The law of insider trading generally moves with the speed of molasses in February. For every two steps forward, there is one (or more) steps backward. But this winter has seen a rapid succession of developments. First, the Himes Bill passed the House of Representatives by an overwhelming margin,[1] but only after its sponsors retreated on its most important provision: the elimination of the “personal benefit rule” from insider trading law.[2] Second, the Bharara Task Force on Insider Trading reported, with a strong and unanimous recommendation that the personal benefit rule be abolished and a new statute passed.[3] Then, in the biggest recent surprise, a Second Circuit panel ruled in late December in U.S. v. Blaszczak[4] that when prosecutors use 18 U.S.C. §1348 they can prosecute insider trading without having to satisfy the Dirks v. SEC test (which requires both a fiduciary breach and a personal benefit paid by the tippee to the tipper).[5] For federal prosecutors, this was an unexpected Christmas present because they had lost (or were forced to re-open and confess error in) many cases in which they could not show that a remote tippee was aware of any personal benefit paid by the original tippee to the original tipper. Revealingly, in Blaszczak, the jury acquitted the defendants of the Rule 10b-5 charges, while convicting them of securities fraud under §1348. To prosecutors, the implication is obvious: Forget Rule 10b-5 and prosecute under the simpler §1348.
There is a delicious irony in Blaszczak: It was decided for the Second Circuit panel by Judge Richard Sullivan, the former district court judge who was sternly reversed in United States v. Newman,[6] which resurrected the personal benefit rule and restated it a very overbroad fashion. Earlier, the migratory Judge Jed Rakoff had authored a decision for the Ninth Circuit that cut back on the scope of Newman, and the Supreme Court affirmed his decision in Salman v. United States.[7] What remained of Newman has now been outflanked in the Martoma decisions (discussed below) or made irrelevant by Judge Sullivan in Blaszczak. The implicit message here for circuit court judges is: Be nice to your district court brethren, as they may in time get an opportunity for payback. District court judges everywhere are likely enjoying the spectacle of Sullivan and Rakoff turning the tables on the Newman panel.
Still, for law professors (and others) who liked Dirks because it seemed intent on preserving market efficiency, Blaszczak sounds an alarm signal. Could it lead to a new era in which prosecutors could simply allege that the use of material, non-public information was criminal because the trader deceived investors by failing to disclose material information to them (regardless of how the defendant acquired the information)? For example, suppose a potential acquirer buys 20% of its intended target’s stock days before it makes a merger proposal at a very large premium to the target. The acquirer may or may not fully comply with the Williams Act and disclose these purchases in a timely fashion. No tender offer is ever made (so that Rule 14e-3 does not become applicable). Still, this conduct should not violate Rule 10b-5 because no fiduciary duty to the target shareholders is ever breached. But if the test under §1348 were only that the acquirer had to deceive the sellers of these securities through a material omission, the issue becomes much less certain (and lawful transactions are chilled). Remember too that the SEC lost in Dirks, and it is not an agency that forgives or forgets easily.
Still, these fears are overstated, in part because §1348 is a criminal statute, located in Title 18, and the SEC has no criminal jurisdiction and can only assert causes of action given it by Title 15. More importantly, Blaszczak was written so as to stress that there had to be a misappropriation of the information by the defendant. Thus, it will not be possible to allege a violation in cases where the defendant developed the information itself. Here, considerable credit is owed to the district court judge (Lewis Kaplan), who wisely instructed the jury that for the Title 18 counts (i.e. wire fraud and §1348), the conduct forbidden “includes the act of embezzlement, which is…the fraudulent appropriation to one’s own use of the money or property entrusted to one’s care by someone else.”[8] More specifically, he further instructed the jury that it could find the existence of a securities fraud under §1348 if a defendant “participated in a scheme to embezzle or convert confidential information … by wrongfully taking that information and transferring it to his own use or the use of someone else.”[9] In short, more than deception or unfairness is needed; there must be a misappropriation or embezzlement of the information. In this sense, Dirks may have been formally rejected, but it is being carefully honored in the breach. A “fiduciary breach” (not required under §1348) is not that different from a “misappropriation.”
Still, some significant differences may exist between the reach of Rule 10b-5 and that of §1348. In the Second Circuit, the test for liability has been reframed by Martoma II,[10] which now focuses on whether there was an intention to make a gift of the information to persons likely to trade on it.[11] Suppose that a stockholder relations manager at a computer company is contacted by three large institutional investors. Each wants to know about last quarter’s earnings, which will be released in several days. Knowing that a sharp decline in earnings is coming, the manager attempts to placate them, giving them a rough estimate of the earnings decline, but predicting a sharp turnaround in the next quarter. Two of the three investors (each a large indexed investor) decide to do nothing (because each sees itself as a permanent investor), but the third (an activist hedge fund) sells to avoid the likely stock price decline. Is this a “gift” of information that violates Martoma II? Or was there a valid corporate purpose behind the manager’s conduct because he was seeking to maintain their loyalty? Certainly, the manager had no friendship or social relation that motivated him to make a gift. Of course, these facts resemble U.S. v. Newman,[12] where the information similarly came from a stockholder relations manager (at Dell).[13] In those circuits that still require a personal benefit paid to the tipper, the prospect of liability is less likely (and the Himes Bill, if it passes, would lead to the same result), because the manager received nothing. Under §1348, however, this conduct may look even less like a misappropriation or embezzlement of information because all investors were given the information (on a platter) by a low-ranking manager seeking to placate them as part of his normal job. Liability only clearly exists here if (1) we abolish the personal benefit rule and call this a fiduciary breach by the manager, or (2) we decide that this somehow was an impermissible gift made with the intention of benefiting the institutional investor that traded. Because this is not a rare case, it suggests that we are not much closer to achieving legal certainty under either of these tests.
There is a distinct possibility that Blaszczak will be granted certiorari. Section 1348 does constitute a potentially important federal statute, and one judge (Amalya Kearse) did dissent.[14] The panel expressly held that §1348 does not have to be read “in pari materia” with the antifraud provisions of the federal securities laws.[15] That conclusion is open to question, because (1) all these statutes are expressly addressing securities fraud and insider trading, and (2) §1348 was part of the Sarbanes-Oxley Act, which was only about securities regulation (and was not an attempt to effect any general criminal justice goals). If it stands, Blaszczak will finally excise the personal benefit rule from the law of insider trading. This author has been calling for that for years.[16] But we are getting there by a strange route indeed.
Even apart from the personal benefit rule, §1348 may reach more broadly than Rule 10b-5, at least in a few, limited settings. For example, to commit a fiduciary breach, one must be a fiduciary. The law of some states does not consider a low-ranking employee to be a fiduciary, and it has not yet been resolved at the appellate level whether state law or federal law resolves the issue of who is a fiduciary.[17] For purposes of §1348, this is not relevant, as the conduct can involve a misappropriation or an embezzlement, even if no fiduciary is involved.
Put more simply, “gifts” (the critical term under Martoma II) and “misappropriations” (the central concept under Blaszczak and §1348) are not the same thing; indeed, they are somewhat antithetical. It is conceptually difficult to embezzle or misappropriate something that you are given freely. Thus, the law under §1348 may over time diverge from that under Rule 10b-5, and different conduct will be covered by each.
Conclusion
Recent years have seen a series of reversals. United States v. Newman,[18] an extraordinarily strong and conservative statement of the law on insider trading, can be seen as a stealth reversal of SEC v. Obus,[19] which had seemed (to me at least) as a stealth reversal of Dirks. Newman was in turn followed by a partial express reversal by the Supreme Court in Salman v. United States[20] and (to my mind) by a stealth reversal in Martoma I and II.[21] All these decisions can be viewed as more legislative than judicial reversals because they all seem intended to implement judicial policy judgments. Blaszczak seems an even more stealthy policy judgment that §1348 can be framed to outflank much of the caselaw under Rule 10b-5 in order to give prosecutors a more effective weapon. Unless Blaszczak is reversed or altered by the Supreme Court (which I do not predict), it may in time trump Rule 10b-5. Predictably, prosecutors may assert a parallel count in their indictments based on Rule 10b-5, but they will chiefly rely on §1348.[22]
Nonetheless, at no point in this succession of stealth overrulings will Congress have truly acted to define the law. Insider trading will remain a common law crime and the product of judicial policy judgments. Congress could, of course change that, either by passing the Himes Bill (with an exclusivity provision making it the only means by which insider trading liability could be asserted in a criminal case[23]) or by leaving things alone and letting prosecutors migrate to §1348. An exclusivity provision gives rise to many objections.[24] But, if Congress tolerates §1348, it is making the Himes Bill largely irrelevant. In contrast, if Congress passes the Himes Bill and makes it exclusive, sweeping changes follow.
A legislative answer is preferable, but one does not have the sense that Congress fully understands what it is doing.
ENDNOTES
[1] The vote on the Insider Trading Prohibition Act (H.R. 2534, 116th Cong., 1st Session) was 410 to 13 on December 5, 2019. See Newstex Blogs, Jim Hamilton’s World of Securities Regulation, December 6, 2019.
[2] The Ranking Member of the Financial Services Committee, Patrick McHenry (R-NC), made a motion to re-insert the personal benefit test into the act, which the bill’s sponsor (Jim Himes, D-Conn.) accepted. This author had consulted on this legislation at the request of Congressman Himes and had chiefly tried to eliminate the personal benefit test. Obviously, I was disappointed, but this shift was intended to make the proposed act acceptable to the Senate. Whether it will remains to be seen. A remaining issue is whether the act should be made “exclusive” (that is, preempting other statutes for criminal law purposes, such as wire fraud, §1348 and even Rule 10b-5).
[3] See Report of the Bharara Task Force on Insider Trading (January 2020). This Task Force, chaired of course by Preet Bharara, had eight members, of whom the most modest and humble was this author.
[4] 947 F.3d 19 (2d Cir. 2019). Judge Kearse dissented on one issue: Whether confidential information about a pending regulation constituted the “property” of that agency. This issue will not affect many insider trading cases. The named defendant was a former employee of that agency (with excellent contacts within it) who went to work as a “consultant” for hedge funds.
[5] 463 U.S. 646 (1983) (where information received by analyst came from a whistleblower who acted lawfully, use of information by analyst did not violate Rule 10b-5).
[6] 773 F.3d 438 (2d Cir. 2014). Prior to Newman, the Second Circuit had seemingly ignored or downplayed the requirement of personal benefit. See SEC v Obus, 693 F.3d 276 (2d Cir. 2012).
[7] 137 S. Ct. 420 (2016). Judge Rakoff’s decision, written as a visiting judge on the Ninth Circuit, was United States v. Salman, 792 F.3d 1087 (9th Cir. 2015).
[8] 947 F.3d at 28 (quoting Judge Kaplan’s charge). Conceivably, another judge might simply have required that the defendant in some way act “deceptively” in order to violate §1348. Section 1348 requires that there be a “scheme to defraud,” and this term (used in the mail and wire fraud statutes) does not by itself require a “misappropriation.” Such a definition would have produced a very broad criminal statute indeed. In my view, it was fortunate that Judge Kaplan gave the carefully framed charge that he did.
[9] Id. at 29
[10] Martoma II, 894 F.3d 64, 79 (2d Cir. 2018), reinterpreted Newman to find that a “corporate insider receives a personal benefit…from deliberately disclosing valuable confidential information without a corporate purpose and with the expectation that the tippee will trade on it.” In Martoma I, 869 F.3d 58 (2d Cir. 2017), the same panel had held that the gift prong of Dirks was satisfied if the tipper expected that the tippee would trade on its information, even if they had only a causal relationship. This opinion was withdrawn and superseded by Martoma II.
[11] See 894 F.3d at 79.
[12] See supra at note 6.
[13] See 773 F.3d at 443.
[14] Judge Kearse dissented on the grounds that the defendants had to obtain “property” under the various statutes charged, and she did not believe that the Centers for Medicare & Medicaid Services’ confidential information as to the substance and timing of certain forthcoming changes in its rules constituted “property” or a “thing of value.” See 947 F.3d at 46-47. See also Cleveland v. United States, 531 U.W. 12 (2000).
[15] 947 F.3d at 35, citing United States v. Mills, 850 F.3d 693, 699 (4th Cir. 2017).
[16] See John Coffee, “Getting Away with Insider Trading,” New York Times Op/Ed column, May 23, 2016 at p. A-19 (arguing that personal benefit test should be eliminated by legislation).
[17] Judge Rakoff has written a well-known decision that federal law should control. See United States v. Whitman, 904 F.Supp 2d 363 (S.D.N.Y. 2012). As usual, I agree with him.
[18] See supra note 6.
[19] 693 F.3d 276 (2d Cir. 2012). For a masterful review of all these recent “wobbles” in insider trading law, see Donald C. Langevoort, “Watching Insider Trading Law Wobble: Obus, Newman, Salman, Two Martomas and a Blaszczak” (forthcoming). I only disagree with this very fluent tour with regard to its treatment of Blaszczak.
[20] 137 S. Ct. 420 (2016).
[21] See supra note 10.
[22] There are other advantages in using §1348. Some decisions have read it to require very little. See U.S. v. Mahaffy, 693 F.3d 113 (2d Cir. 2012). For example, it may not require proof of a purchase or sale of a security (which a Rule 10b-5 prosecution certainly does).
[23] An exclusivity provision was debated in the House (but not adopted); it may yet re-appear in the Senate if the Himes Bill is debated there. Blaszczak may induce the business community to seek such a provision.
[24] An exclusivity provision making §1348 the only source of criminal liability would, for example, preclude a criminal prosecution based on Rule 14e-3, which the Supreme Court expressly upheld in United States v. O’Hagan, 521 U.S. 642 (1997).
This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.