A Look inside H.R. 2534: Insider Trading Prohibition Act

Rahul Mukhi is a partner, Shannon Daugherty is an associate, and Destiny D. Dike is a law clerk at Cleary Gottlieb Steen & Hamilton LLP. This post is based on their Cleary Gottlieb memorandum. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation by Jesse Fried (discussed on the Forum here).

Last month, Representative Jim Himes (D-Conn) and his co-sponsors, Representatives Carolyn B. Maloney (D-NY) and Denny Heck (D-WA), introduced H.R. 2534:  The Insider Trading Prohibition Act. Unlike its substantially similar predecessor, H.R. 1625, which was introduced by Representative Himes on March 25, 2015, H.R. 2534 has gained some momentum in the U.S. House of Representatives, having been unanimously approved by the Financial Services Committee in May 2019. Although the bill is only at the preliminary stage, if the proposal eventually proceeds further in the process of becoming law, it will represent a potentially significant shift in and clarification of U.S. insider trading laws.

Background

Current insider trading prohibitions arise from judicial case law interpreting Section 10(b) of the Securities Exchange Act of 1934 codified in 15 U.S.C. § 78j and the U.S. Securities and Exchange Commission (“SEC”) Rule 10b-5. This current state of judge-made law has increasingly come under attack for lack of certainty and clarity. [1] Some also have argued that the courts’ rooting of insider trading law in “deception” and breach of a duty fails to capture insider trading in the digital age. And others have argued that the lack of a statute specifically addressing insider trading has led to inconsistent interpretation and application by regulators and courts, particularly in the context of remote tippees, thus making it difficult for market participants to understand how to conform their conduct to the law. [2]

The “personal benefit” element, in particular, has been the subject of criticism following the Second Circuit’s decision in United States v. Newman. [3] The Supreme Court and the Second and Ninth Circuits have rejected Newman-inspired arguments attempting to limit “personal benefit” to circumstances where the benefit conferred is pecuniary or tangible. In Gupta v. United States, [3] the Second Circuit, relying on the Supreme Court’s decisions in Dirks v. SEC [5] and Salman v. United States, [6] unequivocally rejected the “pecuniary or similarly valuable nature” limitation formulated in Newman and reiterated that Dirks set out a disjunctive and non-exclusive list of “varying sets of circumstances . . . [that] warrant a finding of the tipper’s illegal purpose.” [7] Despite the Second Circuit’s more recent clarifications, the lack of statutory guidance defining a “personal benefit” remains a potential for uncertainty.

Also in the wake of the confusion following Newman, some prosecutors have sought to avoid the limitations of Title 15 by charging insider trading as wire fraud and Title 18 securities fraud. [8] In U.S. v. Blaszczak, a jury convicted the defendants of wire and securities fraud, but not Title 15 charges. The wire and securities fraud jury instructions notably did not include discussion of breach of a fiduciary duty or personal benefit as would be required under a charge for violating Section 10(b) or Rule 10b-5. [9]  The case is currently on appeal before the Second Circuit. [10] While the Himes bill is a potential step toward bringing greater certainty to this volatile area of law, codifying decades of common law may not prove so simple.

Overview of Bill

As proposed, H.R. 2534 would supersede Section 10(b) of the Securities Act.  In some aspects, the bill memorializes current insider trading law. It forbids trading in a security while in possession of material nonpublic information (“MNPI”), it provides the SEC with authority to exempt any person or conduct from the provisions of the bill, and it limits control liability where the control person acted in good faith. H.R. 2534, 116th Cong. §§ 16A(a), (d), (e) (2019).

Notably, the bill expands upon the duty element and appears to lower scienter requirements. Instead of a breach of a duty, the bill uses a “wrongfully obtained” standard. “[W]rongfully obtained” is defined to include MNPI obtained by:  (i) “theft, bribery, misrepresentation, or espionage (through electronic or other means);” (ii) “a violation of any Federal law protecting computer data or the intellectual property or privacy of computer users;” (iii) “conversion, misappropriation, or unauthorized and deceptive taking of such information;” or (iv) “a breach of any fiduciary duty, a breach of a confidentiality agreement, a breach of contract, or a breach of any other personal or other relationship of trust and confidence.”  Id. at § 16A(c)(1).

In what appears to be an attempt to lower certain scienter requirements, H.R. 2534 provides that liability attaches if an individual was “aware, consciously avoided being aware, or recklessly disregarded that such information was wrongfully obtained or communicated.”  Id. at § 16A(c)(2). In particular, by allowing criminal convictions of persons who “recklessly disregard” that information was wrongfully obtained, the proposal appears to lower the level of intent typically required under federal criminal laws. [11]

Key Takeaways

If passed, while codifying some of the existing insider trading law and clarifying areas of uncertainty, aspects of H.R. 2534 would involve substantive changes to the current insider trading framework. The “wrongfully obtained” standard casts a broader net than current case law. For example, the new standard would capture insider trading by cyber intruders that has to date been difficult to punish as insider trading.  See SEC v. Dorozhko, 574 F.3d 42, 51 (2d Cir. 2009) (holding that MNPI obtained by cyber intrusion is only captured under Section 10(b) if the method of hacking is “deceptive”). This may be appealing to Congress as a long overdue modernization of insider trading that also resolves the dissonance between deception-based insider trading and aggressive theft-based prosecutions and enforcement actions. [12]

But the bill may face scrutiny and resistance from certain circles for its breadth. Beyond the new “wrongfully obtained” standard, the bill includes an expansive list of examples of “wrongful” conduct that includes MPNI obtained in “breach of a contract,” without a requirement that the contract included a promise of confidence as under current law. This would potentially be in tension with the general understanding that “the common law does not permit a fraud claim based solely on contractual breach.” [13]

The bill would also potentially lower the mens rea standard for liability. Under the common law insider trading framework, civil liability attaches when a defendant acts “recklessly,” while criminal liability attaches only if a defendant acts “willfully.” The bill does not appear to draw a distinction between the two and could be viewed as extending criminal liability to “reckless” conduct.

While its proponents have argued that H.R. 2534 would reduce confusion among market participants and represents a long overdue codification and clarification of insider trading law, aspects of it may be met with some resistance. Time will tell whether H.R. 2534 moves forward and becomes the foundation for the future of insider trading law and regulation.

Endnotes

1To establish insider trading liability against a tippee-trader in a criminal case, the government must prove that the defendant: (i) traded in securities while (ii) in possession of material, nonpublic information  that he knew was (iii) obtained as a result of a breach of fiduciary duty and (iv) provided by the tipper in exchange for a personal benefit.  See Salman v. United States, 580 U.S. —, 137 S. Ct. 420, 427-29 (Dec. 6, 2016).(go back)

2See, e.g.Putting Investors First: Reviewing Proposals to Hold Executives Accountable: Hearing Before the Subcomm. on Inv’r Prot., Entrepreneurship, and Capital Mkts. of the H. Comm. on Fin. Servs., 116th Cong. 1 (2019) (statement of Prof. John C. Coffee, Jr., Adolf A. Berle Prof. of Law, Columbia Law School) (“There is general agreement today that the law of insider trading has grown overly complex and technical. As a result, it is hard for the public to understand its logic or for practitioners to give advice with respect to the scope of the prohibition. Moreover, to the extent that insider trading is judge-made law, disparities and inconsistencies among the U.S. circuit courts becomes inevitable because there is little in the way of a definitive statutory text to provide precise guidance.”).(go back)

3Newman held that the personal benefit inferred from a “gift of confidential information to a trading relative or friend,” then well-established under the Supreme Court’s decision in Dirks v. SEC, required “proof of a meaningfully close personal relationship that generates an exchange that . . . represents at least a potential gain of a pecuniary or similarly valuable nature.”  United States v. Newman, 773 F.3d 438, 452 (2d Cir. 2014) (citation omitted).  Newman was called into question by the Supreme Court in Salman, 137 S. Ct. at 428, which reiterated the test from Dirks. But, following Salman, in United States v. Martoma, the Second Circuit arguably preserved at least one part of the Newman holding when it held that the “meaningfully close personal relationship” required by the “gift theory” is only one means to establish a personal benefit: under Dirks, evidence of a relationship that suggests a quid pro quoor a tipper’s intent to benefit the tippee are “independently sufficient bas[es].”  United States v. Martoma, 894 F.3d 64, 77 (2d Cir. 2018) (“Martoma II”).  For further analysis of Newman and Martoma II, see Second Circuit Reverses Insider Trading Convictions of Remote Tippees, Cleary Gottlieb Alert Memorandum (Dec. 15, 2014), https://www.clearygottlieb.com/-/media/organize-archive/cgsh/files/publication-pdfs/second-circuit-reverses-insider-trading-convictions-of-remote-tippees.pdf and Second Circuit Potentially Revives Newman’s “Meaningfully Close Personal Relationship” Test, Amends Martoma Decision, Cleary Enforcement Watch (July 2, 2018), https://www.clearyenforcementwatch.com/2018/07/second-circuit-potentially-revives-newmans-meaningfully-close-personal-relationship-test-amends-martoma-decision/.(go back)

4Gupta v. United States, 913 F.3d 81, 84 (2d Cir. 2019).(go back)

5Dirks v. SEC, 463 U.S. 646, 663-64 (1983).(go back)

6Salman, 137 S. Ct. at 428.(go back)

7Gupta, 913 F.3d at 86.  Dirks articulates five independently sufficient bases for satisfying the personal benefit requirement: a (1) “pecuniary gain;” (2) “reputational benefit;” (3) “relationship between the [tipper] and the [tippee] that suggests a quid pro quo from the latter;” (4) “intention to benefit the [tippee];” or (5) “gift of confidential information to a trading relative or friend.” 463 U.S. at 664. For further analysis of Gupta and other notable cases, see Second Circuit Denies Gupta Appeal of Insider Trading Conviction—Continuing to Give Broad Meaning to “Personal Benefit” Requirement, Cleary Enforcement Watch (Jan. 11, 2019), https://www.clearyenforcementwatch.com/2019/01/second-circuit-denies-gupta-appeal-insider-trading-conviction-continuing-give-broad-meaning-personal-benefit-requirement/.(go back)

818 U.S.C. § 1343; 18 U.S.C. § 1348.(go back)

9Trial Tr., United States v. Blaszczak, 308 F. Supp. 3d 736 (S.D.N.Y. 2018) (No. 17-cr-0357 (LAK)), ECF No. 311.(go back)

10United States v. Blaszczak, 308 F. Supp. 3d 736 (S.D.N.Y. 2018), appeal docketed, No. 18-2811 (2d Cir. Sept. 24, 2018).(go back)

11Under current insider trading law, for criminal liability to attach, the defendant must have willfully breached a duty, 15 U.S.C. § 78ff(a), whereas civil liability only requires that the individual “knew or should have known,” SEC v. Obus, 693 F.3d 276, 287-88 (2d Cir. 2012) (citation omitted) (noting the relaxed scienter standard for civil enforcement actions).(go back)

12Edward Greene & Olivia Schmid, Duty-Free Insider Trading?, 2013 Colum. Bus. L. Rev. 369, 425 (2013) (“[I]ncreased concerns about inexpensive and easy-to-perpetrate hacking and other cyber crimes may make Congress more willing to ensure that laws relating to insider trading cover inappropriate behavior not necessarily involving breached fiduciary or related duties.”).(go back)

13Brief of Defendant-Appellant at 32, United States v. Chow, No. 19-325 (2d Cir. May 21, 2019) (citation omitted).(go back)

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