical consequence of this burden inversion is that it is much easier to convict for criminal securities fraud than it is for civil insider trading, despite both charges arising from the same set of facts. This means that a civil action brought by the SEC under §10(b) will be harder to prove, despite the lower burden of proof, than the criminal action brought under §1348 for the same alleged activity. Insider trading regulation under Rule 10b-5, or under the newly proposed legislation, which retains and codifies the Dirks personal benefit test, may be bypassed entirely by §1348 and general securities fraud prosecutions.
This post comes to us from Karen E. Woody, an assistant professor at Washington & Lee University School of Law. It is based on her recent paper, “The New Insider Trading,” forthcoming in the Arizona State Law Journal and available here.