A major issue in United States v. Blaszczak, 2019 WL 7289753 (2d Cir.), was whether the government needed to prove the elements of a Rule 10b-5 tipping violation from Dirks v. SEC, 463 U.S. 646 (1983), when charging a tipper and tippees with the crimes of wire fraud and securities fraud in Title 18.  The Second Circuit’s answer was no.  In an insider trading case based on tipping charged as a Title 18 fraud, the government did not need to prove that an insider received a personal benefit in exchange for disclosing material, non-public information to an outsider.

The majority in Blasczcak committed serious legal errors in concluding that the Dirks test for tipping does not apply to the Title 18 frauds.  In a recent paper, I  address two of them.  The decision is another example of the misunderstanding of and hostility to the personal benefit element of Dirks evident in Salman v. United States, 137 S. Ct. 420 (2016), and United States v. Martoma, 894 F.3d 64 (2d Cir. 2018).  Dirks is besieged.

Liability of a Tippee for Fraud

The first problem with Blaszczak is that the majority spurned the Dirks test but failed to define the elements necessary to hold a tipper and tippee liable in a securities trading case for a Title 18 fraud.  The majority started on the right track by saying that Section 10(b) of the Exchange Act and the Title 18 frauds prohibit schemes to defraud and that the concept of fraud included embezzlement, which covered the undisclosed appropriation to one’s own use of confidential information, goods, or property in breach of a fiduciary duty of trust and confidence.  (*8)

Using an odd interpretation of statutory purpose, to which we will return, the Blaszczak majority then went off the rails.  The majority reasoned:  The embezzlement theory of fraud did not include the personal benefit test.  Embezzlement did not have the additional requirement that an insider breach a duty to the owner of the property because a breach of duty was inherent in the concept of embezzlement.

The majority’s reasoning and analysis were flawed.  A breach of duty is not inherent in embezzlement in the way the majority implied.  A breach of duty is a prerequisite to fraud by embezzlement because embezzlers do not disclose their actions or lie in advance to the victim.  The leading Supreme Court examples of fraud by embezzlement cited by the Blaszczak majority, such as Carpenter v. United States, 484 U.S. 19 (1987), on mail and wire fraud and United States v. O’Hagan, 521 U.S. 642 (1997), on the Rule 10b-5 misappropriation doctrine, involved an insider who had a pre-existing fiduciary duty to the victim and who misappropriated property, received a personal benefit of cash, and deceived the victim by not disclosing the misappropriation.

The fraud akin to embezzlement concept could not apply to a tippee because a tippee does not owe a fiduciary duty to the victim and has no duty of disclosure.  The Supreme Court did not discuss the liability of a tippee in Carpenter or O’Hagan.  Both O’Hagan and the main defendant in Carpenter were insiders with fiduciary duties.  With no breach of duty, a tippee cannot commit a fraud unless he or she makes a materially false statement.

This was the problem the Supreme Court faced in Dirks.  A tippee did not owe the source of information a fiduciary duty, and it was not clear how a tippee acquired a duty to refrain from trading on inside information.  463 U.S. at 655.  The Supreme Court ultimately concluded:  A “tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.”  Id. at 660.

The breach of fiduciary duty committed by the insider and assumed by the tippee was indispensable to a fraud finding.  Dirks said that, to determine whether a tip deceived, manipulated, or defrauded, the initial inquiry was whether an insider breached a duty.  Id. at 663.  That depended on the purpose of the disclosure, and “the test is whether the insider personally will benefit, directly or indirectly, from his disclosure.”  Id. at 662.

The personal benefit element crystallized the insider trading inquiry about the actions of both the tipper and tippee.  A breach of duty by an insider who makes a personal profit from a securities trade or embezzlement is reasonably easy to detect, but identifying a breach of duty from an insider’s disclosure of information to an outsider is not as easy.  The Dirks Court noted:  “All disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders.”  Id. at 661-62.  Dirks wanted a high level of confidence that a disclosure was improper, and it demanded that a tip produce a secret profit for the insider in the same way that direct insider trading did.  The requirement also protected the tippee by making proof of his or her knowledge of the insider’s breach and benefit more objective and concrete.

The Blaszczak court faced the same problem under the Title 18 fraud provisions that Dirks faced under Rule 10b-5.  Does a fraud prohibition apply when a fiduciary does not trade for a personal profit and instead discloses confidential information to an outsider who does not have a fiduciary duty to the source of the information but who uses the information to trade and make a profit?  How or when is this action fraud by the tipper?  How does disclosure of confidential information to a tippee demonstrate a misappropriation to the insider’s own use if the insider did not receive anything of value in return?  How does a tippee breach a fiduciary duty requiring disclosure and commit fraud?  The Supreme Court in Chiarella and Dirks categorically rejected the position that a person violates the anti-fraud laws just by having and trading on material, non-public information.

The Blaszczak majority answered none of these questions in refusing to apply the Dirks approach.  That is not to say the Dirks personal benefit element is the only or best way to counter criminal fraud in a tipper-tippee situation — the test has many problems and critics – but the majority needed to have addressed those circumstances, and it did not.  Criminal prosecutors will surely use the void to their advantage and to the detriment of participants in the securities markets.

Different Statutory Purposes

The second major legal error by the Blaszczak majority was its distinction between the purpose of the Title 15 fraud provisions of the Exchange Act, defined in the opinion as Section 10(b) and Rule 10b-5, and the purpose of the Title 18 fraud statutes.  The distinction was not persuasive and was not a basis for rejecting a personal benefit test in tipping cases charged as Title 18 frauds.

The Blaszczak majority said this:

[T]he personal-benefit test is a judge-made doctrine premised on the Exchange Act’s statutory purpose.  As Dirks explained, in order to protect the free flow of information into the securities markets, Congress enacted the Title 15 fraud provisions with the limited “purpose of . . . eliminat[ing] [the] use of inside information for personal advantage.”  …  Dirks effectuated this purpose by holding that an insider could not breach his fiduciary duties by tipping confidential information unless he did so in exchange for a personal benefit.

(*8 (citation omitted))

Almost nothing about this analysis is correct.  First, the paragraphs above explained why Dirks adopted the personal benefit element in tipping cases.  It was the test for a breach of fiduciary duty, which was the essential link to an insider’s duty to disclose information before trading, which in turn was the essential link to a fraud violation.  Effecting a fraud prohibition in these circumstances is the same whether the anti-fraud provision is in the securities laws, the banking laws, or the more general laws to promote interstate commerce.

Second, Congress did not enact Section 10(b) with the “limited” purpose of eliminating the use of inside information for personal advantage.  Section 10(b) and Rule 10b-5 were catch-all fraud provisions and reached any conduct viewed as manipulative or deceptive.

Third, Section 10(b) does not protect the free flow of information into the securities markets.  The aim of Section 10(b) and Rule 10b-5 is to provide an assurance of accurate information.

At the moment, Blaszczak portends significant change.  Enforcing a tipping case based on a Title 18 fraud is now easier than one based on Rule 10b-5.  The elements of Title 18 tipping are much more general and open ended than the Dirks personal benefit element.  The reasoning of Blaszczak even casts doubt on the government’s need to prove that a tipper breached a fiduciary duty to the source of information.  Judges and juries in future cases will have less guidance about the conduct necessary for a conviction.  This lack of legal standards for a crime is antithetical to the traditional goals of the criminal justice system.  Prosecutors will have more discretion to subject a greater range of conduct to criminal investigation and prosecution and will be able to extract plea agreements more easily.  Participants in the securities markets will have less guidance about their legal obligations.  Finally, Blaszczak follows Salman and Martoma in eroding the critical role of the Dirks personal benefit element, which could accelerate that trend in Rule 10b-5 cases.

This post comes to us from Andrew Vollmer, a former professor at the University of Virginia School of Law and a former deputy general counsel of the Securities and Exchange Commission.  It is based on his recent paper, “The Second Circuit’s Blaszczak Decision: Dirks Besieged,” available here.