Insider Trading Under Sarbanes-Oxley: Bypassing the Personal Benefit Test.

• Author: Meyer, Andrew J.

United States v. Blaszczak, 947 F.3d 19 (2d Cir. 2019)

1. INTRODUCTION

   Insider trading is broadly defined as the use of material nonpublic information in connection with the trade of stock or other securities. (1) To the average person, the classic case of insider trading is a corporate executive reaping handsome personal profits by trading stock using insider information that he obtained through his position within the corporation. The reality, however, can be much more complicated.

   While insider trading is generally illegal under federal law, the laws regulating it do not explicitly mention the term "insider trading." (2) In addition, not all forms of insider trading are prohibited. (3) Instead, a series of statutes and rules that prohibit fraud more generally are the basis for prosecuting insider trading. (4) Specifically, Section 10(b) of the Securities and Exchange Act of 1934 ("Exchange Act") and Rule 10b-5, promulgated by the Securities and Exchange Commission ("SEC"), bar persons from committing fraud in connection with the sale or purchase of any security. (5) Because those who engage in insider trading typically make no affirmative representation when they trade securities, any "fraud" would have to consist of a failure to speak in the face of a duty to do so. (6) Thus, the courts have found insider trading liability where a person has a duty to speak before trading but instead remains silent. (7) In other words, an insider at a corporation owes a duty to the shareholders of the corporation because he is an agent of it. (8) Therefore, the insider has a duty to disclose any material nonpublic information to the person on the other end of the security transaction prior to its completion. (9) For example, the failure of a CEO to publicly disclose the loss of a lucrative business opportunity prior to selling his stock in the corporation would be fraud under Section 10(b) and

   Rule 10b-5. (10)

   Insiders clearly have a duty to disclose; however, not all traders that use material nonpublic information are insiders to a corporation. (11) These outsider traders generally receive information from an insider in the form of a tip. To expand liability to these individuals, the United States Supreme Court created the personal benefit test. (12) The personal benefit test determines when the recipient of a tip ("tippee") inherits a duty to disclose from the source of the tip ("tipper"). (13) The test states that a tippee inherits a duty when the tipper shares material nonpublic information for personal benefit, and the tippee knows, or should know, that the tipper breached his duty in sharing it. (14)

   In 2002, Congress enacted a new securities fraud provision, 18 U.S.C. [section] 1348, under the Sarbanes-Oxley Act ("Sarbanes-Oxley"). (15) Congress created this criminal statute in response to the scandals of Enron, Global Crossing, Worldcom, and Adelphia, and it contains language similar to that of Rule 10b-5. (16) Section 1348 was largely ignored for years, but a 2019 decision in the United States Court of Appeals for the Second Circuit brought it to the forefront. (17) In United States v. Blaszczak, the Second Circuit considered whether the personal benefit test should extend to the newer Section 1348 securities provision. (18) There, a tipper and tippees were charged with securities fraud under Rule 10b-5 and Section 1348. (19) At trial, the jury acquitted the defendants of securities fraud under Rule 10b-5, but convicted them under Section 1348. (20) The trial court instructed the jury to use the personal benefit test for the Rule 10b-5 charges but not for the Section 1348 charges. (21) On appeal, the Second Circuit affirmed the trial court's decision and held that when a person is charged with securities fraud under Section 1348, the personal benefit test from Rule 10b-5 securities fraud jurisprudence does not apply. (22)

   This Note will discuss the history of insider trading law and analyze the reasoning of the Second Circuit. Part II outlines the facts and holding of Blaszczak, Part III analyzes the background and theories of insider trading liability under Rule 10b-5 and Section 1348, and Part IV describes the Second Circuit's decision in Blaszczak. Finally, Part V critiques the Second Circuit's decision and suggests changes to the future of insider trading law.

2. FACTS AND HOLDING

   Between 2009 and 2014, defendants David Blaszczak, Theodore Huber, Robert Olan, and Christopher Worrall engaged in two schemes to pass and use confidential government information from the Centers for Medicare & Medicaid Services ("CMS") to make securities trades. (23) Worrall worked at CMS, Blaszczak worked as a "political intelligence" consultant for hedge funds, and Huber and Olan worked at Deerfield Management, L.P., a healthcare-focused hedge fund. (24)

   CMS is a federal agency within the United States Department of Health and Human Services that manages and administers large government health programs including Medicare, Medicaid, and the Children's Health Insurance Program. (25) As a regulatory agency, the rules CMS adopts affect businesses and organizations within the health industry. (26) Specifically, CMS determines reimbursement rates for medical treatments covered by the health programs it manages. (27)

   The first scheme involved Blaszczak passing confidential information from CMS about upcoming reimbursement rate changes for medical treatments to Huber and Olan. (28) Prior to becoming a hedge fund consultant, Blaszczak worked at CMS along with fellow defendant Worrall, one of Blaszczak's sources. (29) Defendants Huber and Olan approached Blaszczak to obtain confidential CMS information because they knew Blaszczak enjoyed unique access to this information through his sources at the agency. (30) On four separate occasions, Blaszczak passed confidential information about pending reimbursement rate changes to Huber and Olan, which they used to make stock trades on several companies that would be affected by the changes. (31) In one instance, Huber and Olan received information from Blaszczak about a reduction in the reimbursement rate for certain radiation oncology treatments. (32) Huber and Olan then used this confidential information to enter orders that "shorted" approximately thirty-three million dollars' worth of stock in a radiation device manufacturer. (33) When shorting a stock, a person bets that the stock price will decrease and he profits when it does. (34) In other words, Huber and Olan bet that the manufacturer's stock price would decrease after the information became public, which, in this case, resulted in a profit of over two million dollars. (35) Huber and Olan believed that Blaszczak's information gave them an edge in the market, and through these trades, Huber and Olan's hedge fund accumulated approximately seven million dollars in profits. (36) They described their relationship with Blaszczak as a "money printing machine." (37)

   In the second scheme, which occurred around the same time as the first, Blaszczak shared similar confidential information with Christopher Plaford at another hedge fund. (38) Like Huber and Olan, Plaford also believed that the information provided by Blaszczak gave him an edge in the market and that it was more accurate than that from other sources because Blaszczak's information originated from the "horse's mouth." (39) Plaford used the confidential information to make trades similar to those made by Huber and Olan (40) On one occasion, Plaford accumulated approximately $330,000 in profit (41)

   The United States Department of Justice ("DOJ") filed an eighteen-count indictment related to these two trading schemes. (42) The charges included conspiracy centering on misappropriation of confidential information, conversion of United States property, wire fraud, securities fraud under Rule 10b-5, and securities fraud under Section 1348 (43)

   The DOJ tried the case before a jury starting on April 2, 2018. (44) Because none of the defendants apart from Worrall owed a duty to speak before trading, they would have to inherit such a duty under existing Rule 10b-5 precedents (45) Accordingly, the jury instructions for the Rule 10b-5 securities fraud counts included the personal benefit test (46) Specifically, the trial court instructed the jury that in order to convict the defendants of securities fraud under Rule 10b-5, the government needed to prove that Worrall, who owed a duty to CMS as an employee, tipped confidential information in exchange for a personal benefit, and that each of the other defendants knew that Worrall disclosed the information in exchange for a personal benefit (47) The trial court, however, denied the defendants' request to include the personal benefit test in the Section 1348 securities fraud instructions. (48) Instead, the trial court instructed the jury that in order to convict the defendants of Section 1348 securities fraud, the government needed to prove only that the defendants knowingly and willingly participated in a fraudulent scheme to embezzle or convert confidential information by "wrongfully taking the information and transferring it to his own use or the use of someone else." (49) The jury instructions for the Rule 10b-5 charges covered fourteen pages of the trial transcript and included ten elements, whereas the Section 1348 instructions spanned fewer than five pages. (50) The jury returned a verdict on May 3, 2018, which acquitted all defendants of the Rule 10b-5 securities charges, but convicted Blaszczak, Huber, and Olan of the Section 1348 securities charges. (51)

   On appeal to the Second Circuit, the defendants argued that the trial court erred in refusing to include the personal benefit test in the jury instructions for securities fraud under Section 1348. (52) The court held that when a person is charged with securities fraud under Section 1348, the Rule 10b-5 personal benefit test does not apply. (53)

3. LEGAL BACKGROUND

   In the United...