The U.S. Court of Appeals for the First Circuit yesterday affirmed another conviction in a pair of appeals arising from insider-trading prosecutions. The decision in United States v. McPhail confirms that, under current First Circuit precedent, a tipper of inside information can receive “personal benefits” based on expectations of a free dinner, wine, and a massage parlor, on “kickbacks” from a tippee-friend’s trades, and on his tippee-friends’ “general gratitude for his largesse.”
The McPhail case involved allegedly material, nonpublic information that a corporate executive had provided to 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. McPhail did not trade on the information from the executive, but he allegedly told several of his “golfing buddies” (including Parigian) about it, and the tippees traded on it.
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 relaying it to Parigian and others in exchange for personal benefits. McPhail was convicted, and he appealed. Parigian conditionally pled guilty, but preserved his right to challenge the sufficiency of the indictment.
The First Circuit affirmed Parigian’s conviction in May 2016. And the First Circuit affirmed McPhail’s conviction yesterday.
First Circuit’s Decision
Duty of Trust and Confidence
The court first held that, based on the evidence at trial, the jury could have concluded that McPhail and the executive had shared a relationship of trust and confidence under SEC Rule 10b5-2(b)(2), which provides that a “duty of trust or confidence” exists between the communicator and the recipient of material, nonpublic information when the communicator and the recipient “have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should have known that the [communicator] expects that the recipient will maintain [the information’s] confidentiality.”
The evidence showed that McPhail and the executive were “frequent golf partners” and “close friends,” who traveled on vacation and attended sporting events together, “communicated daily and saw one another several times a week.” The executive had loaned money to McPhail “to pay off a gambling debt that McPhail was trying to hide from his wife,” and he later forgave the debt entirely. The executive’s wife also “asked McPhail to mediate a marital argument that threatened [the executive’s] marriage.”
The court noted that McPhail had not challenged the SEC’s statutory authority to promulgate the rule, so the court “assume[d] without deciding that Rule 10b5-2(b)(2) constitutes a valid exercise of administrative rulemaking.”
Mens Rea Requirement
McPhail took issue on appeal with the jury instructions’ use of Rule 10b5-2(b)(2)’s “knew or should have known” language. He contended that the District Court should have required the jury to find that he had “known” he was breaching his duty to the executive, not merely that he “‘knew or reasonably should have known’ that the [executive] expected him to keep the information secret.”
The First Circuit held that its Parigian decision “suggests that the instruction was likely error.” However, the court concluded that McPhail might have waived his challenge to the jury charge and that, in any event, he had forfeited it, “triggering a review for only plain error.”
The First Circuit did not find plain error in the instructions. Rather, the court observed that “we have not actually held that [such an instruction] is error, and at least two circuit courts have expressly blessed the ‘knew or reasonably should have known’ standard.” The court cited decisions from the Sixth and Seventh Circuits.
Receipt of Personal Benefits
The First Circuit also held that the evidence had sufficiently established that McPhail had received personal benefits in exchange for tipping the material, nonpublic information to Parigian and others. As in the Parigian case, the court assumed that the personal-benefit requirement applies in misappropriation cases, not only in classical insider-trading cases (where an insider trades on confidential corporate information or discloses it in exchange for a personal benefit). And as in Parigian, the court acknowledged that “the nature of the personal benefit requirement in insider trading cases is the source of some inter-circuit tension likely to be resolved by the Supreme Court in its next term.”
However, the court held that, under current First Circuit precedent, the personal-benefit requirement can be “satisfied by benefits as thin as ‘reconciliation with [a] friend’ and the maintenance of ‘a useful networking contact,’ . . . or ‘the mere giving of a gift to a relative or friend.’” Those standards were met in this case based on the three types of personal benefits identified at trial: “McPhail’s expectations that he would receive a free dinner, wine, and a massage parlor visit from the beneficiaries” of his tips; his receipt of “a $3,000 ‘kickback’” from a tippee-friend who had obtained nearly $200,000 in trading profits; and the benefit of the tippee “group’s general gratitude for his largesse.” “Jurors were told: ‘It makes him one of the guys, they’re all kind of impressed.’”
What the Court Did Not Decide
As noted above, the McPhail decision did not decide a number of potentially important issues.
First, the court did not decide whether the SEC had statutory authority to promulgate Rule 10b5-2(b). Other courts, such as the Third Circuit, have upheld the rule.
Second, because of the waiver/forfeiture analysis, the court did not decide the validity of a “knew or should have known” standard for mens rea in a criminal case. However, the court suggested, as it had done in Parigian, that such a standard is inappropriate – although the First Circuit acknowledged that other circuits have concluded otherwise.
Third, the court did not decide whether a tipper must have received a personal benefit in a misappropriation case. The court simply assumed that the requirement applies. Other courts, including the Second Circuit, have said that the requirement applies in both misappropriation and classical insider-trading cases.
Fourth, as in Parigian, the court declined to enter the debate involving the Second and Ninth Circuits’ potentially conflicting constructions of the “personal benefit” requirement. All eyes will be on the Supreme Court next term when it considers the Ninth Circuit’s decision in United States v. Salman.