Supreme Court Agrees to Clarify the Law of Insider Trading
Update 12/6/16: As predicted below, today the Supreme Court unanimously upheld Salman's conviction and rejected the Second Circuit's standard in Newman. I'll have more on the case in a post next week. Just three months after it refused to hear the government’s appeal in a landmark insider trading case from the Second Circuit, the Supreme Court announced last week that it will revisit the law of insider trading after all. The Court’s decision to grant review of the Ninth Circuit's ruling in Salman v. United States may bode well for the government’s future prosecutions. Both Salman and the Second Circuit case, United States v. Newman, involve the question of “tippee” liability for insider trading: when is a person who receives a tip of confidential information from a corporate insider prohibited from trading on that information? The two courts of appeal adopted apparently conflicting standards, and now the high court will weigh in. The Supreme Court declined to take the appeal in Newman, where the government lost, and accepted the appeal in Salman, where the government won. At first glance that might suggest the Court’s decision to take Salman’s case is bad news for the government. But I think there’s a good chance the Court will use Salman’s case to clarify the law of tippee liability while affirming Salman’s conviction and rejecting the narrower legal standard adopted in Newman – an outcome that would favor the prosecution.
The Law of “Tippee” Insider Trading
Insider trading is buying or selling securities based on material, non-public information, in violation of a fiduciary duty or similar duty of trust and confidence. Trading on the basis of inside information alone is not a crime. In order to constitute securities fraud, there must be a breach of a legal duty in connection with the trading. The most classic type of insider trading involves a corporate officer personally trading the company’s stock on the basis of corporate information not available to the shareholders. This violates the officer’s fiduciary duty to act in the best interests of the shareholders and to refrain from misappropriating corporate information for his or her own private benefit. But the ban on insider trading would be pretty toothless if an insider could simply provide confidential information to a friend or family member who did not owe a duty to the shareholders and they were free to trade on that information. Thus the law has long recognized that, under certain circumstances, tippees who receive confidential information are prohibited from trading on it just as if they were corporate insiders. The Supreme Court ruled on tippee liability in the 1983 case of Dirks v. SEC. Raymond Dirks was a broker who received inside information from Ronald Secrist, an officer with a life insurance company called Equity Funding. Secrist claimed there was massive fraud going on within Equity Funding and urged Dirks to investigate and make it public. Dirks spent a couple of weeks investigating and trying to expose the fraud allegations. At the same time, he advised his clients and other investors about what he was finding, and some sold their shares. The stock price plummeted; ultimately the SEC began an investigation and Equity Funding collapsed. The SEC thanked Dirks for his work in exposing the fraud by charging him with a civil insider trading violation. The SEC’s theory was that Dirks, as a tippee who received confidential inside information from Secrist, had an obligation to refrain from trading on that information or encouraging others to do so. But the Supreme Court rejected the SEC’s position. The Court began by reaffirming the holding of its landmark insider trading case from three years earlier, Chiarella v. United States: insider trading is not established simply because someone traded on non-public information. To constitute securities fraud there must be a “manipulation or deception” involved, which means there must be a violation of a legal duty in connection with the use of the information. The Court noted that not all disclosures of confidential information are done with a bad purpose. For example, corporate officers frequently talk with stock analysts, whose job it is to ferret out corporate information and report it to investors. Even the SEC agreed such information flow is good for the markets. Such conversations may sometimes include matters not yet known to the public or to all shareholders, but that is not considered improper if done for the purpose of disseminating information about the company. What matters is not the disclosure of inside information per se, but why it was disclosed: “[w]hether disclosure is a breach of duty . . . depends in large part on the purpose of the disclosure. . . . [T]he test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach [by the tippee].” Accordingly, the Court held, a tippee is prohibited from acting on the inside information only if: 1) the tipper was violating a duty by providing the information; and 2) the tippee knew or should have know about that violation. Whether the tipper was violating a duty depends on the purpose of the tip and whether the tipper received any personal benefit in return. The benefit to the tipper that will indicate a breach of duty is not limited to tangible monetary gains. The Court noted there also can be reputational or other intangible and indirect benefits to the tipper. In particular, the “elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.” Secrist had been providing information not in order to reap some personal benefit but to help expose widespread fraud within the company. Because Secrist himself therefore did not breach a duty, the Court concluded that Dirks did not inherit any obligation to refrain from using the information and could not be liable for insider trading.
Newman and Salman
In 2014, more than thirty years after Dirks, the Second Circuit in Newman dealt a blow to the SEC and prosecutors by adopting a very narrow view concerning the benefit to the insider that must be established for tippee liability. (The Second Circuit includes New York and Wall Street, the venue for most securities fraud cases, so its decisions on these issues are particularly important.) Corporate insiders in Newman disclosed confidential information to several securities analysts who passed the information along to others, including the defendants. After they were convicted for trading on that information, the defendants appealed and argued the government had failed to satisfy both prongs of the Dirks test: they claimed there was insufficient evidence that the insiders had violated a duty by receiving a personal benefit in exchange for the tips, and even if they did, there was no evidence the defendants knew about that violation. The government argued it had presented sufficient evidence of a personal benefit to the tippers. One had received occasional career advice from an analyst to whom he leaked information. The other insider was a family friend of one of the analysts; they went to the same church and occasionally socialized together. The court found this evidence of “personal benefit” was insufficient. Although the court agreed a benefit could arise from a tip to a relative or very close friend, the mere existence of a casual friendship was not enough. Proof of a personal benefit, the court held, requires evidence of a “meaningfully close relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” The evidence in Newman did not meet that standard, and the Second Circuit reversed the convictions. Salman, the case that the Supreme Court took last week, also raises the issue of what kind of benefit to the insider is required. Maher Kara, a Citigroup banker, passed confidential information to his brother Michael while knowing that Michael was likely to trade based on that information. Michael, in turn, shared the information with Salman. There was evidence that Michael and Maher had a very close family relationship, that Salman knew of that relationship, and that Salman knew Maher was the source of the information. Salman argued the Ninth Circuit should apply the Newman standard and require the government to show that any benefit to Maher was “objective, consequential, and represented at least a potential gain of a pecuniary or similarly valuable nature.” He claimed there was no evidence of such a benefit to Maher and so Salman could not be liable as a tippee. But the Ninth Circuit rejected Salman’s claim. The court held the case was a straightforward application of the holding in Dirks that an insider personally benefits from disclosing confidential information when he “makes a gift of confidential information to a trading relative or friend.” Maher passed the information to his brother, with whom he had a close relationship – and that, according to the court, is all that Dirks requires. To the extent Newman went further and would require proof of a “consequential” or “tangible” benefit to the tipper even when the tip was to a close family member, the Salman court disagreed.
What to Expect from the Supreme Court’s Decision
When urging the Supreme Court to take his case, Salman argued that the Second Circuit’s holding in Newman directly conflicts with the Ninth Circuit’s decision in his case. He argued that if a close family relationship between the insider and the tippee is enough to establish a personal benefit to the insider, as the Ninth Circuit held in his case, then Salman loses. But if there must be "an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature," as the Second Circuit held in Newman, then Salman should win. The fact the Court agreed to hear the case may suggest it agrees there is a conflict between the circuits that it wants to resolve; resolving a circuit split is one of the main reasons the Court grants certiorari. But that doesn’t necessarily translate into good news for Salman. It’s true the Court could have granted review in Newman if it disagreed with that court's holding about personal benefit, but Newman was not a great vehicle to address that standard. Although the question of benefit to the tipper was important in Newman, there was a second big issue looming in that case: the defendants had received the inside information second or third hand and were several steps removed from the corporate insiders who made the initial tips. The Second Circuit was deeply troubled by this aspect of the case, and scolded the government for bringing prosecutions the court said have been “increasingly targeted at remote tippees many levels removed from corporate insiders.” In other words, even if the Supreme Court had reversed the Second Circuit on the benefit issue, the defendants in Newman likely would have gone free anyway. The government had failed meet the second requirement of Dirks: proving that the remote tippee knew about the benefit received by the tipper and the corresponding breach of duty. Salman, on the other hand, squarely presents the benefit issue, with no issue about Salman's knowledge of the possible violation. But although the Court granted Salman’s appeal, it would be surprising if it reversed his conviction. As the Ninth Circuit recognized, leaking information to one’s brother is exactly the kind of tip that Dirks held would qualify as a benefit: providing information to a “trading relative or friend.” Reversing Salman’s conviction would not only require effectively overruling Dirks; it would gut the prohibition on insider trading. Corporate insiders would be free to leak confidential information to friends, relatives, neighbors, or anyone, as long as they did not receive a direct tangible benefit in return. That would overturn decades of insider trading law. Although predicting what the Court will do is always a risky exercise in reading tea leaves, I think it is far more likely that the Court will affirm Salman’s conviction while taking the opportunity to affirm and clarify the holding of Dirks – and in the process disagreeing, directly or indirectly, with the narrower Newman rationale. Such a ruling could focus on the statement in Dirks that whether disclosure is a breach of duty “depends in large part on the purpose of the disclosure.” The focus should be more on the insider’s purpose and less on the nature of any benefit received. The Court in Dirks was primarily concerned about sweeping within the insider trading prohibition the activities of corporate officers who were acting in the interest of the corporation by, for example, speaking with securities analysts. Even if inside information was inadvertently disclosed, the officers were acting with the purpose of fulfilling their duties and aiding the corporation, not for some improper personal purpose. Similarly Secrist, who tipped Dirks, was acting not for some personal purpose but for the purpose of exposing fraud and wrongdoing within the company. Once again, the purpose behind the disclosure did not suggest a corporate officer breaching a duty by using corporate information for his own benefit. An insider who tips to a family member, close friend, or golfing buddy is not acting for any proper corporate purpose. Whether or not the insider personally receives some “consequential” or “pecuniary” benefit, he or she is not acting to further the best interests of the company. Even if the benefit received is nothing more than the intangible pleasure of seeing a friend profit from the information, the disclosure violates the insider’s duty to refrain from using corporate information for some personal end. Focusing on the purpose of the disclosure, rather than on the precise nature of the benefit, will better serve the goals of the ban on insider trading. If a corporate insider is not acting with the purpose of fulfilling his or her corporate duties, then they are likely acting with the kind of personal purpose that will result in the required personal benefit, tangible or intangible. Focusing on the purpose of the disclosure also avoids hinging potential criminal liability on murky questions such as whether a particular friendship was sufficiently "meaningfully close" to find that the tipper benefited from the disclosure. That's the kind of issue invited by the Newman standard. The Newman court’s approach of requiring a more tangible kind of benefit may have been born out of that court’s frustration with the government’s “remote tippee” cases, but it seems misplaced. The tippers in Newman had no apparent legitimate corporate purpose for sharing the inside information, and so the benefit they received from sharing that information with friends or colleagues should have been considered sufficient. It’s been more than three decades since the Court last addressed tippee liability. The Court in Salman has the opportunity to reaffirm that a tippee can be liable for trading on inside information, even if the benefit received by the tipper is not necessarily consequential or tangible. Although the government was denied review in Newman, it may still get the clarification of insider trading law that it sought when it tried to appeal that decision. Click here to join the Sidebars mailing list and receive e-mail notifications of future posts.