For the first time since the Supreme Court’s 1983 decision in Dirks v. SEC,[1] the United States Court of Appeals for the Second Circuit affirmed an insider trading conviction without proof of a personal benefit to the insider or tipper. On December 30, 2019, the majority of a Second Circuit panel affirmed insider trading convictions in United States v. Blaszczak[2] that substantially departed from the historical requirement that a tipper must receive a personal benefit to prove insider trading. While this new development is applicable only to criminal cases rather than to civil or enforcement actions, the Second Circuit has made it easier for prosecutors to obtain insider trading convictions.

A. Historical Requirement of a Personal Benefit to Prove Insider Trading

Dirks, mentioned above, is a foundation of modern insider trading law. In that case, the Supreme Court held that when a tipper breaches a fiduciary duty by disclosing nonpublic information, a tippee can be found derivatively liable for the breach.[3]

But some personal benefit to the tipper is required: “Absent some personal gain, there has been no breach of duty to stockholders.”[4] A personal benefit can include a situation where “an insider makes a gift of confidential information to a trading relative or friend [because] [t]he tip and trade resemble trading by the insider himself followed by a gift of profits to the recipient.”[5]

More recently, the Second Circuit and the Supreme Court have grappled with judge-made insider trading law. In its 2014 decision in United States v. Newman, the Second Circuit created a higher standard for tipping liability.[6] In Newman, the Second Circuit held that an inference that a personal benefit had been provided to the tipper “is impermissible in the absence of 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.”[7] The evidence against the third- or fourth-level tippees in that case, who had no knowledge of the insider’s breach or personal benefit, could not meet this higher standard, and the convictions were overturned and the indictment dismissed.

In 2016, the Supreme Court issued its decision in Salman v. United States.[8] In Salman, an insider tipped his brother. Based on Dirks, the Supreme Court affirmed the upholding of the conviction by the Ninth Circuit on the basis that a tipper personally benefits by making a gift of confidential information to a “trading relative,” even without more.[9]

And the Second Circuit revisited these tipping issues in United States v. Martoma. During the pendency of Martoma’s appeal from an insider trading conviction, Newman was decided by the Second Circuit and Salman was decided by the Supreme Court, raising a question of whether Salman abrogated Newman’s requirement of a “meaningfully close personal relationship” to sustain a personal benefit.

The Second Circuit initially held that “the straightforward logic of the gift-giving analysis in Dirks, affirmed by Salman, is that a corporate insider personally benefits whenever he ‘disclos[es] inside information as a gift...with the expectation that [the recipient] would trade’ on the basis of such information or otherwise exploit it for pecuniary gain.”[10]

Nearly one year later, the same Second Circuit panel reheard Martoma’s appeal, and again affirmed his conviction for insider trading.[11] The majority panel explained that “there are many ways to establish a personal benefit” and concluded it “need not decide whether Newman’s gloss on the gift theory is inconsistent with Salman.”[12] The panel read Newman to require evidence of a personal benefit to the tipper through either (i) evidence of a meaningfully close or quid pro quo relationship between tipper and tippee, or (ii) evidence that the tipper intended to benefit the tippee by sharing confidential information. And even in the absence of a personal relationship or quid pro quo arrangement, the majority panel concluded, a jury may “infer that a corporate insider receives a personal benefit (i.e., breaches his fiduciary duty) from deliberately disclosing valuable, confidential information without a corporate purpose and with the expectation that the tippee will trade on it.”[13]

In this context, we turn to Blaszczak and an analysis of how the Second Circuit’s recent decision in that case departs from these precedents.

B. United States v. Blaszczak

1. Background

The facts of Blaszczak do not differ markedly from other insider trading cases, except for the subject of the information, which related to government agencies rather than public companies. At bottom, the government charged four individuals in connection with an alleged scheme to obtain nonpublic information from the Centers for Medicare and Medicaid Services (the “CMS”) pertaining to reimbursement rates for certain medical treatments.

In particular, a CMS employee, Christopher Worrall, allegedly provided material nonpublic information to David Blaszczak, a friend and former CMS colleague of Worrall who was working as a consultant. Blaszczak then allegedly passed that information to analysts at his client, Deerfield Management Company, L.P., who profitably traded on it. Blaszczak allegedly had given Worrall free meals and tickets to sporting events, as well as offering Worrall an opportunity to join his firm, which Worrall declined. Blaszczak was paid through his firm’s consulting arrangement with Deerfield.

Outside of the criminal context, Deerfield agreed to pay more than $4.6 million to settle Securities and Exchange Commission (the “SEC”) charges that it had insufficient safeguards in place to prevent insider trading.[14]

2. Trial and Distinguishing Insider Trading Under Title 15 From Title 18

The prosecutors in Blaszczak took a somewhat novel approach. Rather than allow its case to rise or fall on the “personal benefit” element at issue in the cases discussed above, the government used a backup theory to seek convictions. The cases discussed above all involved criminal charges for violations of Section 10(b) of the Exchange Act, a part of Title 15 of the U.S. Code. By contrast, the wire fraud and securities fraud statutes in the criminal code, Title 18 of the U.S. Code, arguably did not require a personal benefit. Accordingly, the tipper (Blaszczak), tippees (the Deerfield analysts), and government employee insider (Worrall) were charged with violating both Section 10(b) of the Exchange Act (part of Title 15) and the wire and securities fraud statutes under 18 U.S.C. §§ 1343 and 1348.

As the government likely hoped, this had an effect on the jury instructions. The Section 10(b) instructions followed Second Circuit and Supreme Court precedent, but the jury instructions on the Title 18 wire and securities fraud counts omitted any reference to a personal benefit.[15]

After a three-week trial and four days of deliberations, the jury returned a mixed verdict, acquitting the defendants on the Title 15 charges but convicting them on the Title 18 charges.[16] Among other things, the defendants appealed from this purported “end-run” around the limitations that courts have developed in insider trading cases for decades.

3. The Second Circuit Opinion

The two most significant issues on appeal were (i) whether the district court erred by refusing to instruct the jury on the Dirks personal benefit element in the Title 18 counts; and (ii) whether the confidential CMS information was “property” for the purposes of the wire fraud and securities fraud statutes under Title 18.[17] A majority of the panel, Judges Richard J. Sullivan and Christopher F. Droney, concluded that the district court had not erred and that the CMS information was property, and affirmed the convictions. Judge Amalya L. Kearse dissented as to whether the CMS information was “property” and thus as to the affirmance of the convictions, but did not address the “personal benefit” analysis.

i. Whether a “personal benefit” element applies

Writing for the majority, Judge Sullivan initially noted that neither Title 18’s fraud statute nor Title 15’s fraud statute mentions a “personal benefit” test, only schemes to “defraud,” as in embezzlement.[18] “Rather, the personal-benefit test is a judge-made doctrine premised on the Exchange Act’s statutory purpose.”[19] That is, as in Dirks, the Title 15 fraud provision specifically was enacted to “eliminat[e] [the] use of inside information for personal advantage.”[20]

The majority declined to extend Dirks beyond the Exchange Act (and Title 15). The majority reasoned the criminal securities fraud provision, 18 U.S.C. § 1348, was “added to the criminal code by the Sarbanes-Oxley Act of 2002 in large part to overcome the ‘technical legal requirements’ of the Title 15 fraud provisions. . . . Given that Section 1348 was intended to provide prosecutors with a different – and broader – enforcement mechanism to address securities fraud than what had been previously provided in the Title 15 fraud provisions,” the majority declined to “graft the Dirks personal-benefit test onto the elements of Title 18 securities fraud.”[21]

The majority also declined to extend Dirks on the basis of “enforcement policy considerations” like the increased likelihood that prosecutors would “avoid the personal-benefit test altogether” by using Title 18 alone. As Judge Sullivan wrote, “Congress was certainly authorized to enact a broader securities fraud provision, and it is not the place of courts to check that decision on policy grounds.”[22]

ii. Whether the CMS information was “property” under Title 18

Title 18 requires a scheme to defraud to obtain “money or property.”[23] The defendants argued on appeal that a government agency’s confidential information is not “property” because the agency has a “purely regulatory” interest in such information under Supreme Court precedent.[24]

The majority disagreed, holding that the CMS information was indeed “property” under the statute. As an initial matter, Judge Sullivan wrote that “property” under the Title 18 wire fraud and securities fraud statutes “is construed in accordance with its ordinary meaning: ‘something of value’ in the possession of the property holder (in this context, the fraud victim).”[25] Judge Sullivan was then “guided” in his analysis by two particular Supreme Court decisions, Carpenter v. United States[26] and Cleveland v. United States.[27]

In the former decision, the Supreme Court held that “the publication schedule and contents of forthcoming articles in a Wall Street Journal column were the Journal’s ‘property’ because ‘[t]he Journal had a property right in keeping confidential and making exclusive use’ of the information before publication.”[28] Indeed, the Supreme Court there noted that “[c]onfidential business information has long been recognized as property,”[29] and this particular information was effectively “stock in trade, to be gathered at the cost of enterprise, organization, skill, labor, and money, and to be distributed and sold to those who [would] pay money for it.”[30]

In the latter decision, the Supreme Court held that the mail fraud statute did not apply to fraud in obtaining a state or municipal license to operate video poker machines because the license was not “‘property’ in the government regulator’s hands.”[31] In that case, the Supreme Court gave weight to the fact that the licenses themselves had no economic value until issued, and the state’s right to control the issuance of licenses was as a sovereign rather than a property holder.[32] Judge Sullivan pointed to numerous rejected attempts to “apply [Cleveland’s] holding expansively,” citing the Supreme Court’s distinction between purely regulatory interests and economic interests.[33]

Accordingly, Judge Sullivan analogized Carpenter. CMS in Blaszczak, like the Wall Street Journal in Carpenter, “has a ‘property right in keeping confidential and making exclusive use’ of its nonpublic predecisional information.”[34] Furthermore, unlike a state’s right to issue or deny a poker license, the CMS’s information here “implicates the government’s role as property holder, not as sovereign.”[35] And, Judge Sullivan noted, CMS has real economic interests in confidentiality and in preventing leaks.[36] Though there was no monetary loss suffered by CMS, the panel concluded that this was not required and that “both regulatory and economic” interests controlled and the information at issue was “‘property’ in the hands of CMS.”[37]

iii. Judge Kearse’s dissent

Judge Kearse’s dissent took issue with the “property” aspect of the majority’s ruling. Judge Kearse focused on the fact that “CMS is not a business; it does not sell, or offer for sale, a service or a product; it is a regulatory agency.”[38] Thus, regardless of efforts to maintain confidentiality, Judge Kearse “[did] not view a planned CMS regulation as a ‘thing of value’ to CMS.”[39] As Judge Kearse wrote, “CMS does not seek buyers or subscribers; it is not in a competition; it is an agency of the government that regulates the conduct of others. It does so whether or not any information on which its regulation is premised is confidential.”[40]

In Judge Kearse’s view, Cleveland was in fact the better analogy: like gaming licenses, “the predecisional CMS information has no economic impact on the government until after CMS has actually decided what regulation to issue and when the regulation will take effect.” [41] Accordingly, Judge Kearse wrote, “I cannot agree that a premature disclosure of predecisional regulatory information has taken any property from CMS or the government.”[42]

C. Takeaways

As of this writing, the Blaszczak defendants have not indicated whether they will appeal or ask the Second Circuit to review the panel’s decision en banc. Barring further review of the panel’s decision, there are major implications from the Second Circuit’s opinion in this case.

First, the Second Circuit’s stripping of the personal benefit requirement from Title 18 prosecutions and its characterization of agency information as property will lead to more insider trading investigations and criminal charges. In particular, the government’s recent efforts to apply insider trading prosecutions to “political intelligence” likely will be emboldened by Blaszczak. Because many SEC registered firms – including hedge and private equity funds – use such information to bolster investment hypotheses and other companies both within and outside of the financial services industry routinely come into possession of this type of information, this expansion of insider trading law may ensnare many unsuspecting individuals and companies, particularly those operating inside the Beltway. For anyone who may fall into these categories, it is advisable to consult with knowledgeable counsel on whether such information is material or widely disseminated enough to be deemed public prior to trading.

Second, because Title 18 is the criminal code, civil enforcement proceedings brought by the SEC will remain within the purview of Rule 10b-5 and Title 15. This will create a somewhat perverse result, where the SEC in a civil enforcement proceeding must prove the additional element of a personal benefit. Of course, there remains a lower burden of proof for a civil proceeding. Nevertheless, this asymmetry may lead to strange outcomes. There may be cases (like Blaszczak) where the government charges insider trading defendants under both Title 15 and Title 18. But there also may be cases where the government only brings criminal charges (under Title 18) that it previously could not (because it was thought that the personal benefit element of Title 15 applied), or even where civil enforcement proceedings cannot be brought (because Title 15’s personal benefit element still applies). Indeed, the parallel SEC proceedings against the Blaszczak defendants were stayed while the criminal proceeding was underway, and it is unclear whether the SEC will continue the enforcement proceedings after the verdict and Second Circuit affirmance.

In addition, Blaszczak’s holding that predecisional confidential government information constitutes government property heightens the risk of both SEC and Department of Justice investigations in cases involving trading while in possession of confidential executive agency information. Whether the information is obtained directly from a government employee or from a consultant with access to government employees (as in Blaszczak), and whatever the topic (from tariff policies, budgeting decisions, or potential mergers facing antitrust scrutiny, to potential military actions or the calculation of unemployment figures), those with sources of information inside government should be especially wary of receiving and trading on confidential government information. This includes analysts and investors who speak with government personnel themselves, and also “political intelligence” consultants who do so. And trading, even in part, based on confidential government information is risky because the government (at least in the Second Circuit) prosecuting under Title 18 will no longer be required to prove that a tipper received any personal benefit from disclosure of the information.

Third, with the seeming removal of the “personal benefit” element to prove insider trading, counsel and compliance professionals should focus on the other elements of insider trading to protect against its occurrence and defend against prosecutions. In particular, if counsel and compliance professionals ensure that material nonpublic information is not used in trading decisions, then whether a duty was breached (regardless of a personal benefit) is of no significance. More importantly, firms should review their compliance programs to ensure that they properly address the new risks that the Blaszczak decision now presents. For example, communications with government officials, political intelligence firms, and lobbyists should be monitored to ensure that an email, call, or meeting with a political insider may not be viewed by the government in hindsight as conveying material nonpublic information that moves the market on securities that are in the firm’s portfolio. Similarly, firms should train their employees to recognize that such communications may pose insider trading risks and to educate those employees as to what they should do when they suspect that they received material nonpublic information. Knowledgeable counsel can help firms tailor their compliance programs in these ways and address insider trading questions as they arise.

Finally, this decision, and its apparent bifurcation of standards in civil and Exchange Act cases from Title 18 prosecutions, may provide extra incentive for Congress to address the fact that there is no law explicitly banning (and defining) insider trading. In December, the House of Representatives approved a bill that would do so by an overwhelming majority. Notably, while an amendment was added to this Insider Trading Prohibition Act[43] to require evidence of a “personal benefit,” the bill as passed by the House of Representatives would amend only Title 15 of the U.S. Code, not Title 18.

We will continue to monitor these developments to see if the Blaszczak defendants further appeal the Second Circuit’s decision or if the Senate considers the House bill.