Professor Germain Comments: Supreme Court Upholds Integrity of Security Markets By Broadly Defining “Personal Benefit” in Insider Trading Cases
Professor of Law Gregory Germain writes:
On December 6, 2016, a unanimous Supreme Court decided that insiders who breach their fiduciary duties by making gifts of insider information to relatives or friends are guilty of insider trading under Section 10(b) of the 1934 Exchange Act. Salman v. United States (2016), available here. The case is a strong rebuke to over-broad language in the Second Circuit’s decision in United States v. Newman, 773 F. 3d 438, 452, cert. denied, 577 U. S. ___, which required prosecutors to show that insider tippers received a tangible financial benefit in return for the tip in order to maintain a prosecution for insider trading.
Insider trading jurisprudence is primarily judge-made law. Section 10(b) of the 1934 Exchange Act broadly prohibits “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” 17 C.F.R. 240.10b-5 . It makes no attempt to define specific devices or contrivances that are being prohibited, and says nothing about insider trading. SEC Rule 10b(5), in turn, broadly prohibits acts of fraud in connection with the purchase or sale of securities, but says nothing directly about insider trading. Moreover, insider trading does not involve the dissemination of false factual information – which of course is the traditional domain of fraud.
Early insider trading cases imposed liability on anyone who traded while in possession of material non-public information. The Supreme Court twice cut back on the definition of insider trading. First, in Chiarella v. United States, 445 U.S. 222 (1980), and United States v. O’Hagan, 521 U. S. 642, 650–652 (1997), the Supreme Court limited insider trading liability to traders who breached a fiduciary duty to the source of the information by misappropriating and trading on information that did not belong to them. Second, In Dirks v. SEC, 463 U. S. 646 (1983), the Supreme Court limited the liability of tippers who did not trade on the information directly, but instead provided non-public information to third party tippees who traded. The Court held that a tipper would only be liable if the tipper made the tip for “personal gain.” The tipper in Dirks – a former insider named Sechrist who provided security analyst Dirks with material non-public information about his former employer in order to stop the continuation of his former employer’s fraud, did not violate his fiduciary duty because he did not give the information to Dirks for personal gain . The Court further held that the liability of a tippee depends on the liability of a tipper. Tippees can only be liable if the tipper breached a fiduciary duty in making the tip, and the tippee knew or should have known of the tipper’s breach. Dirks and his clients were off the hook because the original tipper, Sechrist, did not make the tip for personal gain, but rather for the altruistic reason of preventing the continuation of his former employer’s fraud. Every tippee down the line who benefits from trading on the insider’s non-public information receives a pass if the original tip was not made for “personal gain.”
The Court recognized in Dirks that the requirement of “personal gain” would be difficult to apply to an insider who makes a gift of insider information to family or friends. The Court said that a jury could infer a personal benefit when the tipper “makes a gift of confidential information to a trading relative or friend,” Id. at 664, but this left some doubt about the required connection between tipper and tippee that would trigger liability
The Court of Appeals for the Second Circuit in United States v. Newman, 773 F.3d 438 (2nd Cir. 2014), jumped headlong into the breach by narrowly defining “personal benefit” where value does not change hands. The Second Circuit held that mutual fund managers who had received third hand inside information from stock analysts, who in turn had obtained the information from friendly corporate insiders, could not be held liable for insider trading because (1) there was insufficient showing that the insiders received “personal gain,” and (2) there was insufficient evidence to show that the traders knew of the tipper’s personal gain (even though they may have had reason to know that the information was likely obtained in breach of fiduciary duty). The Second Circuit panel also held that evidence of close friendships and relationships between the tippers and tippees was not sufficient to establish the “personal gain” required for criminal insider trading liability. Rather, personal gain must “generate an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” The Second Circuit did not directly reject the dicta in Dirks involving tips to friends and family, but required a more direct relationship and knowledge when value did not flow directly to or was not expected by the tipper.
The Court of Appeals for the Ninth Circuit in United States v. Salmon[PDF] was not interested in attempting to parse the distinction between close and further gifts of insider information suggested by the Second Circuit in Newman. In Salmon, the tipper and tippee were close relatives who both knew that they were engaging in improper insider trading. The Ninth Circuit could have attempted to distinguish Newman because of the closeness of the relationship. Instead, the Ninth Circuit chose to reject the analysis of Newman as inconsistent with Dirks, leading the way to the Supreme Court.
In a prior article, I predicted that the Court would reject the analysis of Newman, rather than trying to distinguish it, because Newman was too uncertain, would make insider trading prosecutions more difficult, and would encourage insiders to take advantage of the uncertainty by engaging in donative insider trading. Surely the Supreme Court would recognize the importance to the integrity of the markets that would be sent by adopting the language of Newman.
And the Supreme Court did recognize the importance to the security markets. “To the extent the Second Circuit held that the tipper must also receive something of a “pecuniary or similarly valuable nature” in exchange for a gift to family or friends, Newman, 773 F. 3d, at 452, we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.” A tipper need not expect to receive a valuable quid pro quo to be liable for insider trading in making a gift of insider information to family or friends for the purposes of trading.
Is Newman completely dead law? Maybe not. After Salmon, a close personal relationship between tipper and tippee is enough to presume a “personal benefit” without showing an expectation of monetary gain. But the further relationships of second or third-hand tippees addressed in Newman may not be sufficient to establish a presumption of liability. The Court rejected the “valuable exchange” language in Newman in connection with a close and direct familial or friendship transaction between tipper and tippee. It did not consider whether a gift presumption can be applied to second or third hand tippees who are not natural objects of the tipper’s bounty. Newman’s language went to far, but the requirement to prove the tipper’s intent to make a gift, where the tipper and tippee have more remote commercial rather than personal ties, may well persist. Tips may be made without traditional donative or compensatory motives simply because confidentiality is not of sufficient value to the tipper. With the proliferation of rumors in the security markets, indirect tippees may not know about the tipper’s motives. Salmon leaves plenty of unanswered questions in remote tipping cases.