(Article from Securities Law Alert, June 2016)
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In Dirks v. S.E.C., 463 U.S. 646 (1983), the Supreme Court held an insider can only face liability under Section 10(b) and Rule 10b-5 for disclosing material inside information to a third party—or tipping—if the insider “receive[d] a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.” The Dirks Court found that if a tipper receives no personal benefit for disclosing the information to a third party (the tippee), then the tippee has no duty to abstain from trading on that information.
On May 26, 2016, the First Circuit considered whether the personal benefit requirement applies in criminal tipping cases brought under the misappropriation theory of insider trading liability recognized in United States v. O’Hagan, 521 U.S. 642 (1997), rather than the classical theory of insider trading at issue in Dirks.[1] United States v. Parigian, 2016 WL 3027702 (1st Cir. 2016) (Kayatta, J.). The First Circuit held that to the extent the personal benefit requirement applies in cases involving the tipping of misappropriated inside information, the promise of “various tangible luxury items,” such as steak dinners and golf items, is sufficient to meet that requirement.
The First Circuit’s decision deepened a circuit split on the scope of the personal benefit requirement, an issue the Supreme Court will address in the next term in the case of Salman v. U.S. (No. 15-628). The Supreme Court will consider whether the government must prove “an exchange that is objective, consequential, and represents at least a potential gain [to the tipper] of a pecuniary or similarly valuable nature,” as the Second Circuit held in United States v. Newman, 773 F.3d 438 (2d Cir. 2014)[2]; or whether the government may establish the existence of a personal benefit by presenting “evidence of a friendship or familial relationship between tipper and tippee,” as the Ninth Circuit found sufficient in United States v. Salman, 792 F.3d 1087 (9th Cir. 2015).[3]
Background
The case before the First Circuit involved an alleged insider trading scheme in which an executive at American Superconductor Corporation (“AMSC”) disclosed “highly material inside information” concerning AMSC’s “yet-to-be-announced earnings reports and major commercial transactions” to Eric McPhail, a close friend. Although McPhail and the insider allegedly had “an understanding that information conveyed between them was to remain confidential,” McPhail allegedly began sharing AMSC-related information with a circle of his regular golfing companions, including Douglas Parigian. McPhail did not himself trade in AMSC stock. Rather, he allegedly “solicited ‘getting paid back’ by Parigian and [his other golfing companions] with wine, steak, and visits to a massage parlor.” Parigian allegedly promised McPhail “a nice dinner” at a steakhouse to thank him for the tips, which allegedly netted Parigian more than $200,000 in trading profits.
The government indicted Parigian for insider trading under the misappropriation theory of liability. The government contended that “Parigian knew or should have known that, by providing the inside information to Parigian, [McPhail] both breached a duty of trust and confidence [to the AMSC insider] and personally benefited by doing so.” Parigian unsuccessfully moved to dismiss the indictment, then “entered into a plea agreement that preserved his right to appeal the denial of the motion.” On appeal, Parigian contended that the indictment failed to allege several elements of criminal securities fraud, including a personal benefit to McPhail for tipping the information to Parigian.
First Circuit Finds the Alleged Promise of a Steak Dinner Sufficient to Allege a Personal Benefit in a Misappropriation Case
The First Circuit considered whether a personal benefit to the tipper is an element of an insider trading action brought under the misappropriation theory. The court noted that it has previously addressed this issue twice in the context of SEC civil enforcement actions.
The First Circuit explained that in SEC v. Sargent, 229 F.3d 68 (1st Cir. 2000), it found that “if a benefit need be proven” in a misappropriation-based tipping case, then the requirement was satisfied by “the government’s evidence that the misappropriator and the tipper were business and social friends with reciprocal interests.” Several years later, in SEC v. Rocklage, 470 F.3d 1 (1st Cir. 2006), the court similarly held that if a personal benefit requirement applies in misappropriation-based tipping cases, then “‘the mere giving of a gift to a relative or friend is a sufficient personal benefit’ to the giver.” Parigian, 2016 WL 3027702 (quoting Rocklage, 470 F.3d 1).
While the First Circuit recognized that Sargent and Rocklage were both civil cases, the court found the question of whether a “benefit to the misappropriating tipper [is] an element of a Rule 10b-5 violation . . . would seem to call for the same answer in both a civil and criminal proceeding.” The First Circuit held that if a personal benefit to the misappropriator is in fact required under its precedent, then “the indictment’s allegations of a friendship between McPhail and Parigian plus an expectation that the tippees would treat McPhail to a golf outing and assorted luxury entertainment [were] enough to allege [such] a benefit.”
The First Circuit noted that in Newman, the Second Circuit “adopted a more discriminating definition of the [necessary] benefit to a tipper in a classical insider trading case,” while in Salman, “the Ninth Circuit seemed to align itself more closely with [the First Circuit’s] holding in Rocklage.” The First Circuit stated that it did not know “[h]ow this will all play out” when the Supreme Court considers the personal benefit question next term. However, the First Circuit concluded that it was “bound to follow [its] circuit’s currently controlling precedent,” under which the promise of “various tangible luxury items in return for the tips” is sufficient to meet the personal benefit requirement.
First Circuit Finds the Indictment Sufficiently Alleged McPhail’s Breach of a “Duty of Trust and Confidence” Owed to the AMSC Insider
The First Circuit also considered whether the government sufficiently alleged that “McPhail’s tips to Parigian breached a duty of trust and confidence owed to” the AMSC insider within the meaning of the Supreme Court’s decision in O’Hagan. The court observed that in O’Hagan, “that duty and its breach were obvious” because the misappropriator was the company’s law firm and “it is clear that a company’s legal counsel regularly receives information in trust and confidence.”
Here, however, there was no allegation of any “formal type of fiduciary or confidential relationship” between McPhail and the AMC insider. The First Circuit explained that the indictment only “describe[d] a relationship in which one friend share[d] obviously confidential information concerning his business with another friend.” To determine whether such a friendship could give rise to “the type of breach of trust necessary to support conviction under the misappropriation theory,” the court turned to the text of the O’Hagan decision. The Supreme Court enumerated examples of “the kinds of relationships that might give rise to such a duty,” including “‘a relationship of trust and confidence.’” Id. (quoting O’Hagan, 521 U.S. 642).
The First Circuit also considered the SEC regulation clarifying the types of relationships that give rise to a “duty of confidence” under O’Hagan. Pursuant to the SEC’s rule, “a ‘duty of trust and confidence’ exists . . . whenever [the parties] . . . have a history, pattern or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality.”[4] Id. (quoting 17 C.F.R.§ 240.10b5-2).
The First Circuit found “the indictment expressly allege[d] that [the AMSC insider] and McPhail actually had an understanding, based on their ‘history, pattern and practice,’ that the information [the AMSC insider] shared with McPhail ‘was to remain confidential.’” The court concluded the government’s allegations were “enough to plausibly describe the existence of the requisite duty and its breach.”
First Circuit Finds Mens Rea Requirement of Scienter Applies in Criminal Tipping Cases
Parigian contended that the indictment was defective insofar as it alleged that he “knew or should have known” certain key facts. According to Parigian, the appropriate mens rea standard in criminal insider trading cases is scienter.
The First Circuit found Parigian had both forfeited and waived this argument, but determined that he otherwise "would have had a point.” The court explained that “[t]he state of mind required to establish liability for fraudulently trading securities depends, in relevant part, on whether the government seeks to establish civil or criminal liability.” The court noted that “[i]n a civil case, the government need only show that ‘the tippee knows or should know that there has been a breach [of the tipper’s fiduciary duty].’” Id. (quoting Dirks, 463 U.S. 646). But “[i]n a criminal case such as this one, . . . the ‘knew or should have known’ formulation runs up against a decades-long presumption that the government must prove that the defendant knew the facts that made his conduct illegal.”
The First Circuit noted that both the Sixth and Seventh Circuits have “appl[ied] the Dirks [mens rea] formulation in criminal securities fraud cases.” However, the First Circuit found “[t]he better view is that there is simply no reason why the mens rea requirement of scienter that routinely and presumptively applies in criminal cases would not apply in this criminal case where Congress has given no indication that it should not.”
[1] In Dirks, the Court considered a case in which a corporate insider tipped material inside information to a third party. In O’Hagan, on the other hand, the Court addressed a case in which a law firm entrusted with its client’s material nonpublic information misappropriated that information for trading purposes. In the case before the First Circuit in Parigian, the alleged misappropriator did not himself trade on the basis of inside information, but instead tipped that information to a third party who then traded on the information.
[2] Please click here to read our prior discussion of the Second Circuit’s decision in Newman.
[3] Please click here to read our prior discussion of the Ninth Circuit’s decision in Salman.
[4] The First Circuit recognized that there is a question as to whether this SEC rule “could serve as fully applicable in a criminal proceeding.”