A recent decision by the U.S. Court of Appeals for the Second Circuit may overhaul the way insider-trading cases are charged and litigated.
In United States v. Blaszczak, four men were charged with participating in an insider-trading scheme. In the alleged scheme, an employee of the Centers for Medicare & Medicaid Services gave an outside consultant advance notice of changes to Medicare reimbursement rates. The consultant then allegedly gave this information to two hedge fund employees, who used the nonpublic information to execute profitable trades for their employer.
Classic Insider Trading
This type of insider trading is known as “tipping.” The classic form of insider trading refers to buying or selling a security based on nonpublic information about the security. But one can also violate the securities laws by providing a “tip” about such insider information to someone who then trades on the information.
Normally, such insider trading schemes are charged under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5. The U.S. Supreme Court has long held that, to convict someone of a tipping offense under those rules, the government must prove the person providing the tip (the “tipper”) disclosed the information in violation of a duty of confidentiality and for personal benefit.
The government charged the four defendants in Blaszczak under the Exchange Act and Rule 10b-5, but also under a variety of other statutes, including the wire fraud statute (18 U.S.C. § 1343) and the securities fraud provision of the 2002 Sarbanes-Oxley Act (18 U.S.C. § 1348).
Although the federal trial court required the government to prove the tipper obtained a personal benefit to convict under the Exchange Act, it did not require the government to prove the personal-benefit element when the same conduct was prosecuted as wire fraud or under the Sarbanes-Oxley Act.
Rather, the federal court accepted the government’s argument that prosecutors can avoid the traditional limitations on insider tradition prosecutions simply by charging the same conduct under other fraud statutes.
A jury acquitted all four defendants of the traditional form of securities fraud, while convicting some of them of wire fraud and violating Sarbanes-Oxley’s securities fraud provision. The Second Circuit upheld the convictions, agreeing with the government that prosecutors need not prove the traditional elements of insider trading unless they charge that offense under the Exchange Act.
The decision substantially expands the scope of insider-trade liability in tipping cases. Indeed, if the Second Circuitt’s decision stands—and the wire fraud statute and the Sarbanes-Oxley Act’s securities fraud provision are read to allow conviction for a tipping offense without proof of the traditional elements of a tipping offense, including a personal benefit—it will have several significant consequences.
First, it will upset longstanding rules demarcating what makes trading on material nonpublic information criminally fraudulent rather than lawful analysis of corporate performance. The absence of that clarity hinders efficient market operation.
Second, it will effectively render prosecutions under Section 10(b) and Rule 10b-5 irrelevant. There will be no reason for the government to charge an insider-trading offense under those provisions when it can prevail without proving the traditional insider-trading elements by charging the identical conduct as wire fraud or under the Sarbanes Oxley Act.
Third, under this view of the law, many individuals who cannot be held civilly liable for violating the SEC’s Rule 10b-5 may still be held criminally liable for violating the wire fraud statute or the Sarbanes-Oxley Act’s securities fraud provision. And the latter carries the possibility of a 25-year jail term.
The defendants in Blaszczak have asked the federal appeals court to reconsider its decision. For now, however, the Blaszczak decision is binding on federal courts in Connecticut, New York, and Vermont.
But individuals charged elsewhere with insider-trading offenses under the wire fraud statute or the securities fraud provision of the Sarbanes-Oxley Act can still ask the jury to be instructed on the traditional elements of an insider-trading case, because there is good reason to believe that other courts will disagree with the Second Circuit decision.
After all, the Supreme Court’s decisions limiting tipping offenses to circumstances in which the tipper sought a personal benefit was not based on anything specific to Section 10(b) or SEC Rule 10b-5. Rather, the Supreme Court has explained that while those provisions set forth a broad anti-fraud rule, that rule is not violated unless the government can actually prove fraud.
And, according to the Supreme Court, there is no fraud when a tipper passes on information without any personal benefit. That is true whether the offense is charged under the traditional securities fraud statutes, the wire fraud statute, or the securities fraud provision of the Sarbanes-Oxley Act.
Each of these statutes by its terms outlaws fraud—and only fraud—and there is no evidence at all that, when Congress enacted Sarbanes-Oxley, it intended to alter the Supreme Court’s understanding of what counts as fraud.
Thus far, few insider-trading cases have been prosecuted under the Sarbanes Oxley Act. But after the Second Circuit’s decision, prosecutors can be expected to try more often.
In the meantime, markets will have to deal with exactly the sort of uncertainty that the Supreme Court has warned accompanies lack of clarity about the scope of insider-trading liability. In the end, the Supreme Court will likely be asked to restore clarity to this important area of law.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Anton Metlitsky is a partner in the New York offices of O’Melveny & Myers LLP and a member of its Supreme Court and Appellate Litigation practice group. He has drafted numerous briefs and presented oral argument in the U.S. Supreme Court and federal and state appellate courts throughout the country.
Kendall Turner is a counsel in the Washington, D.C., offices of O’Melveny & Myers LLP and a member of its Supreme Court and Appellate Litigation practice group. She has drafted numerous briefs and presented oral argument in the U.S. Supreme Court and various federal courts of appeals.