Shutterstock

In 2014, the U.S. Court of Appeals for the Second Circuit threw a wrench into the government's insider trading prosecutions by ruling that a tippee cannot be found guilty under §10(b) of the Securities Exchange Act unless the tippee knew that the insider had divulged the information for a personal benefit. United States v. Newman, 773 F.3d 438, 449 (2d Cir. 2014). Such knowledge can be particularly difficult to prove for "remote tippees"—i.e., tippees one or more steps removed from the tipping corporate insider.

One question that Newman left unanswered was whether its holding applies to tippee prosecutions under the Title 18 statutes, such as wire fraud (18 U.S.C. §1343) and securities fraud (18 U.S.C. §1348). In December 2019, the Second Circuit finally answered that question. The court reasoned in United States v. Blaszczak that §10(b) and the Title 18 fraud statutes have distinct statutory purposes, and that Newman's "personal-benefit test is a judge-made doctrine premised on the Exchange Act's statutory purpose." Accordingly, the court declined to apply Newman to §1343 and §1348. United States v. Blaszczak, 947 F.3d 19, 34-37 (2d Cir. 2019). (The Blaszczak defendant-appellants are currently petitioning the Second Circuit for rehearing or rehearing en banc.)

Much of the post-Blaszczak commentary has focused on how eliminating the personal-benefit requirement makes §§1343 and 1348 easier to satisfy than §10(b), and that the government may now shift to relying more on the Title 18 statutes in insider trading prosecutions. This article offers a slightly different view: namely, that with respect to remote tippees, the Title 18 statutes actually create a different hurdle to conviction, one which Blaszczak's logic actually reinforces.

Section 10(b) and Derivative Tippee Liability

For both tippers and tippees, §10(b) liability is premised on the insider's breach of his or her fiduciary duty to the corporation. Dirks v. SEC, 463 U.S. 646, 654-55 (1983). The tippee, of course, has no such duty. So what makes the tippee—and remote tippees down the chain—also liable? The answer lies in the doctrine of "derivative tippee liability."

Derivative tippee liability provides that any tippee who knows of an insider's breach "inherits" the insider's obligation not to trade on the information. Id. at 660. The doctrine allows a jury to impute an insider's breach to downstream tippees who become aware of the breach and trade on the information—regardless of whether the tippee was involved in the breach or even knew of it when it occurred. In effect, the tippee is punished for his "role as a participant after the fact in the insider's breach of a fiduciary duty." Id. at 659 (quoting Chiarella v. United States, 445 U.S. 222, 230 n.12 (1980)).

Derivative tippee liability is judge-made doctrine that reflects a compromise between "requir[ing] equal information among all traders" (which could have an "inhibiting influence on the role of market analysts") and holding that tippees "always are free to trade on [inside] information" (which would have the perverse effect of allowing "devious dealings in the name of others that the [insider] could not conduct in his own"). Id. at 657-59.

This concept of extending principal liability to a person solely because he knew of and benefitted from someone else's crime is unique to §10(b). No other theory of vicarious criminal liability allows a person to be convicted as a principal without some contemporaneous association in the unlawful scheme. Co-conspirator liability, for example, requires that the defendant have made an agreement to join a conspiracy for which the crime was a reasonably foreseeable necessary or natural consequence. See 18 U.S.C. §371; Pinkerton v. United States, 328 U.S. 640, 647-48 (1946). Aiding and abetting liability requires that the defendant have a specific intent that the crime be committed, and that he aid, abet, counsel, command, induce, or procure the commission of the crime. See 18 U.S.C. §2; see also, e.g., United States v. Pipola, 83 F.3d 556, 562 (2d Cir. 1996). In contrast, derivative tippee liability is the equivalent of charging a person who knowingly accepted the proceeds of a bank robbery (say, by picking up some loose bills dropped by a bank robber who was fleeing the police)—with robbing the bank.

The Blaszczak court reasoned that §10(b) and the Title 18 fraud statutes have different statutory purposes, and that courts accordingly should refrain from applying §10(b)'s "judge-made doctrine[s]" to §1343 and §1348. If one accepts this premise, the government should not be permitted to rely on the doctrine of derivative tippee liability in Title 18 prosecutions—but instead should be forced to prove one of the Title 18 theories of vicarious liability.

Proving Remote Tippee Liability Under §1343 or §1348

This is exactly what a court found in United States v. Slawson, a remote tippee case that we (Andrew and Karen) helped to defend the year after the Second Circuit decided Newman. The government charged Slawson, co-founder of the hedge fund Titan Capital Management, under 18 U.S.C. §§1343 and 1348 for his trading in shares of children's apparel maker Carter's. The allegations encompassed three distinct "tipping chains" in which Slawson was either two or three steps removed from the Carter's insiders. Indictment, Docket No. 1, United States v. Slawson, No. 1:14-cr-186 (N.D. Ga. May 20, 2014). The government also charged Slawson under 18 U.S.C. §1349 for allegedly conspiring to violate §§1343 and/or 1348. See id.

Because the government had charged the case solely under the Title 18 fraud statutes, the court declined Slawson's request to give a personal-benefit instruction under Newman. The government then proposed an instruction that the jury could convict (merely) if it found that Slawson had "bought or sold Carter's securities or attempted to buy or sell Carter's securities on the basis of material nonpublic information about Carter's that he knew to have been improperly obtained from one or more Carter's employees." See Mot. for Pretrial Ruling on Applicable Offense Instrs., Docket No. 54, Slawson (July 13, 2015) (emphasis added). Slawson objected that this was effectively an effort to improperly import the Title 15 doctrine of derivative tippee liability into the context of a case charged as a Title 18 fraud.

Section 1343 prohibits the use of the wires by a person who knowingly has devised or intends to devise a scheme to defraud. Section 1348 prohibits knowingly executing a scheme to defraud in connection with a security. The Supreme Court has explained that the Title 18 fraud statutes can apply to insider trading because the original tipper's conduct is akin to an embezzlement or theft of the company's confidential information. Carpenter v. United States, 484 U.S. 19, at 27-28 (1987).

Slawson argued that, under these statutes, the government should be forced to prove either that Slawson "devised" or "executed" the scheme to defraud—that is, the scheme to steal confidential information from Carter's—or that one of the ordinary bases for vicarious criminal liability applied to make him liable for that conduct. Def.'s Requests To Charge the Jury, Docket No. 112, Slawson (Aug. 13, 2015). In short, the government needed to prove he had some involvement with the "first link" in the information chain. Derivative tippee liability did not apply.

The court ultimately gave the following instruction:

In order for the government to prove [its case], you must find beyond a reasonable doubt that the Defendant knew that he was obtaining material nonpublic information from one or more Carter's employees who were embezzling the information from Carter's for their own use, such as by sharing it with others so that they could trade on the basis of the information, and that the Defendant in some way knowingly and intentionally aided, counseled, commanded, induced, or procured that embezzlement.

Jury Instrs., Docket No. 118, Slawson (Aug. 17, 2015).

In so doing, the court rejected the government's effort to use the less demanding derivative tippee liability doctrine as a means of circumventing proof of individual liability under Title 18.

The jury acquitted Slawson on all counts after just a few hours of deliberation.

Conclusion

We have not seen this issue litigated since Slawson, but the issue takes on new significance after the Second Circuit's ruling in Blaszczak. Even if the Title 18 fraud statutes do not incorporate Newman's personal-benefit requirement, those statutes unquestionably impose their own hurdles, especially with respect to remote tippees. If the government shifts to charging more insider trading cases under the Title 18 fraud statutes rather than using §10(b), the courts will continue to tell us just how different the statutes really are.

Andrew E. Tomback is a partner in White & Case's global commercial litigation group. Karen Eisenstadt is counsel and Julian Canzoneri is an associate at the firm. Mr. Tomback and Ms. Eisenstadt advised Steven E. Slawson in the 'Slawson' case discussed herein.