by Jakob Sebrow
The Second Circuit’s recent decision in United States v. Blaszczak [1] has been read as heralding an expansion of insider trading liability by rejecting the “personal benefit” requirement for insider trading prosecutions under the wire fraud and securities fraud statutes in Title 18 of the U.S. Code (“Title 18”). While this holding may encourage more insider trading prosecutions under Title 18, Blaszczak also contains dicta that provides support for questioning, and perhaps eliminating, one of the more controversial theories of insider trading—the contract-based misappropriation theory.
The Misappropriation Theory of Insider Trading
Under existing judicial interpretations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), there are two primary theories of liability for insider trading: the classical theory and the misappropriation theory. Under the classical theory—first recognized by the Supreme Court in Chiarella v. United States[2]—a corporate insider commits fraud under Section 10(b) of the Exchange Act when he trades in the stock of his own corporation based on material non-public information that he obtained from his insider position. This is considered fraud because of the “fiduciary or other similar relation of trust and confidence” that exists between the corporate insider and the shareholders of his corporation, which requires him to disclose any advantageous non-public inside information to those shareholders prior to transacting with them.[3] Notably, what makes the insider’s actions fraudulent is not the trading itself, but the failure to disclose the non-public information to shareholders prior to trading. As the Chiarella court explained, this theory of fraud-by-nondisclosure derives from the common law, which extends fraud liability to “one who fails to disclose material information prior to the consummation of a transaction . . . when he is under a duty to do so.”[4]
In United States v. O’Hagan,[5] the Supreme Court recognized an alternative theory of insider trading—the misappropriation theory.[6] While the misappropriation theory relies on the same fraud-by-nondisclosure principle that underlies the classical theory, it differs from the classical theory with respect to the types of duties that give rise to the liability. In contrast to the classical theory, where liability arises out of the fiduciary-like duties owed by a corporate insider to his corporation’s shareholders, the misappropriation theory premises liability on a “duty of trust and confidence” owed by any “fiduciary” to the source of the non-public information upon which he trades. As the O’Hagan Court put it, “a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.”[7] Under the misappropriation theory, corporate outsiders without a fiduciary relationship with the corporation whose stock is traded—for example, lawyers or bankers for a potential acquiring company who purchase stock of the target, or even officers of the acquiring company who trade stock in the target—could be held liable for insider trading as long as they violated a “duty of trust and confidence” owed to the source of that information.
Rule 10b5-2(b) and the Rise of Contract-Based Insider Trading
O’Hagan’s endorsement of the misappropriation theory greatly expanded insider trading liability under Section 10(b) of the Exchange Act, and the Securities and Exchange Commission (“SEC”) quickly attempted to codify this expansion through administrative rulemaking. In 2000, the SEC issued Rule 10b5-2, which purports to provide a “non-exclusive definition of circumstances in which a person has a duty of trust or confidence for purposes of the ‘misappropriation’ theory of insider trading.” In particular, subsection (b)(1) of the Rule provides that a “duty of trust or confidence” exists “[w]henever a person agrees to maintain information in confidence.”
On its face, Rule 10b5-2(b)(1) purports to extend insider trading liability to any individual who trades on the basis of material non-public information in violation of a confidentiality agreement. Over the past two decades, this “duty” codified in Rule 10b5-2(b)(1) has been criticized by some academics and practitioners because of its tension with the fiduciary-centered theory described in O’Hagan. While O’Hagan described the misappropriation theory as “premis[ing] liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information,”[8] Rule 10b5-2(b)(1) extends the theory to purely contractual arrangements which, as a legal matter, are different from the duties traditionally owed by fiduciaries.[9] Relatedly, Rule 10b5-2(b)(1)’s extension of insider trading liability to a breach of contract is arguably inconsistent with the common law theory of fraud-by-nondisclosure that underpins all of insider trading jurisprudence. Under the common law, an individual’s failure to disclose material facts to another party does not constitute fraud unless the individual owed a fiduciary-like duty to the other party—a purely contractual obligation is ordinarily not enough.[10]
Notwithstanding this criticism, in the two decades since the issuance of Rule 10b5-2, the SEC and the Department of Justice have brought numerous enforcement actions and prosecutions against individuals based only on alleged violations of written or oral confidentiality agreements, and not on traditional fiduciary relationships.[11] Relatively few defendants in these cases have tried to challenge the validity of Rule 10b5-2(b)(1) in court and, with the exception of one notable lower court decision,[12] those challenges have been unsuccessful.[13] Most courts that have addressed the issue have concluded that the Supreme Court’s opinion in O’Hagan is ambiguous regarding the precise contours of the “duty of trust and confidence,” and that Rule 10b5-2(b)(1) merits the judicial deference accorded to agency rulemaking under Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).[14] The Supreme Court itself has never addressed the validity of Rule 10b5-2(b)(1).
Blaszczak Strengthens the Case Against Rule 10b5-2(b)(1)
The Second Circuit’s recent opinion in Blaszczak concerned a criminal conviction based on the misappropriation theory of insider trading. While the case did not involve a confidentiality agreement, the Second Circuit’s opinion describes the misappropriation theory in a manner that raises significant questions about the continued viability of Rule 10b5-2(b)(1) and the contract-based misappropriation theory.
Blaszczak involved a scheme in which several employees of a government agency–the Centers for Medicare & Medicaid Services—obtained confidential information regarding planned changes to certain Medicare and Medicaid reimbursement rates and provided the information to a former colleague, who then tipped employees of a hedge fund that traded and profited based on the information. The members of the alleged scheme were indicted for insider trading based on the misappropriation theory and were charged under Section 10(b) of the Exchange Act and the criminal wire fraud and securities fraud statutes of Title 18. At trial, consistent with the Supreme Court’s 1983 decision in Dirks v. SEC, the district court instructed the jury that the Exchange Act charge required proof that the defendants had obtained some “personal benefit” from their misappropriation of the non-public information. The district court did not, however, include such an instruction for the Title 18 charges, concluding that the “personal benefit” requirement was not an element of those charges. After the defendants were convicted, they appealed, in part, on the grounds that the “personal benefit” requirement applies equally to insider trading prosecutions under Title 18.
The Second Circuit ultimately agreed with the district court that the “personal benefit” requirement does not apply to insider trading prosecutions under the wire fraud and securities fraud statutes of Title 18.[15] Before stating this holding, however, the Court expounded on the similarities between Section 10(b) of the Exchange Act and the Title 18 fraud statutes. The Court explained that, “for each of these provisions, the term ‘defraud’ encompasses the so-called ‘embezzlement’ or ‘misappropriation’ theory of fraud.”[16] Citing O’Hagan, the Second Circuit stated that, under both Title 18 and the Exchange Act, “[t]he undisclosed misappropriation of confidential information, in breach of a fiduciary or similar duty of trust and confidence, constitutes fraud akin to embezzlement.”[17]
The Second Circuit’s confirmation of the misappropriation theory’s uniformity across the Exchange Act and Title 18 is significant as it relates to the contract-based misappropriation theory of insider trading. Unlike the debate surrounding Rule 10b5-2(b)(1) and the use of contractual violations to support liability for fraud under the Exchange Act, there is no such controversy under Title 18. Case law interpreting the Title 18 fraud statutes follows the traditional common law approach that a breach of a contract cannot constitute fraud under most circumstances.[18] In United States ex rel. O’Donnell v. Countrywide Home Loans, Inc., for example, the Second Circuit held that the mail and wire fraud statutes in Title 18 incorporated the common law principle that “rejects any attempt to prove fraud based on inferences arising solely from the breach of a contractual promise.”[19]
While courts deciding misappropriation cases under the Exchange Act have been free to ignore Title 18 case law in the past, the Second Circuit’s statements in Blaszczak suggest that this case law is directly relevant to Section 10(b) and to an analysis of Rule 10b5-2(b)’s viability. As discussed above, previous judicial decisions upholding Rule 10b5-2(b)(1) have depended upon reading ambiguity into O’Hagan’s description of a “fiduciary’s . . . duty of loyalty and confidentiality.” This approach becomes more difficult in the face of analogous Title 18 case law that decisively rejects a contract-based theory of fraud, especially given that the Title 18 precedent derives from the same common law roots as the judge-made insider trading law under the Exchange Act.
While it may not be realistic to expect a court to invalidate Rule 10b5(2)(b)(1) imminently, Blaszczak provides more ammunition to the Rule’s critics. At the very least, the dicta in Blaszczak helps expose the incongruence between the contract-based misappropriation theory and the established contours of fraud in most other legal contexts. It is certainly possible that this incongruence may one day persuade a court to reconsider the use of contractual violations as a basis for insider trading liability, and to return the misappropriation theory of insider trading to its common law roots. More immediately, it should be noted that the Title 18 case law precluding the contract-based misappropriation theory means that the potential wave of insider trading prosecutions expected in the wake of Blaszczak will likely not proceed under that theory.
Footnotes
[1] No. 18-2811, 2019 WL 7289753 (2d Cir. Dec. 30, 2019).
[2] 445 U.S. 222 (1980).
[3] Id. at 228 (quoting Restatement (Second) of Torts § 551(2)(a) (1976)).
[4] Id. at 227-29.
[5] 521 U.S. 642 (1997).
[6] Prior to O’Hagan, the misappropriation theory had been adopted by several Circuit Courts of Appeal, the first being the Second Circuit in United States v. Newman, 664 F.2d 12 (2d Cir. 1981).
[7] 521 U.S. at 652.
[8] 521 U.S. at 652.
[9] See Ray J. Grzebielski, Friends, Family, Fiduciaries: Personal Relationships as a Basis for Insider Trading Violations, 51 CATH. U. L. REV. 467, 492 (2002). (“While the Rule’s requirement of an agreement to keep information confidential is slightly different from saying possession of information, without more, can violate Rule 10b-5, a contractual agreement for confidentiality does not necessarily create a fiduciary duty.”); Donna M. Nagy, Insider Trading and the Gradual Demise of Fiduciary Principles, 94 IOWA L.REV. 1315, 1340-64 (2009); Brief of Amici Curiae Law Professors in Support of Defendant-Appellee at 7–17, SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010) (No. 09-10996); Joel M. Cohen, Mary Kay Dunning, & Gregory H. Shill, Erosion of the Fiduciary-Duty Requirement in Insider-Trading Actions, Am. Bar Assoc. Securities Litig. J., Spring 2010.
[10] See Nagy at 1322-1324.
[11] See, e.g., SEC v. Nothern, 598 F. Supp. 2d 167 (D. Mass. 2009); SEC v. Kirch, 263 F. Supp. 2d 1144 (N.D. Ill. 2003); United States v. Kosinski, No. 3:16-CR-00148 (VLB), 2017 WL 3527694, at *5 (D. Conn. Aug. 16, 2017); Press Release, District of NJ USAO, California Man Sentenced to 18 Months in Prison for Role in Three-Year, Cross-Country Insider Trading Scheme that Netted More Than $3.9 Million; Press Release, SEC, SEC charges Hedge Fund Manager Leon Cooperman With Insider Trading, (Sept. 21, 2016)
[12] See SEC v. Cuban, 634 F. Supp. 2d 713, 730 (N.D. Tex. 2009), vacated and remanded on other grounds, 620 F.3d 551 (5th Cir. 2010).
[13] See, e.g., Nothern, 598 F. Supp. 2d; Kirch, 263 F. Supp. 2d at 1150; Kosinski, 2017 WL 3527694 at *5.
[14] See SEC v. Yun, 327 F.3d 1263, 1271 & 1273 n.23 (11th Cir. 2003); United States v. Corbin, 729 F. Supp. 2d 607, 615 & 618 (S.D.N.Y. 2010); see also United States v. McGee, 763 F.3d 304 (3d Cir. 2014) (upholding Rule 10b5-2(b)(2) under a similar analysis). In fact, it is arguable whether Rule 10b5-2(b) is a candidate for Chevron deference at all. Chevron applies to an agency’s interpretation of statutory text, but Rule 10b5-2(b) purports to interpret the meaning of the phrase “duty of trust or confidence,” which derives from the Supreme Court’s decision in O’Hagan. Under established precedent, an agency’s interpretation of judicial precedent is not accorded Chevron deference. See MikLin Enterprises, Inc. v. National Labor Relations Board, 861 F.3d 812 (8th Cir. 2017); New York New York, LLC v. N.L.R.B., 313 F.3d 585, 590 (D.C. Cir. 2002); Thomas Hodgson & Sons v. F.E.R.C., 49 F.3d 822, 826 (1st Cir. 1995).
[15] The Blaszczak Court also held that the insider information in that case constituted government “property” for purposes of the Title 18 fraud statutes.
[16] Blaszczak, 2019 WL 7289753 at *8.
[17] Id.
[18] See, e.g., United States ex rel. O’Donnell v. Countrywide Home Loans, Inc., 822 F.3d 650, 658-662 (2d Cir. 2016); United States v. Kreimer, 609 F.2d 126, 128 (5th Cir.1980) (“the [mail fraud] statute does not reject all business practices that do not fulfill expectations, nor does it taint every breach of a business contract. Its condemnation of a ‘scheme or artifice to defraud’ implicates only plans calculated to deceive.”); McEvoy Travel Bureau, Inc. v. Heritage Travel, Inc., 904 F.2d 786, 791 (1st Cir.1990) (stating, with reference to mail and wire fraud statutes, “[n]or does a breach of contract in itself constitute a scheme to defraud”); Johnson Enterprises of Jacksonville, Inc. v. FPL Grp., Inc., 162 F.3d 1290, 1318 (11th Cir. 1998) (Plaintiff’s allegations of “nothing more than breach of contract … would not constitute a ‘scheme to defraud’ proscribed by the mail and wire fraud statutes.”); Carr v. Tillery, 591 F.3d 909, 918 (7th Cir. 2010) (“But those allegations amount merely to a breach of contract claim, which cannot be transmogrified into a RICO claim [by way of predicate acts of wire fraud] by the facile device of charging that the breach was fraudulent, indeed criminal.”)
[19] O’Donnell, 822 F.3d at 659.
Jakob Sebrow is an associate at Richards Kibbe & Orbe LLP.
Disclaimer
The views, opinions and positions expressed within all posts are those of the author alone and do not represent those of the Program on Corporate Compliance and Enforcement (PCCE) or of New York University School of Law. PCCE makes no representations as to the accuracy, completeness and validity of any statements made on this site and will not be liable for any errors, omissions or representations. The copyright of this content belongs to the author and any liability with regards to infringement of intellectual property rights remains with the author.