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1 The definitive source of INSIDER TRADING Lessons for Hedge Fund Managers From the Government s Failed Prosecution of Alleged Insider Trading Under Wire and Securities Fraud Laws By Todd R. Harrison McDermott Will & Emery LLP [I]t is easy to imagine a trader who receives a tip and is unaware that his conduct was illegal and therefore wrongful. [1] The Supreme Court stated clearly in Chiarella v. United States that the mere fact that a person receives material nonpublic information and then executes a trade based on that information does not constitute a crime. [2] But judicial intervention has not stopped the government from trying to come up with novel theories by which to prosecute so-called remote tippees recipients of information several steps removed from the corporate insiders at the beginning of the chain for insider trading. [3] This is exactly what happened in the recent prosecution of Steven E. Slawson, co-founder of the hedge fund Titan Capital Management. In a guest article, Todd Harrison, lead trial counsel for Slawson and a partner at McDermott Will & Emery, discusses the government s unsuccessful prosecution of Slawson and the wire and securities fraud statutes upon which it was based, analyzing the ramifications of the case for hedge fund managers. For additional insight from McDermott partners, see SEC s Hedge Fund Focus to Include Review of Funds That Outperform the Market (Apr. 29, 2011). For recent coverage of insider trading issues, see SEC Continues to Focus on Insider Trading and Fund Valuation (Jun. 30, 2016); Hedge Fund Managers Must Ensure That Insider Trading Compliance Policies and Procedures Cover Third-Party Consultants (Jun. 9, 2016); and SEC to Return Insider Trading Settlement Payment to Level Global (Feb. 4, 2016). Events Leading up to Slawson United States v. Newman, the Second Circuit s recent blockbuster insider trading case, was already pending on appeal when the grand jury indicted Slawson in May In Newman, the government had convicted two remote tippees for insider trading under Section 10(b) of the Securities Exchange Act of The defendants appealed, and the Second Circuit ultimately reversed their convictions, holding that Section 10(b) requires the government to prove that (1) the insider divulged inside information in exchange for a personal benefit of some consequence ; and (2) the tippee knew of that personal benefit. [4] Shortly after the Second Circuit issued its opinion in Newman, the government petitioned the court to rehear the case with respect to the first of its two holdings, namely, that the insider must receive a personal benefit of some consequence. The Second Circuit declined to rehear the case. On July 29, 2015, the government petitioned the Supreme Court for a writ of certiorari on the same issue. That petition was denied on October 3, [5] See our series on Supreme Court s Denial of Cert in Newman : Part One (Oct. 29, 2015); and Part Two (Nov. 5, 2015). Given the heightened criteria laid down by the Second Circuit in Newman for a Section 10(b) case, the government elected to charge Slawson under the wire fraud statute (18 U.S.C. 1343) and a rarely used securities fraud statute ( 1348), rather than under Section 10(b).[6] It was common in the 1980s for the government to charge insider trading conduct under both Section 10(b) and the Title 18 mail/wire fraud statutes. (Sections 1348 and 1349 were not enacted until 2002 as part of the Sarbanes-Oxley Act.) In recent years, 1

2 for whatever reason, many prosecutors fell out of the habit of charging parallel Title 18 counts. [7] This trend left the government particularly vulnerable to what occurred in Newman. That the government s charging decision against Slawson was a blatant attempt to end run the personal benefit and knowledge of personal benefit requirements at issue in Newman became obvious as Slawson s prosecution unfolded when the government argued repeatedly (and successfully) to the court that these two elements are irrelevant to insider trading prosecutions charged under the Title 18 fraud statutes. [8] Though Slawson sought a jury instruction on both elements, the court denied his request. [9] Nonetheless, after 11 days of trial, the jury acquitted Slawson on all counts. The government s gambit to circumvent Newman by bringing securities fraud charges under 1348 failed because it neglected to take two things into account. First, even if courts decide that the personal benefit and knowledge of personal benefit elements apply only to Section 10(b) cases and not to 1348 cases, the wire fraud and securities fraud statutes encompass their own requirements that can be, in some situations, even more difficult for the government to prove. Second, no matter how much the government tries to (and succeeds) in lowering the mens rea bar, a jury will hesitate, and may even refuse, to convict a defendant if the government cannot prove the defendant knew he was committing a crime. The Indictment The indictment charged Slawson with 10 counts of wire fraud ( 1343), 25 counts of securities fraud ( 1348) and one count of conspiracy to violate the wire fraud or securities fraud statutes ( 1349). [10] All of these charges related to Slawson s trading in the stock of Carter s, Inc., a children s clothing company. The allegations encompassed three distinct tipping chains in which Slawson was either two or three steps removed from the Carter s insiders. [11] Though the indictment formally charged Slawson only with Title 18 violations, the allegations read like a selective mishmash of Title 15 and Title 18 concepts designed to ease the government s path to conviction. For example, the indictment alleged that the Carter s insiders had breached their fiduciary and other duties of trust and confidence to Carter s in exchange for personal benefit[s]. [12] These are distinctively Title 15 concepts. At the same time, however, the indictment also alleged that Slawson had misappropriate[ed] confidential information with the goal of depriv[ing] Carter s of the exclusive use of its intangible property, to wit, confidential business information [13] which is language drawn directly from the Supreme Court s wire fraud decision in Carpenter v. United States. [14] One thing that was notably absent from the indictment was any allegation that Slawson knew of any personal benefit to the insiders. To all appearances, then, the government s plan was to convict Slawson using the Section 10(b) standard for conviction (including the Section 10(b) concept of derivative tippee liability ) shorn of the troublesome but crucial requirement that the government prove the remote tippee s knowledge of a qualifying personal benefit to the insider. Applying the Wire Fraud and Securities Fraud Statutes to Insider Trading Conduct The wire fraud statute prohibits the use of wires by a person who has devised or intends to devise a scheme or artifice to defraud or to obtain money or property by means of false or fraudulent pretenses. [15] The securities fraud statute, which was patterned on the mail and wire fraud statutes, similarly prohibits knowingly executing a scheme or artifice to defraud any person in connection with a security or obtain money or property by means of false or fraudulent pretenses in connection with the purchase or sale or a security. [16] The Supreme Court explained in Carpenter how the Title 18 fraud statutes can appropriately be applied to insider trading conduct. In Carpenter, R. Foster Winans, 2

3 a reporter for the Wall Street Journal, entered into a scheme to give advance information about the contents of his notorious Heard on the Street stock column to several brokers. The brokers then executed trades based on the information and everyone including Winans shared the profits. [17] For this conduct, Winans and the brokers were charged with, among other things, wire fraud. On review, the Supreme Court reasoned that this insider trading scheme fell within the reach of the... wire fraud statute... because Winans conduct was akin to the embezzlement of the Journal s property, that is, its confidential information. [18] In other words, the Court held that insider trading conduct can be prosecuted as wire fraud if one conceives of the scheme to defraud as being a scheme to steal a company s confidential information. This point was central when it came to the jury instructions the court gave at Slawson s trial. Slawson s Trial At the trial, three cooperators testified for the government including the two analysts who had allegedly tipped Slawson about Carter s. The government also presented a seemingly strong circumstantial case of tipping based on telephone and trading records. As was the case in Newman, however, the government offered very weak evidence of the personal benefit elements of a Title 15 violation. The government s sole evidence of any personal benefit to the insiders during the first five years of the alleged conspiracy was an ipod that one of the analysts gave to one of the insiders for Christmas. The government offered no evidence that Slawson knew of the ipod gift or the provision of any other personal benefits to the insiders. The government also had a very weak case that Slawson even knew the information was illegitimate. On this point, the government relied almost exclusively on the argument that Slawson must have realized he was receiving illegal inside information because of the detailed nature and accuracy of the information, the fact that Slawson was a sophisticated trader and the testimony of the two analysts that they occasionally mentioned to Slawson that they had spoken to contacts or investor relations people at Carter s. [19] The defense countered this argument with compelling evidence that Slawson did not know the information was illegitimate. Slawson testified that he did not know, and several other witnesses, including the CEO of Carter s, explained to the jury that it is perfectly acceptable for analysts to speak to corporate insiders (and particularly investor relations personnel, whose job it is to have such conversations with analysts and investors). Thus, the defense argued, any references by the analysts to having spoken with their contacts at Carter s would not have signaled any impropriety to Slawson. The defense also offered an expert who testified that Slawson s trading patterns in Carter s stock were inconsistent with the knowing possession of inside information. No Derivative Liability Under Title 18 Consistent with the government s position that the personal benefit and knowledge of personal benefit requirements do not apply in a Title 18 wire fraud case, the government proposed a jury charge that omitted any reference to these elements. [20] Slawson requested that the jury be charged on these elements, but the court refused the request. [21] The government also argued for a conscious avoidance knowledge instruction, namely, that the jury could find knowledge if the defendant was aware of a high probability that [a] fact existed unless the defendant actually believed that fact did not exist. [22] Finally, the government requested an instruction that would have permitted the jury to convict Slawson on the theory of derivative tippee liability. Specifically, the government proposed an instruction stating that the jury could convict 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 3

4 material nonpublic information about Carter s that he knew to have been improperly obtainedfrom one or more Carter s employees. [23] Slawson objected to the conscious avoidance jury instruction as unwarranted on the facts and to the derivative liability instruction as incorrect as a matter of law. [24] Slawson argued that if the court refused to instruct the jury on the personal benefit elements (on the ground that those elements are specific to Section 10(b)), then the court must also refuse to instruct the jury on derivative liability (because that concept is likewise specific to Section 10(b)). [25] Derivative liability is a doctrine under Section 10(b) that enables a jury to impute an insider s breach of fiduciary duty 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 knew of it when it occurred. [26] The Supreme Court has explained that derivative liability is akin to being charged as a participant after the fact in the insider s misconduct.[27] This concept of being liable as a principal because you knew of and benefitted from a crime is unique in the criminal law. No other theory of vicarious criminal liability allows a defendant to be convicted as a principal without some active association in the original scheme to defraud by appropriating inside information. [28] When isolated from its rightful context in the Section 10(b) federal common law, derivative 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. Slawson argued that the court could not allow the government to mix and match elements from Title 15 and Title 18 in the jury charge the way the government had done in the indictment. Slawson stressed that, if the government chose to avoid charging under Title 15 and instead use Title 18 to avoid the Newman personal benefit requirements, then the government could not also rely on the Title 15 derived theory of derivative liability to convict him. Rather, the government would need to prove that Slawson devised or executed the scheme to defraud (which in the Title 18 context, per Carpenter, must be conceived of as the scheme to embezzle confidential information from its rightful owner). [29] Thus, Slawson argued that the government needed to prove that he devised or executed a 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. [30] Ultimately, the court rejected the government s derivative liability language, though the court also declined to adopt Slawson s proposed language that the government must prove that the Defendant knowingly executed a scheme to embezzle confidential information from Carter s. It is not enough for the Government to show that the Defendant received information knowing that the information was confidential Carter s information that had been embezzled from Carter s. [31] The court did, however, instruct the jury that it needed to find that Slawson in some way knowingly and intentionally aided, counseled, commanded, induced, or procured [the] embezzlement of Carter s confidential information. [32] In other words, to convict, the government needed to prove that Slawson was somehow affirmatively involved in the first link of the information chain wrongfully obtaining the information from the insiders (either directly or through one of the ordinary forms of vicarious liability). The court allowed the government s conscious avoidance instruction over Slawson s objection. [33] Despite the conscious avoidance instruction and the government s argument that Slawson should be convicted of wire fraud simply because he must have realized the information was illegally obtained, the jury deliberated for only five hours before returning an acquittal on all 34 remaining counts. 4

5 Conclusion The government s defeat in Slawson may dampen its eagerness to use Title 18 to solve its Newman-related woes. Given the continuing ramifications of Newman, however, that may be wishful thinking. [34] Defendants should therefore be on the lookout for the government s attempt to mix and match the elements of Title 15 and Title 18 to create a lower bar for conviction than is permitted under either regime. Sections 1343 and 1348 incorporate their own protections, and defendants particularly those who, like Slawson, are innocent should not hesitate to force the government to prove every element of those statutes. Defendants should also take heart from the wisdom of the jury that acquitted Slawson. No matter how much the government may try to erode the legal elements of the relevant statutes (as it did throughout the Slawson case), many jurors are guided by their own intuitive sense of justice. The Slawson jurors apparently understood that Slawson was similar to the trader the Newman court sought to protect a trader who receive[d] a tip and [was] unaware that his conduct was illegal and therefore wrongful. The jury s verdict in the Slawson case was a clear statement that, in the jury s judgment, at least, such a trader has not committed a crime. Todd R. Harrison, a partner in the New York office McDermott Will & Emery, focuses his practice on white-collar and corporate defense, internal investigations, regulatory and compliance matters, and complex civil litigation in state and federal courts. He is a former Assistant U.S. Attorney and Deputy Chief for the U.S. Attorney s Office for the Eastern District of New York. [1] United States v. Newman, 773 F.3d 438, 450(2d Cir. 2014) (quoting United States v. Kaiser, 609 F.3d 556, 569 (2d Cir. 2010)), petition for cert. filed (U.S. Jul. 30, 2015) (No ) [2] 445 U.S. 222, 233 (1980) (rejecting the proposition that there exists a general duty between all participants in market transactions to forego actions based on material, nonpublic information and noting that Congress has never adopted a parity-of-information rule for securities trading). [3] Despite the Supreme Court s rejection of the government s proposed information asymmetry theory of liability in Chiarella, leading up to Newman, the government s insider trading prosecutions increasingly stretched the law to reach ever-more-remote tippees. See Newman, 773 F.3d at 448 (criticizing the doctrinal novelty of the government s recent insider trading prosecutions targeted at remote tippees). [4] 773 F.3d at 449, 452. [5] In neither petition did the government request a review of the Second Circuit s holding that the tippee must know of the personal benefit to the insider. This may signal the government s recognition that the tippee knowledge requirement is not open to serious challenge in light of the Supreme Court s opinion in Dirks v. SEC, 463 U.S. 646 (1983). [6] 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 for allegedly conspiring to violate 1343 and/or Id. [7] The trend against charging Title 18 violations in insider trading cases may also explain why so few cases have been charged under 1348, though the statute was enacted more than ten years ago. Indeed, prior to Slawson s trial, it appears that only one published case involved a jury charge under 1348 for a similar type of offense. That case, United States v. Mahaffy, No. 05-CR-613, 2006 WL (E.D.N.Y. Aug. 2, 2006), involved a front-running scheme in which several stockbrokers gave day traders access to information about the impending purchase or sale of large blocks of securities for the brokerage firm s institutional clients so that the day traders could purchase or sell the same securities prior to the firm s execution of the orders. Id. at *1. We discuss Mahaffy further infra notes 16, 31. [8] See, e.g., Resp. in Opp n to Def. s Mot. to Dismiss the Indictment, Docket No. 29, Slawson (Oct. 21, 2014); Gov t Resp. in Opp n to Def. s Mots. For Reconsideration, Docket No. 58, Slawson (Jul. 17, 2015). Cf. Peter J. Henning, A New Way to Charge Insider Trading, N.Y. Times (Aug. 24, 2015), available at [9] Resp. in Opp n to Mot. For Pretrial Ruling on Applicable Offense Instructions, Docket No. 70, 5

6 Slawson (Jul. 22, 2015); Order, Docket No. 77, Slawson (Jul. 27, 2015). [10] Indictment, supra note 6. [11] Id. [12] Id. [13] Id. [14] 484 U.S. 19, 28 (1987). [15] 18 U.S.C [16] 18 U.S.C See, e.g., United States v. Harris, No. 1:09-CR-0406, 2010 WL , at *3 (N.D. Ga. Oct. 22, 2010) (stating that 1348 was patterned on 18 U.S.C. 1341, 1343, and 1344 ); Mahaffy, 2006 WL , at *11 (noting that the text and legislative history of 18 U.S.C clearly establish that it was modeled on the mail and wire fraud statutes ). [17] Carpenter, 484 U.S. at [18] See id. at ( [The Court has] little trouble in holding that the conspiracy here to trade on the Journal s confidential information is not outside the reach of the mail and wire fraud statutes... [because] Winans continued in the employ of the Journal, appropriating its confidential business information for his own use, all the while pretending to perform his duty of safeguarding it. ). [19] If this argument sounds familiar, that is because the government argued for the same inference in Newman. In that case, the government contended that Newman and Chiasson were criminally liable for insider trading because, as sophisticated traders, they must have known that information was disclosed by insiders in breach of a fiduciary duty due to the detailed nature and accuracy of the information. Newman, 773 F.3d at 444, 454 (emphasis added). Newman soundly rejected the government s argument, reasoning that, even if detail and specificity could support an inference as to the nature of the source, it cannot, without more, permit an inference as to that source s improper motive for disclosure. Id. at 455. [20] Mot. for Pretrial Ruling on Applicable Offense Instructions, Docket No. 54, Slawson (Jul. 13, 2015); Government s Requests to Charge, Docket No. 93, Slawson (Jul. 31, 2015). [21] See supra note 9. [22] Mot.for Pretrial Ruling, supra note 20. [23] Id. (emphasis added). [24] Response, supra note 9; Def. s Requests to Charge the Jury, Docket No. 112, Slawson (Aug. 13, 2015). [25] Id. [26] See Dirks, 463 U.S. 646, 659 (1983); Newman, 773 F.3d at [27] See Dirks, 463 U.S. at 659 (quoting Chiarella, 445 U.S. at 230 n.12). [28] Ordinary theories of vicarious criminal liability, such as aiding and abetting liability or co-conspirator liability, require that the defendant have a purposeful intent that the crime be committed, rather than just the knowledge that the crime occurred. [29] See supra note 24. [30] Id. For example, under Title 18, the government could theoretically try to prove that the defendant aided and abetted a scheme to embezzle confidential information, or that he entered into a conspiracy in which the theft of such information should have been foreseeable. The latter was in fact the theory of conviction that the government used to convict the day trading defendants in Mahaffy. See 2006 WL , at *17 (stating that though the day trading defendants may not have had a duty to the Brokerage firms or the firms clients, and thus might not have committed the substantive 1348(1) offense directly, it is axiomatic that a defendant who does not directly commit a substantive offense may nevertheless be liable if the commission of the offense by a co-conspirator in furtherance of the conspiracy was reasonably foreseeable to the defendant as a consequence of this criminal agreement (quoting Cephas v. Nash, 328 F.3d 98, 101 n.3 (2d Cir. 2003). [31] See supra note 24. [32] Transcript of Proceedings on 8/13/2015, Docket No. 126, Slawson (Aug. 27, 2015). [33] Id. [34] The Second Circuit s decision led quickly to the vacating of four insider trading convictions based on guilty pleas in another case. See United States v. Conradt, No. 12 CR 887 (ALC), 2015 WL (S.D.N.Y. Jan. 22, 2015). Many other defendants have filed motions seeking to vacate their convictions in light of Newman. See, e.g., Mot. Pursuant to 28 U.S.C to Vacate Conviction and Setnence, Docket Nos. 328, 329, United States v. Goffer et al., No. 1:10-cr RJS-6 (S.D.N.Y. Mar. 12, 2015). On September 14, 2015, the SEC lost an administrative case against a trader due to its inability to prove the personal benefit element required by Dirks and Newman. See Gregory T. Bolan, Jr., & Joseph C. Ruggieri, Initial Decision Release No. 877, 2015 WL (ALJ Sept. 14, 2015). The continuing impact of Newman is likely to motivate prosecutors to continue to test new methods of pleading around the Section 10(b) personal benefit requirements. 6