When Steak and a Massage Equals Insider Trading

Is “wine, steak, and visits to a massage parlor” a quid pro quo personal benefit which, if received in conjunction the dissemination of material, non-public information, is sufficient to establish a breach of duty for illegal tipping in violation of the federal securities laws? The first circuit court of appeals recently concluded that it is sufficient in that circuit, conceding that it may not be in others. U.S. v. Parigian, No. 15-1994 (1st Cir. Decided May 26, 2016).

Douglas Parigian was indicted for insider trading along with his golfing friend, Eric McPhail. The two men were alleged to have traded in advance of earnings announcements regarding American Superconductor Corporation. The information traced to unnamed Insider who was a friend of Mr. McPhail. By 2009, according to the charging papers, Mr. McPhail and Insider had a relationship of trust and confidence. The two men had an understanding that information they shared would remain confidential.

It did not. Mr. McPhail misappropriated it, disseminating the information virtually on receipt. Much of the information was circulated in emails. One expressly cautioned the recipients to keep quiet about the information. The indictment also alleged that Mr. Parigian was aware that his information source knew an executive at American Superconductor. Mr. McPhail did not trade. The indictment claims, however, that he solicited “getting paid back” through wine, steak and similar items.

After his motion to dismiss the indictment was denied, Mr. Parigian pleaded guilty. His plea agreement preserved the right to appeal the denial of the motion. Subsequently, he was sentenced to time served and three years of supervised release with eight months of home confinement.

The circuit court considered three issues, rejecting each. First, the court considered a question regarding the sufficiency of the allegations regarding mens rea. The indictment alleges at various points that Mr. Parigian “knew or should have known” certain facts. This presents a question regarding whether the “knew or should have known” standard is adequate in a criminal case and, if so, whether sufficient facts have been pleaded to support the claim.

In a civil case the government is only required to establish the “knew or should have known” standard the court held, citing Dirks v. SEC, 463 U.S. 646, 660 (1983). In a criminal case, however, that formulation conflicts with the presumption that the government must prove that the defendant knew the facts that made his conduct illegal. While there are at least two circuit courts that have used the civil standard in criminal cases, there was no challenge to its use in those actions. In criminal cases the “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” the court noted. That is consistent with the requirement that the government prove the additional element of “willfulness” in a criminal securities case. The indictment here is inconsistent with this notion. Since the defendant failed to raise this question until it was referenced in a reply brief however, it was waived.

The second point the court considered is whether the indictment adequately alleged that the defendant knew or should have known that the tips were made in breach of a duty of trust and confidence. The misappropriation theory only requires a breach of a “duty of trust and confidence” owed by the tipper to the insider under U.S. v. O’Hagan, 521 U.S. 642 (1997). Following O’Hagan the SEC issued Rule 10b5-2 which specified that a duty of trust and confidence exists when a “person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the . . .” person furnishing the information expected that it will remain confidential. While it is questionable whether the standard of this rule applies in a criminal case, that issue was waived. Under the standard the allegations here are sufficient.

The final question involves the personal benefit to the tipper. Dirks required that the government establish the tipper benefited directly or indirectly from his disclosure. Previously, the circuit held that evidence establishing that the “misappropriator and the tipper were business and social friends with reciprocal interests allowed a jury to find a benefit in the form of the misappropriator’s reconciliation with a friend and the maintenance of a useful networking contact.” See, e.g., SEC v. Rocklage, 470 F.3d 1 (1st Cir. 2006). Although this standard is drawn from civil actions it is applicable here. Since the indictment alleged that Messrs. Parigian and McPhail were “reasonably good friends” and that there was a benefit of “various tangible luxury items in return for the tips” it is adequate under the prior decisions of the circuit.

Finally, the court noted that the second circuit had adopted a “more discriminating definition of the benefit to the tipper . . .” in U.S. v. Newman, 773 F. 3d 438 (2nd Cir. 2014), cert. denied, 136 S.Ct. 242 (2015). The ninth circuit in U.S. v. Salman, 792 F. 3d 1087 (9th Cir. 2015) cert. granted in part, 136 S.Ct. 899 (2016) in contrast, adopted a standard closer to that being applied here. While the Supreme Court will ultimately resolve this question “we do not venture to say [how] because, as a three-judge panel, we are bound to follow this circuit’s currently controlling precedent.” The court thus concluded that the indictment was sufficient under prior circuit decisions.