Overview
As Congress struggles to determine whether it will finally pass a law defining insider trading, the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) have trained their sights on an ever-widening array of insider trading practices and theories. Recent cases have focused on the purchase and sale of material non-public information on the dark web and the use of a variation of traditional insider trading called “shadow trading.” The government is now investigating whether financial institutions have engaged in insider trading by tipping some of their clients about large, market-moving "block trades" in securities that the financial institutions are scheduled to handle for other clients. This article discusses how the government might frame insider trading cases based on allegations of tipping before the execution of block trades in securities.
Block Trading Explained
A block trade in securities is a transaction involving either more than 10,000 shares or shares worth at least $200,000. See 17 CFR §242.600(b)(12); NYSE Information Memorandum Number 14-06 (Feb. 25, 2014). Because block trades are large, these trades may be "market moving." To minimize the market impact, a shareholder trading a large block of stock will often conceal its role in the block trade by running it through a financial institution. Block trading is big business for the financial institutions who handle these transactions. According to data from Dealogic, in 2021, broker-dealers executed more than $70 billion of block trades in the United States. Gillian Tan, Katherine Burton, Sridhar Natarajan, What Block Trades Are and Why the SEC’s Investigating, Bloomberg, Feb. 16, 2022
Historically, block trading of securities has been regulated by individual stock exchanges, and not by the DOJ or the SEC. The New York Stock Exchange, for example, has warned its members against trading on information about impending block trades or sharing that information with other market participants. NYSE Information Memorandum Number 95-28 (July 10, 1995).
The DOJ and SEC are now asserting themselves in the world of block trading, investigating whether broker-dealers executing block trades have committed insider trading by providing other clients with advance notice of these trades. The government's concern appears to be that investors, armed with advance notice of block trades, can place profitable (or loss avoiding) trades. For example, the sale of large block of stock will typically depress the market price of the underlying stock. Investors with advance notice of a block sale can trade profitably by selling their own positions in the stock (to avoid a loss), buying put options to sell the stock (to lock in a gain), or implementing short term derivative trading strategies to capitalize on the anticipated drop in the stock price.
According to public reports, the DOJ and SEC have issued subpoenas to financial institutions seeking records relating to block sales over the past few years. If this investigation culminates in insider trading charges against the financial institutions or their employees, these charges will chart new territory and raise a number of novel questions in the realm of insider trading regulation and enforcement.
Section 10(b) and Rule 10b-5 Insider Trading
There is no federal statute explicitly prohibiting the practice of insider trading in securities. Instead, insider trading has traditionally been policed through §10(b) of the Securities Exchange Act and Rule 10b-5 promulgated by the SEC thereunder.
For example, according to the "traditional" or "classical" insider trading theory, §10(b) and Rule 10b-5 are violated "when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information." U.S. v. O’Hagan, 521 U.S. 642, 651-52 (1997).
And, under the "misappropriation theory" of insider trading, "a person commits fraud 'in connection with' a securities transaction, and thereby violates §10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information." Id. at 652. The misappropriation theory posits that "a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information." Id.
The Misappropriation Theory as Applied to Block Trading
The government appears likely to rely on the misappropriation theory of insider trading as it considers potential charges related to the block trading of securities.
To successfully allege §10(b) and Rule 10b-5 insider trading liability against financial institutions in connection with block trading under the misappropriation theory, the DOJ and SEC will have to prove that (1) the financial institution handling the block trade breached a duty of trust and confidence to the owner of the block of stock, (2) any information about the block trade that the financial institution shared with other clients was material and nonpublic, and (3) the financial institution received a personal benefit by providing this information to its other clients. U.S. v. Chow, 993 F.3d 125, 136-142 (2d Cir. 2021).
Duty of Trust and Confidence. A recent decision in an analogous, derivatives trading context, issued in the Southern District of Texas, Commodity Futures Trading Commission v. EOX Holdings L.L.C, sheds some light on how the government might approach the first of these three elements—whether a duty of trust and confidence exists between a financial institution and its client for whom a block trade has been executed.
The EOX Holdings case involved a firm that executed block trades of energy commodities for its clients. The Commodity Futures Trading Commission (CFTC) alleged that a trader at the firm improperly disclosed information about these block trades to other firm clients. The CFTC alleged that the firm and its trader violated §6(c)(1) of the Commodity Exchange Act, and Rule 180.1 promulgated thereunder, "each time [they] traded on the basis of material, nonpublic information or tipped material, nonpublic information to" the other clients. C.F.T.C. v. EOX Holdings L.L.C., No. H-19-2901, 2021 WL 4482145, at *19 (S.D. Tex. Sept. 30, 2021). The court noted that §6(c)(1) and Rule 180.1, applicable to commodities transactions, are modelled on §10(b) and Rule 10b-5, applicable to securities transactions. Id. at *19-20.
In EOX Holdings, the court identified three paths available to the CFTC to prove that the firm owed a duty of trust and confidence to its clients for whom it executed block trades. First, whether applicable law mandates the confidentiality of block trade order information. Second, whether restrictions set forth in the rules of individual exchanges impose confidentiality on block trade order information. And, finally, whether the financial institution and its block trading clients entered into confidentiality or nondisclosure agreements. Id. at *23-26.
The court in EOX Holdings found that, in the context of commodities transactions, applicable law may mandate the confidentiality of block trade order information. The court noted that a CFTC regulation prohibits "introducing broker[s] or any of its affiliated persons [from] … [d]isclos[ing] that an order of another person is being held by the introducing broker or any of its affiliated persons, unless such disclosure is necessary to the effective execution of such order … " 17 C.F.R. §155.4(b)(1). The court found that this regulation "impose[s] … a duty of trust and confidentiality not to use customer order information 'unless such disclosure is necessary to the effective execution of such order.'" EOX Holdings, No. H-19-2901, 2021 WL 4482145 at *24. This analysis, however, may have limited application to a case relating to the block trading of securities because the SEC has not adopted a rule applicable to broker-dealers that mandates the confidentiality of information about a securities order.
The SEC and DOJ might have more success proving the existence of a duty of trust and confidence based on exchange regulations and client agreements. For example, as noted above, the NYSE prohibits the disclosure of block order information to other clients. And a client selling a block of stock will often enter into a nondisclosure agreement with its broker-dealer before disclosing to the broker-dealer the identity of the securities it plans to sell.
Financial institutions may argue, however, that EOX Holdings permits them to disclose block order information as part of the appropriate distribution of "market intelligence and market color." The court held that customer agreements and "custom and practice in the industry" may permit this sort of disclosure about block trades. No. H-19-2901, 2021 WL 4482145, at *32.
Personal Benefit. With respect to the "personal benefit" element of the misappropriation theory of insider trading, recent Second Circuit decisions offer a roadmap for the government to potentially establish the existence of such a benefit to financial institutions who have shared information about block trades with their clients.
In U.S. v. Martoma, the Second Circuit explained that the personal benefit requirement may be established through proof of (1) "a 'pecuniary gain,'" (2) "a 'reputational benefit that will translate into future earning,'" (3) "a 'relationship between the insider and the recipient that suggests a quid pro quo from the latter,'" (4) "the tipper's 'intention to benefit the particular recipient,'" and (5) "a 'gift of confidential information to a trading relative or friend' where '[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.'" Id. at 74. Indeed, Martoma also concluded "it is settled law that personal benefits may be indirect and intangible and need not be pecuniary at all." Id. at 75. In Gupta v. U.S., the Second Circuit added that "[w]here the recipient of the tip is the tipper's 'frequent' 'business' partner, the tipper'’s anticipation of a quid pro quo is easily inferable." 913 F.3d 81, 86 (2d Cir. 2019) (per curiam). (In a later opinion, the Second Circuit clarified that "such an inference is permissive, not mandatory." Marshall v. U.S., 807 Fed. Appx. 56, 59 (2d Cir. 2020).)
While the personal benefit issue is very fact dependent, the DOJ and SEC may argue that, at the very least, financial institutions sharing advance notice of block trades received a "reputational benefit" or a personal benefit under the "quid pro quo" theory.
18 U.S.C. §1348 as a Fallback Option
If the government struggles to satisfy these elements of the misappropriation theory of insider trading under §10(b) and §10b-5, it has another potent option. The DOJ has made increasing use of 18 U.S.C. §1348, a criminal statute adopted as part of the Sarbanes Oxley Act of 2002, to prosecute insider trading. Section 1348, a securities fraud statute modelled on the federal mail and wire fraud statutes, could serve as a useful tool for any prosecution of insider trading in the block trading space because it does not require prosecutors to establish a breach of a duty by or a personal benefit to the tipper. (DOJ may also consider employing the federal mail and wire fraud statutes themselves, which would provide similar advantages to §1348 as described herein.)
In U.S. v. Blaszcak, the government alleged that defendants violated §1348 by misappropriating confidential information from the Centers for Medicare and Medicaid Services. 947 F.3d 19 (2d Cir. 2019), judgment vacated by Blaszczak v. U.S., 141 S.Ct. 1040 (2021). In Blaszack, the Second Circuit concluded that §1348, unlike §10(b) and Rule 10b-5, does not include a "personal benefit" requirement in connection with disclosing material, nonpublic information. In reaching this conclusion, Blaszcak also suggested that §1348 does not "require[] that the government prove a breach of duty in a specific manner … " Id. at 36. Instead, Blaszcak argued that "breach of duty is [] inherent in" wire fraud and Title 18 cases. Id. While the judgment in Blaszcak was vacated, it was done so on other grounds. Therefore, the Second Circuit's discussion regarding personal benefit and breach of duty is likely to remain persuasive.
An added benefit to the DOJ of relying on §1348 is that its elements cover ground largely familiar to prosecutions based on mail and wire fraud. For example, §1348(1) requires the government to prove "(1) ‘fraudulent intent'; (2) ‘a scheme or artifice to defraud’; and (3) 'a nexus with a security'." U.S. v. Hatfield, 724 F. Supp.2d 321, 324 (E.D.N.Y. 2010). Alternatively, §1348(2) requires the government to establish (1) 'a scheme or artifice’; (2) ‘to obtain, by means of false or fraudulent pretenses, representations, or promises, any money or property'; while possessing (3) fraudulent intent.” Id. And "[t]he [g]overnment must also prove a nexus with a security." U.S. v. Ramsey, No. 19-268, 2022 WL 596378, at *8 (E.D. Pa. Feb. 22, 2022). Under “both subsections, the [g]overnment must prove the 'security' involved is 'of an issuer with a class of securities registered under section 12 of the Securities Exchange Act of 1934 (15 U.S.C. 78l) or that is required to file reports under section 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(d)).” Id.
Conclusion
After years of ramping up enforcement of alleged insider trading violations, the DOJ and SEC appear to have found their next target. DOJ or SEC enforcement actions in the block trading space would raise new and interesting cases about the application of existing insider trading law. As suggested by recent case law, such an enforcement action brought under §10(b) and Rule 10b-5 will likely hinge on the facts of each specific case (mainly whether the facts establish a duty of trust and confidence and personal benefit to the tipper). In addition, given the potential complexities associated with §10(b) and Rule 10b-5, defense attorneys should also prepare for the likelihood that the DOJ will rely on 18 U.S.C. §1348 for any prospective prosecution.
The original publication of this article can be viewed at the New York Law Journal.
Reprinted with permission from the May 12, 2022 edition of ALM’s New York Law Journal© 202X ALM Global Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-256-2472 or reprints@alm.com.
