Last week, the House of Representatives passed the “Insider Trading Prohibition Act” (“ITPA”).[1] Proponents are hailing it as a triumph of bipartisan cooperation. Conversely, critics are calling it the “Insider Trading Protection Act.” This is because the bill codifies in statutory law the “personal benefit” requirement under which the tippee can only be convicted if that person paid or promised some benefit (tangible or even intangible and reputational) to the tipper. That requirement had resulted in many convictions being overturned (and even more prosecutions probably not being commenced in the first place). In the Second Circuit, this doctrine had led prosecutors to turn to other statutes: chiefly, wire fraud and a special securities fraud statute (18 U.S.C. Section 1348) to outflank it. Seemingly, this approach has worked, as in Blaszczak v. United States[2] a Second Circuit panel agreed that “personal benefit” was not a necessary element for either a wire fraud or Section 1348 conviction.[3] But the passage of ITPA would imperil that result and require even different statutes to be reinterpreted. The key question is whether all these different statutes that apply to insider trading need to be read in pari materia.
A third perspective is also possible about this bill: It was drafted through last minute compromises with the ultimate product looking like it was written by a “committee that could not shoot straight.”[4] How its critical parts fit together and modify each other remains a mystery. Let me explain by initially quoting the critical provision that endorses the “personal benefit” rule. ITPA would add a new Section 16A to the Securities Exchange Act of 1934, and Section 16A(c) thereof would essentially define insider trading by describing various forms of “wrongful” use of material nonpublic information that violate this statute. Proposed Section 16A(c)(1)(D) restates the essential criteria of Dirks v. SEC[5] in the following language:
(D) a breach of any fiduciary duty, a breach of a confidentiality agreement, a breach of contract, a breach of any code of conduct or ethics policy, or a breach of any other personal or other relationship of trust and confidence for a direct or indirect personal benefit (including pecuniary gain, reputational benefit, or a gift of confidential information to a trading relative or friend).
Immediately, there is a question about whether the phrase “for a direct or indirect personal benefit” modifies only “other relationship of trust and confidence” or whether it applies to all the breaches listed in clause (D). For example, does it apply also to persons who breach a contract, a code of conduct or ethics policy, or some other source of law not involving a fiduciary duty? Let’s assume that it does (which seems likely).
Overshadowing this narrow question, however, is whether Section 16A(c)(1)(D) also subjects persons covered by Section 16A(c)(1)(A), (B), or (C) to the above standard specified in Section 16A(c)(1)(D). To illustrate, Section 16A(c)(1)(C) covers the “conversion, misappropriation, or other unauthorized and deceptive taking of such information.” Similarly, Section 16A(c)(1)(A) covers information obtained through “theft, bribery, misrepresentation, or espionage…” Now, suppose in a given case the prosecutor believes there is both a fiduciary relationship that has been breached and a theft (which is covered by clause (A)) or an unauthorized and deceptive “conversion” or “misappropriation” (which is covered by clause (C)). Can the prosecutor simply ignore clause (D) and proceed on the theory that there has been either a “theft,” a “conversion,” or a “misappropriation,” which only requires that the prosecutor show the misappropriation or conversion to be unauthorized and deceptive? In short, can the prosecutor convict without any showing of “personal benefit?” A conventional interpretation would say yes. A provision in clause (D) cannot logically modify clause (A) or (C). But this is the same “in pari materia” issue on which the U.S. Supreme Court just granted certiorari (before vacating the case in Blaszczak).
This conventional interpretation would likely reach some fairly marginal cases. Let’s take two examples. In Example 1, a person in the next business class seat on an international air flight reads a memo that an investment banker has left on the tray table while he or she goes to the restroom. The adjoining seat holder later trades and profits on this information. Is this a “deceptive” taking or misappropriation? Suppose the memo is instead placed back into an unlocked thick folder before the investment banker goes to the restroom, or it is placed into an unlocked briefcase (either way, the occupant of the next seat opens it and reads the memo during this interval). Arguably, this is more “unauthorized” and “deceptive” taking of information, but there is still no “personal benefit” paid by the tippee in the next seat to the unintentional tipper. While culpable, this is considerably less so than the case where money changes hands for the information.
As a second example, assume that I, as an experienced M&A attorney, overhear a conversation in a Manhattan elevator in which a “blabbermouth” law firm associate discloses material nonpublic information, which I (but few others) understand. Again, I trade on it. Arguably, this may be a “conversion” or “misappropriation,” but is it “deceptive” and “unauthorized?” It would only seem so if the law mandates that I have some duty to disclose that I understood what the “blabbermouth” was saying. Certainly, there is no “personal benefit” being paid or promised here.
How should these different cases be treated? Logically, Section 16A(c)(1)(C) requires a “conversion,” “misappropriation,” or other “taking,” but does not require any “personal benefit” paid by the tippee to the tipper. Trading on what the “blabbermouth” says in the elevator or on anything that the investment banker leaves spread out in plain sight is probably not criminal (at least under Rule 10b-5)[6]. More than a mere ethical shortcoming should be necessary for criminal liability.
The danger is real that courts will read the “personal benefit” language in clause (D) to also apply to clauses (C) and (A). Why? Everything about the law of insider trading until now has been judge-made law, and this will be the first time that Congress has clearly spoken. Terms, such as “conversion” and “misappropriation” are broad, and, fearing over-criminalization, the Supreme Court might say that the language in clauses (A) and (C) should be read in pari materia with clause (D). After all, “personal benefit” was a core element in Dirks, which was the original source for modern insider trading law. The argument also might be that Congress would not have spoken so clearly about clause (D) if it had not assumed that similar standards should apply to clauses (A) and (C) also. From a policy perspective, no good reason exists for requiring a higher standard for proving liability in the case of a fiduciary then in the case of non-fiduciaries. The fiduciary’s conduct is inherently more culpable and should not be protected by a “personal benefit” standard that applies uniquely to the fiduciary.
Or, a court might say that the judicial common law on insider trading that has evolved over the three decades since Dirks should yield to, and be read consistently with, what Congress has now explicitly said in clause (D). Put differently, courts may be allowed to infer what Congress intended when it did not speak clearly, but it must defer to what Congress clearly did say.
Still another possible argument is that the void for vagueness doctrine requires that we cut the broad reach of clauses (A) and (C) back to the narrower reach of clause (D). In Skilling v. United States,[7] Justice Ginsburg cut back the wire fraud statute (partly to save it from invalidation), arguing that its ambiguous reach had to be read in harmony with its narrowest plausible interpretation. That claim could be raised here as well, although ITPA is far less ambiguous than the statute that Justice Ginsburg re-interpreted.[8]
I do not mean to endorse these narrow interpretations of Section 16A, and I believe that clauses (A), (B), and (C) should not be read to require a showing of “personal benefit.” Although it is anomalous that a higher and more demanding standard of proof is required only in the case of the fiduciary (whose misbehavior is in principle more culpable), that does not mean that a curious statutory distinction renders the statute unconstitutionally vague. Nonetheless, the fact that I believe the “in pari materia” argument will fail does not mean that the courts will agree.
From a public policy perspective, it is important to explain why courts should not read “personal benefit” into the other clauses in Section 16A(c)(1) and why Dirks should not be extended beyond Rule 10b-5. Both in 18 U.S.C. Section 1348 and now in ITPA, Congress has recognized that insider trading prosecutions can be difficult to bring and almost impossible to win when one must show that a professional trader or institution paid for its confidential information. Here, the facts of United States v. Newman[9] are instructive and representative. There, a corporate public relations employee in two instances released material nonpublic information to institutional investors that this employee was expected to appease and mollify. No evidence existed that any payment was made or that the tipping amounted to a traditional “gift” (within the meaning of Dirks). The evidence showed “that a group of financial analysts exchanged information they obtained from company insiders,”[10] and that the two individual defendants were third and fourth level remote tippees who earned $72 million in profits from their trades for their funds.[11]
What does this show? In the modern world, institutions and other professionals do not pay for nonpublic information. Rather, Wall Street is a giant “favor bank.” If you need a favor, you owe a favor in return. Norms of reciprocity are well recognized, and the tipper can safely anticipate that it will be paid back in due course. But the criminal law requires proof beyond a reasonable doubt of a specific payment. An implicit expectation of a future payment based on years of doing business in the industry does not satisfy that evidentiary standard. Thus, both Section 1348 and ITPA attempted to simplify the law to make it easier for prosecutors to reach professional traders. That attempt will fail if “personal benefit” is read back into the law based on loose arguments about in pari materia.
So what should happen next? Very modest changes in ITPA could preclude any plausible argument that “personal benefit” was required in all the cases specified in Section 16A(c)(1). Much of the bill is desirable, but this is too important to let ambiguities remain. No hearings were held in the House this year, and no one pointed out to the House that the Bharara Task Force on Insider Trading had unanimously agreed that the “personal benefit” rule should be deleted from the law of insider trading. Instead, the House just re-enacted the bill that had passed in 2019, but that bill is the product of a last minute compromise and incorporated an amendment by Congressman Patrick McHenry (R.-N.C.), which appears to have been accepted in the hopes of obtaining Republican votes in the Senate. The result was something of a mishmash, but it has now been passed again without anyone recognizing that it was an unholy compromise. Error compounded is still error. If Republicans think they have restored the “personal benefit” rule, they could be easily surprised. If Democrats believe that they have outflanked the “personal benefit” rule, they may also be frustrated.
Only a few words need to be changed to give clarity to this bill, but absent those changes, the impact of ITPA is unpredictable – both in terms of how it will be interpreted and how wire fraud and Section 1348 will also be read.
ENDNOTES
[*] This is a reference to a question posed by an eminent scholar of game theory and competitive human behavior, Charles Dillon Stengel (also known as “Casey” or as “The Ol’ Perfesser”), in assessing the performance of a young start-up venture, the New York Mets, in its first year of operation. See Jimmy Breslin, “Can’t Anybody Here Play This Game?” (1963).
[1] Formally, the bill is H.R. 2655 (117th Congress 2021). It was introduced by Congressman James A. Himes (D-Conn.) on April 19, 2021. An earlier and virtually identical bill (H.R. 2534) was also introduced by Congressman Himes in 2019, and this author consulted with his staff on that legislation. Originally, the 2019 bill did eliminate the personal benefit requirement, but this provision was reversed by a last-minute amendment introduced by Representative Patrick McHenry (R-N.C.), which restored the personal benefit requirement. With Republican support assured by this amendment, the bill passed the House in 2019 by an overwhelming margin, but stalled in the Senate. Now, with a razor-thin Democratic majority in the Senate, it is again before that body.
[2] 947 F.3d 19 (2d Cir. 2019), vacated by Olan v. United States, 2021 U.S. LEXIS 93 (January 11, 2021). The solicitor general asked the Court to vacate and remand the decision in light of an intervening case, Kelly v. United States, 140 S. Ct. 1565 (2020), which called into question whether the confidential information possessed by the government agency in Blaszczak amounted to “property,” and the Court obliged in Olan.
[3] In Blaszczak, the Second Circuit split 2-1, finding that certain “predecisional information” possessed by the Centers for Medicare & Medicaid Services constituted “property” (with Judge Kearse dissenting), but all three judges agreed that Section 1348 did not have to be read “in pari materia” with Rule 10b-5, given the congressional history to Section 1348 indicating that Congress had wanted to simplify insider trading prosecution. The Supreme Court granted certiorari on two issues: (1) the in pari materia question of how to read Section 1348 and (2) the property issue raised by Kelly. Although Blaszczak has no continuing authority in light of the Supreme Court’s decision to vacate, it does reveal the unanimous position of the Second Circuit panel on the “in pari materia” issue, which may influence other panels.
[4] This is a reference to a 1969 novel (and later a movie) by Jimmy Breslin about an incompetent Mafia family. I realize that these references to popular culture, including “Perfesser” Stengel and Jimmy Breslin, will confuse narrow-minded academics under the age of 70, but they can ask their more broadly educated senior colleagues.
[5] 463 U.S. 646 (1983) (specifying the elements necessary to show unlawful insider trading).
[6] Assume for this purpose that Rule 14e-3 is inapplicable because there is no tender offer.
[7] 561 U.S. 358 (2010). Skilling narrowly construed the “honest services” statute (18 U.S.C. Section 1346) to require the payment of a bribe or kickback, even though the original legislation’s intent seemingly went much further.
[8] In Skilling, Justice Ginsburg was interpreting a far broader-reaching statute where the underlying case law was arguably inconsistent. ITPA has much more detail and is hardly vague in the usual sense, but it is ambiguous about what role it intends to give to “personal benefit.”
[9] 773 F.3d 438 (2d Cir. 2014).
[10] Id. at 443.
[11] Id.
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.