Insider trading and official corruption prosecutions—two of the cornerstones of recent white-collar enforcement efforts by the Department of Justice—have both generated sufficient doctrinal confusion to land them on the Supreme Court’s docket this year and next. This past April, the Court heard the appeal of former Virginia Governor Bob McDonnell from his corruption conviction, and next term, the Court is set to hear Bassam Salman’s appeal from his insider trading conviction. On the surface, these cases have little in common: McDonnell concerns what constitutes a sufficient “official action” to trigger criminal liability under anti-corruption laws, and Salman concerns what constitutes a sufficient “personal benefit” to trigger criminal liability under insider trading precedent. But beneath the surface, the legal doctrines at issue are related, in that both official corruption and insider trading cases are rooted in theories of fraud. Further, one of the fundamental principles of fraud—that a material misrepresentation is an element of the crime—could provide important guidance as to how these cases and others might be resolved.
By way of background, in a typical mail or wire fraud case, a defendant makes a material misrepresentation—or fails to disclose material information notwithstanding a duty to do so—to a victim in order to obtain the victim’s money or property. The theories of fraud underlying insider trading and official corruption cases, however, are not so simple.
First, insider trading is not explicitly proscribed by any statute, and has instead been interpreted as a type of fraud—a “deceptive device”—within the meaning of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. In a so-called “classical” insider trading case, for example, a corporate insider defendant owes fiduciary duties to the corporation and its shareholders, and thus has a duty either to disclose his intent to trade or to abstain from trading on the basis of material non-public information. When the insider trades on material non-public information or discloses the information to a tippee in exchange for a personal benefit, the insider breaches his fiduciary duty. As one former Director of Enforcement at the SEC observed, “[t]his breach of duty to shareholders constitutes the deception necessary for liability in a classical insider trading case.”
Whereas insider trading is prosecuted under judicial interpretations of Section 10(b), the federal government prosecutes official corruption (whether state or federal) under several statutes that are somewhat more plainly intended to address it. For example, the federal government prosecutes official corruption at the state and local levels as honest services fraud, Hobbs Act extortion, federal programs bribery, or a violation of the Travel Act, while prosecuting corruption at the federal level primarily under Chapter 11 of Title 18, United States Code, which covers “bribery, graft, and conflicts of interest.” McDonnell, for example, who was a state official, was prosecuted for both honest services fraud and Hobbs Act extortion.
In a typical honest services fraud case, brought under Section 1346 of Title 18, United States Code, a public official is accused of violating his duty to the voters by performing an “official action” that helps a third party in exchange for a personal benefit. Unlike a typical fraud case, in which a victim’s loss of money or property supplies the defendant’s gain, honest services fraud generally involves cases where a public official betrays his or her constituents while a third party, who had not been deceived, provides the enrichment. “The basic idea,” as one court has noted, “is that the public is not getting what it expects and deserves: honest, faithful, disinterested service from a public official.”
Thus, in general, both insider trading and official corruption cases (at least those prosecuted as honest services fraud) can involve similar kinds of fraud: In both cases, a defendant owes a duty (to shareholders or the public), and commits fraud by failing to disclose that the defendant secretly provided a thing of value (by tipping material non-public information or by performing an official action) in exchange for a personal benefit.
Notwithstanding these common roots in fraud, with its well established elements and familiar principles, recent cases have shown courts struggling to identify new language to cabin insider trading and official corruption prosecutions. For example, in United States v. Newman—whose holding Salman expressly asks the Supreme Court to endorse—the Second Circuit strained to craft language to separate personal benefits that would give rise to criminal liability from those that would not, writing that “in order to form the basis for a fraudulent breach, the personal benefit received in exchange for confidential information must be of some consequence.” With respect to the specific context where a personal benefit is inferred from the relationship between a tipper and tippee, the Second Circuit explained—in new and unfamiliar language—that the inference is permissible only where there is proof “of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”
Similarly, in the corruption context, at oral argument in McDonnell, multiple justices of the Supreme Court appeared to be searching for new standards to limit both sides of the quid pro quo in official corruption cases. Justice Breyer said he was “looking for” a “set of words that will describe in both sides’ positions what we should write as the words that describe the criminal activity involved,” emphasizing that he “want[ed] to know what the right words are.” Justice Alito explained that “we’re looking for . . . some limiting principle.” Justice Breyer weighed in again by expressing a concern with criminalizing conduct “when the quid is a lunch or a baseball ticket.” And Justice Kennedy suggested that it’s “stunning” that “the government has given us no workable standard.”
The workable standard, however, could start with the same fundamental principles of fraud that serve as the basis for insider trading and honest services liability in the first place. Instead of working out new language, as the Second Circuit did in Newman, courts addressing insider trading and corruption cases would perhaps do well to look for limiting principles in the well-established standards of fraud, and in particular in the principle that fraud requires that the misrepresentation or omission at issue be material.
The Scond Circuit has taken this road before. More than a decade ago, in United States v. Rybicki, the Second Circuit rejected a vagueness challenge to the honest services fraud statute in the private sector context. Writing en banc, the Second Circuit set out the elements of honest services fraud, which include the requirement that “the misrepresentation or omission at issue for an ‘honest services’ fraud conviction must be ‘material,’ such that the misinformation or omission would naturally tend to lead or is capable of leading a reasonable employer to change its conduct.” The court explained that “the ‘materiality’ test . . . has the virtue of arising out of fundamental principles of the law of fraud: A material misrepresentation is an element of the crime.” (Emphasis in original). Further, the court explained, the materiality standard would effectively separate out cases in which criminal liability was appropriate from those in which it was not: “We doubt that the failure to disclose to an employer a de minimis ‘bribe’—the free telephone call, luncheon invitation, or modest Christmas present—is a material misrepresentation in the sense in which we and other Circuits use the term.”
This materiality standard could provide helpful guidance in current cases, as the undisclosed quid pro quo in insider trading and corruption cases alike would have to be material to shareholders and the voting public. That is in line with what the Second Circuit suggested in Newman, when it said that the personal benefit had to be of “some consequence,” but unlike Newman’s language, the materiality test has the virtue of being a more familiar and workable standard. The question in Salman—which involved the gift of material non-public information to a trading relative—could be framed as whether the benefit one obtains from making a gift of such information to a trading relative is necessarily a material one to shareholders. The question in McDonnell could similarly be framed as whether McDonnell’s actions—like hosting an event at the governor’s mansion—were not only official but also material to voters. A standard along these lines could help avoid criminalizing telephone calls and luncheon invitations—the kinds of borderline official acts the Supreme Court expressed concern about at the McDonnell oral argument.
The question that remains is why courts have not done more to incorporate fraud principles in insider trading and corruption cases. For example, the word “material” does not appear once in the McDonnell briefs or oral argument before the Supreme Court, notwithstanding the role materiality has played in past honest services fraud cases like Rybicki. One answer could be that neither insider trading nor official corruption cases fit comfortably within the fraud theories outlined above. Indeed, there are already indications of a movement that, in the near future, could take insider trading and public corruption cases even further away from fraud-related principles. With respect to insider trading, reformers have introduced bills in Congress that eliminate the personal benefit requirement and unmoor insider trading from its original fraud underpinnings. With respect to corruption, the Supreme Court’s recent decision in Ocasio v. United States—which upheld the Hobbs Act conviction of a former police officer for routing cars damaged in accidents to a particular repair shop in exchange for bribes—could lead prosecutors to bring corruption cases principally under the Hobbs Act. As long as insider trading and official corruption cases remain rooted in fraud, however, courts that are attempting to refine the scope of criminal liability in these areas may do well to draw on the fundamental principles of fraud.
From The Insider Blog: White Collar Defense & Securities Enforcement.