The Senator Traded While His Constituents Died: A Legal Analysis of Insider Trading by Public Officials

The coronavirus’ impact across the United States will make an epic, even Tolstoyan, saga, sweeping across all levels of American society and featuring brave heroes and tragic victims. But so far, this story has lacked one figure that every drama needs: a clear villain – someone the public can despise. No, President Trump cannot play this role. Reckless, ignorant, and delusional as he may be, he can only play the fool of the story, but not the villain, because he has not been profiting off the tragedies of others.

A true villain would be useful. In the 1930s, much of the New Deal’s securities legislation did not pass Congress until the president of the New York Stock Exchange was convicted and jailed for looting his clients’ trust funds.[1] Such a figure is now emerging. Senator Richard Burr (R-N.C.) appears to have unloaded much of his stock portfolio the day after receiving a February 13 briefing about the coronavirus from high-level White House officials. If a Hollywood studio were writing this script, this is the figure that its central casting office would be searching for to give life to the script.[2] Accordingly, this brief column will leave the morality issues to others and focus simply on the legality of the senator’s conduct. Can prosecutors convict him?

Other scholars have debated this issue, but unsuccessfully in my judgment, because they have been subject to a tunnel vision focused only on Rule 10b-5.[3] Today, federal prosecutors have learned that they have better and more effective weapons than Rule 10b-5 (although that will work as well). These alternative weapons include: (1) the STOCK Act; (2) wire fraud (18 U.S.C. §1343); (3) conversion of governmental property (18 U.S.C. §641); and (4) a new securities fraud charge (18 U.S.C. §1348).

Here, the case that best shows the reach of these weapons (and why prosecutors need not rely on Rule 10b-5) is United States v. Blaszczak.[4] Decided by the Second Circuit on December 30, 2019, it upheld convictions of insider traders who acquired confidential information from a government agency on several of these theories. Moreover, because the jury acquitted the defendants in Blaszczak of the Rule 10b-5 counts in the indictment, while convicting on the other charges, the message to prosecutors could not have been clearer: Use these other charges and avoid the complexity in Rule 10b-5.

Why is it harder to convict under Rule 10b-5? The answer involves the growing complexity of the legal standard announced in Dirks v. SEC,[5] and extended in United States v. Newman[6] and later cases. Dirks requires that there be a fiduciary breach and that the tippee have paid a “personal benefit” to the tipper. The critical holding in Blaszczak is that these criteria do not apply for purposes of charges brought under Title 18 of the United States Code. Put more simply, prosecutors do not need to show a fiduciary breach or a personal benefit under these latter charges. That makes life much simpler for prosecutors.

Accordingly, let’s examine what would have to be shown under the most likely charges that could be filed:

1. The STOCK Act. Passed in 2012 after some empirical studies had found that trading by congressmen yielded extraordinarily high returns, it had become obvious that either most congressmen who traded were smarter than Warren Buffett or they had access to material nonpublic information. The STOCK Act (which is an acronym for “Stop Trading On Congressional Knowledge”) sought to restrict such trading on material nonpublic information by creating a new fiduciary duty that they would owe (along with their staff and all Executive Branch employees and the judiciary) to “the Congress, the United States Government and the citizens of the United States… with respect to material, nonpublic information derived from such person’s position… or gained from the performance of such person’s official responsibilities.” Incidentally, this statute passed the Senate by a vote of 96-3, with Senator Burr being one of the three dissenters. Now set forth in §21A(g) of the Securities Exchange Act, this duty is the functional equivalent of the common law fiduciary duty owed by corporate officers and directors to their shareholders. Because a senator is a fiduciary under this statute (and not a tippee), issues such as “personal benefit” do not arise, because that issue is applicable only to the tipper/tippee relationship.

To be sure, a defendant can claim that the information he or she received was not material (but the senator was an expert on pandemics, having sponsored 2006 legislation on this topic[7]). Possibly, a defendant such as the senator could claim that while he “possessed” such information, he did not “use” it. SEC Rule 10b5-1 requires only that the defendant be “aware” of the material, nonpublic information. Although one can doubt whether this rule applies in a criminal case, this issue is overshadowed by the fact that §32(a) of the Securities Exchange Act requires that the prosecution prove that the defendant “willfully” committed the violation. Overall, Second Circuit law is favorable to the prosecution on all these points. Also, the fact that the senator made a large number of trades, dumping a variety of stocks (including stocks in hotel and resort companies that were predictably likely to drop) the day after his briefing from White House officials, strengthens the prosecution’s case substantially.

2. The Wire Fraud Statute. In Carpenter v. United States,[8] a Wall Street Journal reporter was convicted on wire fraud charges where he showed his future columns for the Journal to a broker who traded on them, splitting the profits with the reporter. According to a unanimous Supreme Court, it was sufficient to violate the wire fraud statute that the reporter deprived his employer of “exclusive possession” of confidential business information. No competitive injury to the Journal had to be shown because its property was being embezzled by such use. Blaszczak reached a similar conclusion (with one judge dissenting) with respect to information possessed by a government agency about planned changes in its reimbursement rates.[9] Unless Blaszczak is reversed by the Supreme Court, the wire fraud charge sounds like a slam dunk for the prosecution.

3. Section 641. Section 641 applies to anyone who “knowingly converts” any “thing of value of the United States.” Blaszczak found that intangible property (such as confidential information) can be a “thing of value” (as have earlier Second Circuit decisions).[10] By taking information given to him for a governmental purpose and using it for a personal purpose (i.e., trading), the senator arguably converted a “thing of value.” The case law here is on the prosecution’s side.

4. Section 1348. This relatively new provision covers any “scheme…to defraud” that the defendant pursues in either the securities or commodities markets, and it has been used to convict persons engaged in “spoofing.” Again, Blaszczak found that the prosecution did not need to show a Dirks-style fiduciary breach to convict under this statute, but only that material nonpublic information was “embezzled” or “misappropriated.” Here, a defendant might plausibly argue that §10(b) of the Securities Exchange Act and §1348 should be read “in pari materia” as they apply to insider trading, but Blaszczak expressly rejected this argument, finding that Congress wrote §1348 to simplify the law and ease the prosecution’s burden.

5. SEC Jurisdiction. The SEC has standing only to enforce provisions in Title 15 and not Title 18. Hence, it cannot use §1343, 1348 or 641. But it can use the STOCK Act to show a violation of Rule 10b-5.

Conclusion

Will prosecutors dare to indict a senator, particularly when political control of the Senate might be affected? Because the governor of North Carolina is a Democrat (Roy Cooper), Senator Burr’s departure could affect that control. In theory, either the U.S. Attorney for the District of Columbia (where the tipping occurred) or the U.S. Attorney for the Southern District of New York (where the trading occurred) has jurisdiction and venue. Possibly, prudent prosecutors will wait to see what information the Senate Ethics Committee develops and what conclusions it reaches (and will keep a low profile in the interim).

But the challenge is there. Even if political pushback is possible, the “Sovereign District” of New York has long prided itself on its independence. This could be the test case of whether it is the “Sovereign” or “Servile” district.

ENDNOTES

[1] Richard Whitney was president of the New York Stock Exchange (from 1930 to 1935) and remained on its Board of Governors until 1938, when he was charged with embezzlement (to which he pleaded guilty). He was sentenced to a term of five to 10 years, and newspaper reports indicate that a crowd of 6,000 showed up at Grand Central Terminal to see him, in handcuffs, be placed on a train to Sing Sing. Major federal securities litigation was passed in 1940.

[2] Think of the villainous banker, played by Lionel Barrymore, in “It’s a Wonderful Life” who cheats honest Jimmy Stewart.

[3] Here, I must respectfully disagree with Professor Andrew Verstein, who argued in a recent Blue Sky Blog column, “Senator Richard Burr and Mixed Motives for Insider Trading” (March 21, 2020), that the “use/possession” issue could prevent Senator Burr’s conviction in some circuits. While I disagree somewhat with his analysis of Rule 10b-5, my real point is that Rule 10b-5 and fiduciary duties are no longer central to criminal liability for insider trading.

[4] 947 F.3d 19 (2nd Cir. 2019).

[5] 463 U.S. 646 (1983).

[6] 773 F.3d 438 (2nd Cir. 2014).

[7] Senator Burr co-sponsored the Pandemic and All-Hazards Preparedness and Advancing Innovation Act (PAPAI), which was enacted in 2019, extending an earlier statute he had also co-sponsored and that was enacted in 2006. Within the Senate, he is the expert in this field, and thus had to appreciate that the new information he was receiving was material.

[8] 484 U.S. 19 (1987).

[9] Judge Amalya Kearse dissented in Blaszczak on the ground that confidential information possessed by a governmental agency did not constitute “property” in her view. This is indeed an interesting issue, but beyond the scope of this modest column.

[10] See United States v. Girard, 601 F.2d 69 (2d Cir. 1979).

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.

2 Comments

  1. Chris Bonner

    In terms of abstract ethics, this case highlights the use/possession issue. Suppose that before you received the inside information, you estimated the probability of a crash of the stock market from Coronavirus at 5% and continued normalcy for several months at 95%. After you received the inside information, you changed your estimate to 30% crash and 70% normalcy. You considered a wash sale of your entire portfolio, where your risk is that, when you repurchase your portfolio in the future, you have to pay a higher price. The risk of loss may now be high enough that you are willing to take the risk — maybe 50/50, because who knows what the market will do, even in normal times? — of possibly missing out on potential market gains and of having to repurchase your portfolio later at a higher price. So, you sold your portfolio, but you still think that normalcy is the more probable outcome.

    In this scenario, when you possessed the inside information, it entered your calculations and you used it.

  2. Martin Nunez

    This is a perfect example of how Rule 10b-5 and fiduciary duties are no longer the only ways to prove criminal liability for a conviction of insider trading.

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