Securities Snapshot January 15, 2020

Second Circuit Holds That Government Can Criminally Prosecute Insider Trading Under Title 18 Without Proving Personal Benefit To Tipper


Second Circuit Holds That Government Can Criminally Prosecute Insider Trading Under Title 18 Without Proving Personal Benefit to Tipper; SEC Outlines Examination Priorities For 2020, Including Fintech and Information Security; Southern District of New York Dismisses Securities Class Action Complaint Against Inverse ETF; Delaware Court of Chancery Dismisses Stockholder Challenge to Billion Dollar Merger.

On December 30, 2019, the United States Court of Appeals for the Second Circuit (in a 2-1 opinion) ruled that the government can criminally prosecute insider trading under Section 1348 of Title 18 without proving a personal benefit to the tipper. In doing so, the court refused to incorporate the doctrinal “personal benefit” limitation that the Supreme Court’s 1985 decision in Dirks v. S.E.C. had imposed on Section 10(b) insider-trading prosecutions.  

In United States v. Blaszczak, et al., the government alleged that Blaszczak, a former employee of the Centers for Medicare & Medicaid Services (“CMS”) who became a hedge fund consultant, provided confidential information he had received from CMS employees to traders at a healthcare-focused hedge fund. The government charged Blaszczak, a CMS employee, and the traders with multiple counts, including securities fraud under both Title 15 (Section 10(b)) and Title 18.  Following a three-week jury trial in April 2018, defendants were acquitted of the Title 15 charges, and Blaszczak and the traders (but not the CMS employee) were convicted of the Title 18 securities-fraud charges.

At trial, the court had instructed the jury that it could convict on Title 15 fraud only if the CMS employee had tipped information in exchange for a “personal benefit,” but refused to give a similar instruction for the Title 18 counts. On appeal, defendants argued that the elements of insider-trading fraud, including the “personal benefit” requirement under Dirks, were the same under both statutes. The court rejected this argument, holding that while the Title 15 fraud provisions had been enacted for the “purpose of . . . eliminat[ing] [the] use of inside information for personal advantage,” Title 18 is based on an embezzlement theory of fraud and there is no additional requirement that an insider breach a duty because it is “impossible” to embezzle without committing a fraud. The court noted that Title 18 “was intended to provide prosecutors with a different—and broader—enforcement mechanism,” and “decline[d] to graft the Dirks personal-benefit test onto the elements of Title 18 securities fraud.”  


On January 7, 2020, the United States Securities and Exchange Commission Office of Compliance Inspections and Examinations (“OCIE”) issued its 2020 Examination Priorities. These priorities cover a number of areas, including Financial Technology (FinTech) and information security. 

With respect to FinTech, OCIE noted firms’ increased use of “alternative data” and related technologies that “may drive investment decision-making,” and announced its intent to “focus on firms’ use of these data sets and technologies to interact with and provide services to investors, firms, and other service providers.”  OCIE also highlighted the market for “digital assets,” which OCIE sees as presenting various risks, including the risk that “retail investors . . . may not adequately understand the differences between these assets and more traditional products.” In light of these perceived risks, OCIE will examine: “(1) investment suitability, (2) portfolio management and trading practices, (3) safety of client funds and assets, (4) pricing and valuation, (5) effectiveness of compliance programs and controls, and (6) supervision of employee outside business activities.” OCIE also outlined its intent to continue to hone in on the rise of “robo-advisers”—or automated investment tools and platforms—with a focus on: “(1) SEC registration eligibility, (2) cybersecurity policies and procedures, (3) marketing practices, (4) adherence to fiduciary duty, including adequacy of disclosures, and (5) effectiveness of compliance programs.”

OCIE also noted that it will “continue to prioritize information security” across its examination programs. Examinations will include a focus on more granular information security issues, such as “proper configuration of network storage devices” and general information security governance. With respect to registered investment advisors, OCIE will focus on the protection of clients’ personal financial information, with particular focus on the following areas: “(1) governance and risk management; (2) access controls; (3) data loss prevention; (4) vendor management; (5) training; and (6) incident response and resiliency.” OCIE also will focus on “oversight practices related to certain service providers and network solutions,” including cloud-based storage, as well as safeguards concerning the disposal of retired hardware. 


On January 3, 2020, in In re ProShares Trust II Securities Litigation, the Southern District of New York dismissed a putative securities class action complaint alleging that ProShares’ registration statement for its SVXY fund failed to disclose adequately the fund’s risks.  The complaint brought claims under (among other things) Section 11 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934.

The SVXY fund, which is an inverse ETF, is designed to deliver the opposite performance of the VIX Short-Term Futures Index. As the court explained, “SVXY is a derivative financial product that loses value when stock market volatility rises and gains value when the market is calm.”  On February 6, 2018, the New York Stock Exchange halted trading for several hours in the SVXY fund and, when trading resumed, the SVXY fund share price had suffered a large decline.  

The plaintiffs principally alleged that the registration statement for the SVXY fund had failed to disclose that “the Fund’s own conduct of rebalancing in an overly crowded VIX futures market could itself drive up the price of VIX futures contracts, the level of market volatility, and the level of the VIX Short-Term Futures Index – thereby driving down the value of SVXY shares.” The District Court held that, “reading the Registration Statement cover-to-cover, the disclosures and representations taken together and in context could not have misled a reasonable investor about the nature of the SVXY Fund and the risks associated with this complex financial product.”  Specifically, the District Court found that “the Registration Statement discloses the primary omission alleged by plaintiffs – that the late-afternoon rebalancing of the Fund’s portfolio could cause illiquidity in the VIX futures contract market.”

The plaintiffs also alleged that ProShares’ public filings after the registration statement became effective gave rise to liability because they reiterated the same risk warnings and other statements contained in the registration statement even as those risks had grown. The District Court held, however, that those public filings adequately warned that “the degree of risk could change over time depending on liquidity in the VIX futures contracts,” which was “precisely what plaintiffs allege was omitted.”


On December 30, 2019, in In re Essendant, Inc. Stockholder Litigation, the Delaware Court of Chancery dismissed a putative class action complaint challenging the January 2019 merger of Essendant, a national wholesale distributor of office supplies and equipment, and Sycamore Partners, a private equity firm specializing in retail and consumer investments. The plaintiffs brought claims against the Essendant board of directors and Sycamore (among others) for breaches of fiduciary duty, waste, and aiding and abetting breaches of fiduciary duty.

In Spring 2018, Essendant signed a merger agreement with Genuine Parts Company (“GPC”) in which Essendant would have combined with a GPC affiliate in a stock-for-stock transaction that would have resulted in Essendant stockholders owning 49 percent of the combined company. Shortly after signing the merger agreement, the Essendant board of directors received an all-cash offer from Sycamore, which owned approximately 10 percent of Essendant. After further discussions with Sycamore, the Essendant board decided to terminate the GPC merger agreement and accept Sycamore’s offer, which represented a 51 percent premium to Essendant’s unaffected stock price.

The plaintiffs principally alleged that the Essendant board of directors succumbed to pressure from Sycamore and improperly turned away GPC in favor of an inferior proposal from Sycamore.

The court dismissed the plaintiffs’ claims against the Essendant directors because (among other things) the plaintiffs “failed to well plead either that the Essendant Board was dominated and controlled by Sycamore or that a majority of the Essendant Board acted out of self-interest or in bad faith when approving the Sycamore merger.” The court explained that, “at best, the allegations support an inference that the Essendant Board did exactly what it said it would do. That is, it chose a cash transaction with Sycamore rather than a stock deal with GPC—a judgment call well within a board’s prerogative when pursuing the highest value reasonably available to the Essendant shareholders.”

The court also dismissed plaintiffs’ claims against Sycamore because the plaintiffs did “not well plead that Sycamore’s less than 12% stake in Essendant at the time of the events in question was coupled with the kind of influence that could justify a finding that Sycamore was Essendant’s controlling stockholder.” In addition, the court concluded: “The fact that the Essendant Board preferred Sycamore’s cash offer to a stock offer from GPC cannot be laid at Sycamore’s feet as supporting an inference that Sycamore somehow aided and abetted the Essendant fiduciaries in making that determination.”