December 13, 2019
Commercial Litigation & White Collar Defense Alert
Commercial Litigation & White Collar Defense Alert
If the Insider Trading Prohibition Act (HR 2534) recently passed by the U.S. House of Representatives becomes law, it would not only provide some clarity, but also expand the scope of conduct that is subject to liability.
The current legal framework for insider trading has been described by one judge as “a straightforward concept that some courts have somehow managed to complicate.” If the Insider Trading Prohibition Act (HR 2534) (the “Act”) recently passed by the U.S. House of Representatives becomes law, it would not only provide some clarity, but also expand the scope of conduct that is subject to liability. In the meantime, the Securities and Exchange Commission (SEC) and Department of Justice (DOJ) are pursuing new theories to use existing laws to prosecute perceived insider trading violations.
The SEC defines illegal insider trading as “buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security.” This definition does not appear in any statute; rather, it has been developed through 50 years of case law. Enforcement is based on the catchall anti-fraud provisions of the securities laws, which prohibit the use of any “scheme or artifice to defraud” “in connection with the sale or purchase of any security.” The contours of the breach of fiduciary duty element, and in particular, the requirement that an insider receive a “personal benefit” from disclosing the inside information, have become increasingly unclear over the course of the past decade.
The personal benefit requirement first arose in 1983 when the Supreme Court held in Dirks v. SEC that “[a]bsent some personal gain, there has been no breach of duty.” It came to the forefront in 2014 when the Second Circuit attempted to narrow the definition of personal benefit in Newman, a case involving a “remote tippee” who was several layers removed from the insider. The Salman and Martoma decisions blunted the impact of Newman, but the effect was significant uncertainty in the jurisprudence. As courts considered issues such as whether career advice is a gift, what constitutes a “meaningfully close personal relationship,” and whether the promise of a steak dinner was sufficient to sustain a criminal conviction, calls for reform that would eliminate the need for courts to use the anti-fraud framework increased. In light of the uncertain state of the law surrounding the personal benefit requirement, the Act eliminated it as a required element for liability.
The Act makes it unlawful for a person to trade while aware of material, nonpublic information if that person knows, or recklessly disregards, that the information was obtained wrongfully, or that making that trade would constitute a wrongful use of that inside information.
The Act also prohibits those with material, nonpublic information from wrongfully communicating that information to others, or “tipping” them, if it’s reasonably foreseeable that the recipient of the information, or “tippee,” will trade on that information or pass it along to others who will.
The Act specifies that when material nonpublic information is obtained in the following four ways, trading or communication of that information is wrongful:
The Act applies a “recklessness” standard to the state-of-mind requirement, which does not require that the person trading or communicating has to “know” that the information was obtained improperly; rather, it requires only a finding that the person consciously avoided knowing or “recklessly disregarded” that the information was wrongfully obtained, improperly used, or wrongfully communicated. What constitutes “recklessness” is a continuously debated topic in securities law, and that would no doubt continue to be the case in insider trading cases brought under the Act if it becomes law.
While much of the Act serves to codify the current case law, in our view it would expand the scope of liability by broadening the definition of information that has been “wrongfully obtained,” making it easier for prosecutors to bring cases that don’t fit into the breach-of-fiduciary model. For example, trades based on information obtained by computer hacking would fall squarely within the statute and, as noted above, knowledge of a personal benefit conveyed to an insider would not be necessary for a finding of liability.
It remains to be seen how the Act will be received by the Senate Committee on Banking Housing and Urban Affairs, where it now awaits consideration.
In the meantime, the contours of the personal benefit requirement remain uncertain. Perhaps in an effort to circumvent the issue, the government is seeking new ways to use existing laws to prosecute individuals for illegal insider trading. For example, in U.S. vs. Blaszcak, a closely watched insider trading conviction that was heard by the Second Circuit in November, the SEC and DOJ charged defendants with the usual violations of 10(b), but also the STOCK Act (Stop Trading on Congressional Knowledge), and mail and wire fraud statutes, 18 U.S.C. §§1343 and 1348, with inconsistent results.
In our view, whether or not the Act becomes law, the SEC and DOJ will continue to explore new ways to pursue this cornerstone of their securities enforcement agenda.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.
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