Professor Gregory Germain: The Supreme Court Should Reconsider the “Personal Gain” Requirement in Insider Trading Cases
n honest legal system and honest security markets are the twin pillars supporting the American economy. While speculators may view the security markets as a game, long term investors, who are the true backbone of the market and the economy, will risk their capital only if they trust in the fairness of the system.
Virtually all past economic collapses resulted from investors discovering that markets were rigged. Following each collapse, governments sought to restore confidence by enacting laws to prevent market rigging.
So it was with the Great Depression of the 1930s. Congress responded to the crises in confidence by enacting comprehensive securities laws requiring large public companies to disclose comprehensive corporate financial information, both when offering securities for sale, and on a regular basis.
Congress also prohibited securities fraud in an originally sleepy rule known as Section 10b-5 of the 1934 Securities Exchange Act. The section broadly prohibited fraud and deception in connection with the purchase or sale of a security, without defining the terms. Over the past 80 years, the courts have been trying to put meat on the bones of that section by determining what constitutes “fraud and deception” in the securities markets.
The Supreme Court long ago recognized that public corporations may keep secrets, but that employees and other insiders of the corporation have a fiduciary duty to maintain and use those secrets only for proper corporate purposes. Employees and insiders who trade on the corporation’s non-public information breach their duty of confidentiality to the corporation, and have an unfair trading advantage over non-insiders. Inside traders are liable both in enforcement actions brought by the SEC and in private actions by contemporaneous traders. The insider trading rule is known as “disclose or abstain:” insiders must abstain from trading in the corporation’s securities unless they first publicly disclose the material nonpublic information.
But what if instead of trading directly, the insider gives the information as a tip to another? The courts quickly found that insider tippers who sell non-public corporate information to tippee traders, and the traders who know or have reason to know of the insider’s breach of duty, are both liable for insider trading.
But some insider disclosures are not wrongful. In Dirks v. SEC, 463 U.S. 646 (1983), a stock analyst learned from a former employee of Equity Funding named Secrist that the company was engaged in a massive fraudulent financial scheme. Dirks tried to get the Wall Street Journal to report on the fraud, but the Journal could not believe that such a massive fraud could be true, and delayed publication. Meanwhile, Dirks reported the information to his clients who traded on the information (selling their stock, or possibly shorting the stock of Equity Funding). Instead of giving Dirks its “analyst of the year” award for uncovering the fraud, the SEC charged Dirks with insider trading, because he had received the “tip” from insider Secrist, and in turn tipped his clients who traded in the stock.
The Supreme Court absolved Dirks of wrongdoing by holding that both tipper and tippee could be liable for insider trading only if the tipper made the tip for “personal gain,” and the tippee knew of should have known of the tipper’s breach of fiduciary duty. The Court held that Secrist’s disclosure was altruistic – he only wanted to do good by disclosing the fraud; he was not acting for “personal gain.” Since Secrist did not disclose the information for “personal gain,” neither he, nor Dirks, nor Dirks’s clients, were liable for insider trading. Secrist’s altruistic disclosure breaks the chain of liability in the first loop. Thus, after Dirks, liability turns on the motivation of the tipper.
Looking back on Dirks, one must ask why Secrist, a former employee of Equity Funding, reached out to Dirks to disclose the fraud? Was Secrist an altruist, seeking to make a better world by ending the fraud, as the Court found? Or was he a bitter former employee seeking revenge? And if it was the latter – the bitter employee seeking revenge – was he making the disclosure for “personal gain?” Under existing law, the subtle distinction between altruism and personal gain determines whether everyone in the chain – Sechrist, Dirks, and Dirks’ clients – were lawful traders or unlawful securities law violators who would be subject to severe civil and criminal sanctions.
The meaning of “personal gain” has bedeviled the courts ever since Dirks was decided. In United States v. Newman, 773 F.3d 438 (2nd Cir. 2014), the Court of Appeals held that mutual fund managers who had received third hand inside information from stock analysts who had obtained the information from corporate insiders friends could not be held liable 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 Ninth Circuit Court of Appeals in United States v. Salmon[PDF] created a conflict among the circuits by rejecting the sweeping language of Newman to hold that the giving of tips between family members with the expectation of trading is sufficient to constitute “personal gain.”
The Supreme Court has granted certiorari in Salmon to consider the meaning of “personal gain.”
A holding in Salmon that insiders are free to give insider information to relatives for the purpose of trading as long as no money is paid to the insider would all but eliminate any restriction on insider trading by providing a playbook for avoiding liability. Confidence in the integrity of the markets would suffer. The Court must find a way to make family tipping illegal, and to distinguish between proper disclosure and wrongful tipping in a meaningful way.
In my opinion, the original “personal gain” language in Dirks was unfortunate, and has spawned confusion in the courts ever since. The test should not be trained on tipper’s “personal gain,” but on whether the tipper had a legitimate non-trading reason for disclosing the information. Liability should attach whenever an insider gives non-public information to a trader, unless there was some legitimate non-trading purpose for the disclosure (as in Dirks).
The insiders in Newman who gave non-public information to friends without a legitimate non-trading reason for the disclosure should be liable if they had reason to know that the tippees would trade. Conversely, the tippees should be liable if they knew that the tipper breached the duty of confidentiality to the employer by disclosing the information without a legitimate non-trading reason for the disclosure.
The insiders in Salmon who give non-public information to family members knowing that they will trade on it should be liable. The family members who knew or had reason to know that the information derived from an improper tip should also be liable.
The law should state a clear rule to insiders: “do not disclose material nonpublic corporate information that has been entrusted to you without a legitimate non-trading reason for doing so.” The “Personal gain” language misplaces the nature of the insider’s duty, which is to guard and use the corporation’s information only for corporate and not personal purposes.
Professor of Law & Director, Bankruptcy Clinic