The U.S. Court of Appeals for the First Circuit held yesterday that friends’ gifts of wine, steak dinners, and other luxury items can constitute the types of personal benefit needed to establish a breach of duty in connection with a prosecution for insider trading. The court’s May 26, 2016 decision in United States v. Parigian also suggested, but did not expressly hold, that the state of mind required for criminal insider trading is the same as in other types of criminal cases – and that a “knew or should have known” standard should not suffice for liability.

Factual Background

The Parigian case involved allegedly material, nonpublic information that an unidentified corporate executive had provided to his friend McPhail.  The executive and McPhail had allegedly had a close relationship and a history, pattern, and practice of sharing professional and personal confidences so that the executive purportedly had reason to believe that McPhail would not disclose the confidences.  The executive was therefore not accused of wrongdoing.

McPhail, however, allegedly told several of his “golfing buddies” – including Parigian – about the information he had received from the executive, allegedly intending that they would profit from the tips. McPhail allegedly “solicited ‘getting paid back’ by Parigian and the others with wine, steak, and visits to a massage parlor,” as well as a golf outing.

The Government indicted McPhail and Parigian under the misappropriation theory of insider trading, contending that McPhail had breached a duty of trust and confidence to the executive by misappropriating the confidential information disclosed to him – and that McPhail had then tipped Parigian, who had allegedly been aware of McPhail’s relationship with the executive and had known “or should have known” that McPhail had disclosed the inside information in breach of a duty owed to the executive. The indictment also alleged that Parigian had known that McPhail expected to receive a benefit from disclosing the inside information.

McPhail was convicted of insider trading and has appealed his conviction. (We previously blogged about the McPhail case here.)  Parigian conditionally pled guilty, but preserved his right to challenge the sufficiency of the superseding indictment.  The First Circuit therefore addressed only the face of the indictment.

First Circuit’s Decision

       Mens Rea Standard in Criminal vs. Civil Cases

The court first held that Parigian had waived any challenge to the indictment’s allegations that he “knew or should have known” certain facts. The court noted that, “[i]n a civil case, the government need only show that ‘the tippee [here, Parigian] knows or should know that there has been a breach [of the tipper’s fiduciary duty],’” but that, in criminal cases, “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.”

While recognizing that at least two appellate opinions (from the Sixth and Seventh Circuits) applied the “knew or should have known” standard in criminal cases, the First Circuit observed that “[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.” But the court held that Parigian had waived any argument about the potentially improper use of the “knew or should have known” formulation because he had not raised it in the District Court or sufficiently preserved it on appeal.

       Duty of Trust and Confidence for Misappropriation Theory

The First Circuit held that the indictment had sufficiently alleged that McPhail and the insider had shared a duty of trust and confidence and that McPhail had breached that duty by disclosing confidential information to Parigian and other friends. The court noted the allegations that Parigian had been aware of the relationship between McPhail and the insider, had received emails warning of the need for secrecy, and had deleted his emails.

The court also dipped its toe into the possible circuit split about the “personal benefit” that a tipper such as McPhail needs to have received in order for the tip to constitute a breach of duty to the source of the information (here, the insider). The court held that the indictment’s allegations that McPhail and Parigian were friends and that McPhail had requested – and was promised – “various tangible luxury items in return for the tips . . . appear[ed] to be enough under our precedent.”

The court recognized that the Second Circuit, in United States v. Newman, “recently adopted a more discriminating definition of the benefit to a tipper in a classical insider trading case, rejecting as insufficient the mere existence of a personal relationship ‘in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.’”  The court also noted that the Ninth Circuit, in United States v. Salman (a case now on certiorari to the Supreme Court), “seemed to align itself more closely with our holding in” SEC v. Rocklage, which had held that “‘the mere giving of a gift to a relative or friend is a sufficient personal benefit’ to the giver.”

The First Circuit concluded: “How this will all play out, we do not venture to say because, as a three-judge panel, we are bound to follow this circuit’s currently controlling precedent.  We therefore hold that 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 is enough to allege a benefit if a benefit is required.”

What the Court Did Not Decide

The Parigian decision did not decide a number of potentially intriguing issues.

First, because of the waiver analysis described above, the court did not squarely decide the validity of a “knew or should have known” standard for mens rea in a criminal case.  However, the court strongly suggested that “[t]he better view” is that such a standard is inappropriate in that context.

Second, the court observed that Parigian “does not dispute that the misappropriation theory of criminal securities fraud can apply . . . to a remote tippee.” The court therefore assumed that the theory could apply and did not delve into the considerations that can arise in cases involving remote tippees.

Third, the court held that Parigian had waived any argument that the SEC had “‘unilaterally expanded’” the scope of insider trading through its Rule 10b5-2, which provides that the requisite duty of trust or confidence can be based on a history of sharing of confidential information with the mutual understanding that confidentiality will be maintained. The court therefore did not analyze the Rule’s validity.

Fourth, as noted above, the court declined to enter the debate involving the Second and Ninth Circuits’ constructions of the “personal benefit” requirement. However, the decision might suggest that current First Circuit precedent is closer to the Ninth Circuit’s Salman decision than to the Second Circuit’s Newman ruling.  We will see where the Supreme Court comes out on this issue next term in Salman.

We previously blogged about Newman and Salman here, here, here and here.