It has been nearly 60 years since the SEC first clearly prohibited insider trading in its 1961 decision in In re Cady, Roberts & Co. You would think that would be long enough for the doctrinal rules to have become reasonably clear. Think again! The recent evidence shows otherwise: A month ago, U.S. District Judge Paul Gardephe for the Southern District of New York permitted a defendant who had plead guilty to insider trading charges in 2013 to withdraw his guilty plea because there had been “insufficient” evidence that a personal benefit had been paid by the tippee to the tipper. See United States v. Lee, 13-Cr.-00539 (PGG). Lee shows the continuing impact of United States v. Newman, 773 F.3d 438 (2d Cir. 2014). Newman had been limited by the Supreme Court in Salman v. United States, 137 S. Ct. 420 (2016) and seemingly laid to rest earlier this year by the Second Circuit's decision in Gupta v. United States, 913 F.3d 81 (2d Cir. 2019). Nonetheless, Newman retains enough residual vitality to necessitate a new trial for Richard Lee, a former trader at now defunct SAC Capital. Pundits are predicting that the case will discourage the Government from bringing cases involving remote tippees.

Perhaps. No doubt prosecutors have been perplexed by a number of new decisions (which may or may not apply in other Circuits). They are today reacting in a predictable way that may sow even greater confusion by turning to alternative statutes. Congress also may be responding with new legislation—the Himes Bill (H.R. 2534), which recently unanimously passed the House Financial Services Committee. Still, prosecutors do not have time to wait to see what happens to the Himes Bill if it reaches the Senate (where good legislation often goes to die). Given the ambiguities surrounding what constitutes a “personal benefit” and when it must be shown, prosecutors have begun to explore other existing statutes that can also reach insider trading. These include:

(1) The mail and wire fraud statutes (which were used in Carpenter v. United States, 484 U.S. 19 (1987));

(2) The STOCK Act (Stop Trading on Congressional Knowledge); and, most importantly,

(3) 18 U.S.C. §1348 (a provision added in 2002, as part of the Sarbanes-Oxley Act).

What are the advantages of these provisions? Any criminal prosecution under the federal securities laws requires the prosecutors to prove “willfulness.” See, e.g., §32(a) of the Securities Exchange Act (which would apply in the case of a prosecutions based on Rule 10b-5). But “willfulness” need not be shown in a prosecution under the mail and wire fraud statutes (although here the prosecutor would be required to prove “specific intent”). The difference here may only be marginal (opinions vary).

The STOCK Act applies to Congress, its staff and “political intelligent” consultants. Revealingly, in U.S. v. Blaszczak, 308 F. Supp. 3d 736 (S.D.N.Y. 2018), prosecutors alleged violations of both the STOCK Act, the mail and wire fraud statutes, §1348 and Rule 10b-5 in a case in which information was misappropriated from the Centers for Medicare and Medicare Services and conveyed to professional traders (who made millions). The jury convicted some defendants under the STOCK Act 1348, wire fraud and §1348, but acquitted all defendants on the Rule 10b-5 counts. Why? Juries do not say, but a proper charge on the Rule 10b-5 counts would have required the jury to be told that they must find that the tipper received a personal benefit and that remote tippees were aware of this benefit. Possibly, the jury found it easier to convict on the other theories.

Thus, §1348 may become increasingly popular, and it certainly has a much broader applicability than the Stock Act. Is this good news? Not necessarily. The problem is that §1348 can be read so broadly that it may permit prosecutors to outflank and ignore Dirks v. S.E.C., 463 U.S. 646 (1983), and its long-established rule that there must be a breach of a fiduciary duty (or a similar duty of trust and confidence) before the use of material non-public information becomes unlawful. The result could be significant overcriminalization and, at a minimum, undesirable uncertainty about the scope of the insider trading prohibition.

This is not mere alarmism (which, to be sure, some law professors engage in regularly), because the Second Circuit has come very close already to saying this (as discussed below). Section 1348(1) applies to any person who:

knowingly executes, or attempts to execute, a scheme or artifice:

(1) to defraud any person in connection with any commodity for future delivery, or any option on a commodity …, or any security of an issuer with a class of securities registered under Section 12 of the Securities Exchange Act …”

Section 1348(2) then address “false or fraudulent pretenses, representations or promises,” thereby giving rise to the obvious interpretation that no false statement or representation is required under §1348(1). And that is what the Second Circuit has already held in United States v. Mahaffy, 693 F.3d 113, 125 (2d Cir 2012), where it wrote broadly: “False representations or material omissions are not required for a conviction under §1348(1).”

In 2007, the Seventh Circuit agreed in United States v. Coscia, 866 F.3d 782 796 (7th Cir. 2017), cert. den., 138 S. Ct. 1989 (2018), finding (in a “spoofing” case) both that no false representation or omission was necessary and that the deceptive conduct need not be “material.” According to both Circuits, the necessary elements for a conviction under §1348 are only three: “(1) fraudulent intent; (2) a scheme or artifice to defraud, and (3) a nexus with a security [or commodity].” Id. Indeed, the district court decision in Mahaffy said that §1348(1) “does not restrict, or even contemplate, the status of the victim.” See United States v. Mahaffy, 2006 WL 2224518 at *12 (E.D.N.Y. Aug. 2, 2006). Thus, a person not owed a fiduciary duty could seemingly be a victim under §1348(1), and transactions not involving a purchase or sale would be covered (as they have been in spoofing cases).

What could this mean? In my youth (before the last Ice Age), a favorite hypothetical was this: Assume a trader is standing at dawn on a ridge in Silicon Valley and suddenly sees the San Andreas fault open up and swallow all of Intel. He does the logical thing for a trader (at least those trained in American business schools) and places an order to buy 100,000 put options on Intel. Is this unlawful insider trading? Allegedly, Stanley Sporkin, the SEC enforcement chief in my youth, answered this hypothetical and said that it was. But Dirks ended this possibility by imposing a fiduciary duty requirement. It may now be possible to outflank this requirement by using §1348(1). Some decisions seem to go almost this far. See United States v. Melvin, 143 F. Supp. 2d 1354, 1372 (N.D. Ga 2015).

What is the better answer here? Although a fraudulent misstatement is always actionable, it can (and should be) the law that silence is not actionable “unless there is a duty to disclose.” See Basic v. Levinson, 485 U.S. 224, n.17 (1988). Thus, if §1348 requires at least a “scheme to defraud,” courts should rule that in cases involving only silence, there is no “scheme to defraud,” absent some fiduciary or similar duty. This argument has not yet been clearly addressed under §1348, and defense counsel should request such a charge. In this view, the defendant who sells short or buys put options when he sees the San Andreas fault swallow up Intel has defrauded no one because he is not under any obligation as a fiduciary to disclose anything. His silence is not actionable.

Prosecutors may not agree, however, and the Chief of the Justice Department's Fraud Section has recently co-authored a law review article stressing that §1348 does not incorporate the usual elements of insider trading. See Sandra Moser and Justin Weitz, “18 U.S.C. §1348—A Workhorse Statute for Prosecutors,” 66 DOJ Journal of Federal Law and Practice 111 (2018).

There are at least some signs that Southern District judges may be more cautious. In the earlier-noted Blaszczak case in which the jury acquitted on the Rule 10b-5 counts but convicted on §1348 and wire fraud, Judge Lewis Kaplan instructed the jury that they could find a “scheme to defraud” (and thus convict) “if you find that [the defendant] participated in a scheme to embezzle or convert confidential information from [the Center for Medicare Services] by wrongfully taking that information and transferring it to his own use, or the use of another person.” Although I might have liked this charge to have said something about breaching a duty of trust or confidence, Judge Kaplan's charge did succinctly get to the heart of the matter with its focus on embezzlement or wrongful conversion.

Nonetheless, for the time being, the bottom line is that contemporary insider trading law has the potential to both overreach and underreach. Culpable traders, even those who plead guilty, may be able to renounce their pleas years later (as in Lee) because the record of the guilty plea did not stress sufficiently that they knew of a personal benefit paid by the original tippee to the original tipper. Conversely, traders who trade on immaterial information or owing no duty to anyone may be liable under §1348(1) if prosecutors convince courts that that section requires proof of none of the elements in a Rule 10b-5 case.

This states the case for reform. But what should be done? As one of those involved in drafting the Himes Bill (H.R. 2534), I predictably favor the passage of that legislation (even though I also think it needs some further tinkering). The Himes Bill would accomplish three things:

(1) It would largely eliminate the need to prove that a “personal benefit” was received by the tipper and known to even remote tippees;

(2) It would cover material non-public information wrongfully obtained by non-fraudulent means (such as theft, computer hacking or extortion). Today, unless the information was acquired by means that involved deception, the SEC is powerless; and

(3) It would at last respond to the conceptual problem that insider trading is a “common-law crime” created by courts and never truly legislated by Congress.

Two counter-arguments are sometimes made to these advantages of a legislative approach:

(1) “You will never get it passed, because Congress is paralyzed”;

(2) After §1348 comes into greater use, everything is illegal, and there is no need for more legislation.

The first argument could be correct, and others have more powerful crystal balls, which can see the political future (or so they claim). But the case for legislation is even stronger if you believe §1348 will reach too far. The answer to that prospect (which some have urged to me) is to make the Himes Bill exclusive (for criminal prosecutions of insider trading) and limit §1348 in cases of manipulation (including “spoofing”). This makes sense but it would give the SEC heart failure as they are wedded for life to their old ally, Rule 10b-5.

If legislation seems unobtainable, could new SEC rules solve the problem (just as Rules 10b5-1 and 10b5-2 worked back in 2000)? I think this is unlikely. “Chevron deference” is largely dead at the Supreme Court, and any SEC rule that sought to abolish the “personal benefit” requirement will likely be rejected by the court, as it conflicts head-on with Dirks and other Supreme Court decisions. A more ingenious approach might be to promulgate an SEC rule that expansively defines “personal benefit.” Such a rule could make clear that a “reputational benefit” or the expectation of a reciprocal benefit (such as a tip of material non-public information in return) or the expectation of some future favor or service would suffice. Similarly, a new SEC rule could address what constitutes a “gift” or shows the intention to make a “gift” in violation of Dirks.

To sum up, a dual track strategy makes sense. That is, only legislation will truly solve the problem, but some new SEC rules could perform a useful, gap-filling function. As always, the greatest problem is “who will bell the cat?”, as neither Congress nor the SEC moves quickly.