The Supreme Court, Salman, and Insider Trading: Why Stock Tips Make Bad Stocking Stuffers
Almost exactly two years ago, this blog posed the following question in a post about insider trading:
Suppose your brother-in-law has too much eggnog at Christmas dinner and starts blabbing about confidential inside information concerning the company where he works. If you trade the company’s stock based on that information, do you risk finding a subpoena from the SEC in your stocking?
Last week, in Salman v. United States, the Supreme Court provided some answers to this holiday conundrum. The bottom line: insider stock tips still make lousy holiday gifts.
The Standards for Tippee Liability: Dirks v. SEC
Salman involves a subspecies of insider trading called “tippee” liability. Insider trading is defined as buying or selling securities based on material, non-public information, in violation of a duty of trust and confidence. Corporate insiders and others who acquire company secrets may not use that information to enrich themselves in violation of a duty owed to the source of the information. But the ban on insider trading would be easily evaded if a corporate insider, forbidden to trade herself, could simply tip off an outside friend or family member and encourage them to trade instead. Accordingly, in some circumstances such tippees may themselves be charged with insider trading. The Supreme Court first addressed tippee liability in Dirks v. SEC in 1983. Dirks held that a tippee who does not owe a direct duty to shareholders may nevertheless be liable for insider trading, but only if: 1) the tipper was violating a duty by providing the information; and 2) the tippee knew or should have known about that violation. Whether the tipper was violating a duty, the Court said, turns on the purpose of the tip: “[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].” The Court recognized that potential benefits to tippers are not limited to monetary gains and may include reputational benefits or other intangibles. In particular, a benefit could be inferred when an insider “makes a gift of confidential information to a trading relative or friend.” An important aspect of the Dirks test, therefore, is determining whether the tipper received a personal benefit sufficient to find a breach of duty. The Court took the Salman case to shed some light on how courts should approach this question.
Teeing up Salman: The Second Circuit’s Newman Decision
To fully appreciate Salman one must first consider the U.S. Court of Appeals for the Second Circuit’s 2014 decision in United States v. Newman, the subject of my post two years ago. Corporate insiders in Newman had 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 the insiders had received a personal benefit in exchange for the tips and thus violated their duty, and even if they did, there was no evidence the defendants knew about that violation. The Second Circuit agreed that the government’s evidence of personal benefit to the tippers was inadequate. The government had argued that one tipper received occasional career advice from an analyst to whom he leaked information, while the other tipper and another analyst were social friends who attended the same church. The Court agreed that “personal benefit” could include intangible benefits, but this did not mean the government could simply establish that the tipper and tippee were friends. If that were sufficient this requirement would practically disappear, because at least a casual friendship between tipper and tippee probably exists in almost all such cases. Accordingly, the court held, proof of a personal benefit requires evidence of a “meaningfully close relationship [between tipper and tippee] 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 so the court reversed the convictions. The Supreme Court turned down the government’s request to review Newman, but then just three months later it granted certiorari in Salman, a Ninth Circuit case that also raised the “personal benefit” issue. (I wrote about Salman at the time, in a post you can find here.)
Salman: What Qualifies as a Benefit to the Tipper?
Salman represents the Supreme Court’s first foray into tippee liability since Dirks. Maher Kara, a Citigroup investment banker, repeatedly passed confidential information about upcoming mergers and acquisitions to his brother Michael, knowing that Michael would use it to trade. Michael, in turn, shared the information with Bassam Salman, a close friend whose sister was married to Maher. Salman made more than $1.5 million by trading on these tips before the scheme was discovered. He was convicted of insider trading and sentenced to 36 months in prison. On appeal to the U.S. Court of Appeals for the Ninth Circuit, Salman urged that court to apply Newman to overturn his conviction. Salman argued that Maher, the tipper, was simply helping his brother out and did not receive anything of a “pecuniary or similarly valuable nature” in exchange. Under the Newman test, he claimed, that meant no violation of a duty by Maher and thus no tippee liability for Salman. The Ninth Circuit rejected Salman’s arguments, finding that his case involved a straightforward application of Dirks and disagreeing with the analysis in Newman. That created a circuit split that likely led the Supreme Court to take Salman’s case. But when it came to convincing the high court to adopt Newman, Salman was swimming upstream. In a unanimous opinion by Justice Alito, the Court agreed with the Ninth Circuit and held that Dirks “easily resolves the narrow issue presented here.” Dirks, the Court observed, held that a personal benefit may be inferred when an insider “makes a gift of confidential information to a trading relative or friend.” Maher passed information to his brother knowing he would trade on it, which falls squarely within this language. Game, set, match. The Court noted that if Maher had traded on the information himself and given the proceeds to his brother, there is no question that would be insider trading. By passing the information to his brother knowing he would trade himself, Maher achieved exactly the same goal. “In such situations, the tipper benefits personally because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.” Because he obtained this personal benefit, sharing the information was a violation of Maher’s duty of trust and confidence to his clients – a duty that Salman inherited and then violated when he traded on the information with full knowledge of its improper origins. The Supreme Court expressly rejected the more stringent benefit test adopted by Newman: “To the extent that the Second Circuit [in Newman] held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends . . .we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.” The Court also rejected Salman’s claim that the benefit test was unconstitutionally vague. Although it agreed that determining whether a benefit occurred might be difficult in some cases, the Court said it did not need to confront that issue because “Salman’s conduct is in the heartland of Dirks’s rule concerning gifts.”
Issues Remaining after Salman: Moving Beyond Friends and Family
The most significant aspect of Salman is its rejection of Newman. Because the Second Circuit includes New York and Wall Street, Newman had caused quite a stir and was seen as a significant blow to the government. Prosecutors were forced to drop a number of insider trading cases in the wake of the decision. Salman thus should give a boost to both criminal and civil insider trading investigations. The court of appeals in Newman had also considered what the government must prove concerning the tippee’s knowledge – the second part of the Dirks test. The government argued it had to prove the tippee knew the information was given in violation of the tipper’s duty but did not need to prove the tippee knew the tipper had received a benefit. The Second Circuit, however, held that the government must prove that the tippee knew both. The knowledge issue was not before the Supreme Court in Salman, as the Court noted in a footnote. But the briefs, oral argument, and opinion all indicate the government now agrees it must prove the tippee knew both that the tipper violated a duty and that he received a benefit. Salman therefore provides some clarity on the knowledge prong of the Dirks test as well, and that portion of Newman appears to remain good law. And that means cases like Newman involving “remote tippees” – those several steps removed from the source of the information and thus less aware of the details of the tipper's activities – may continue to be challenging for the government. Some commentators have suggested Salman leaves unanswered how close a friendship must be before the tipper can be said to benefit from disclosure. Must there be a close, personal friendship, or would the standard apply to an occasional golfing buddy or even a casual Facebook friend? And who qualifies as a “relative”? In-laws? Second cousins twice removed? I think future cases are unlikely to hinge on such questions. Basing criminal liability on determining, for example, whether a friendship was sufficiently “meaningfully close,” as the Second Circuit suggested in Newman, would likely be vague and unworkable. The Court in Dirks listed a gift of information to a friend or relative merely as an example of an improper disclosure, not as the definition of one. It would be a mistake to believe that a court must now determine whether a tippee is truly a “friend” or "relative" and what exactly that means. The test should focus not on the nature of the relationship but on the purpose behind the tip. Dirks held that whether disclosure is a breach of duty “depends in large part on the purpose of the disclosure,” and the Court in Salman reaffirmed this language. Much of the Salman oral argument also focused on the purpose of the gift, with the Justices (and the government) pointing out that Maher’s gift of inside information was done for a personal purpose and not a corporate one. The government in Salman argued that the benefit requirement of Dirks is met any time an insider discloses information for a personal purpose rather than a corporate purpose. The Court did not need to go that far because Salman fell squarely within the language of Dirks about disclosure to a relative, and the Court simply took the narrowest path possible to decide the case at hand. But for future cases a test that hinges on the tipper’s purpose is the logical outgrowth of Dirks and Salman. To borrow an analogy used during oral argument, suppose I see a sad person on the street and feel bad for them, so I give them inside information intending that they trade on it. If I traded on the information myself and give the stranger the money, that would be insider trading. That tip benefits me – it allows me to make the desired charitable gift without actually taking money out of my pocket. As the Court said in Dirks: “[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.” A test based on the tipper’s purpose does not make criminal liability rest upon something as nebulous as the closeness of the relationship between tipper and tippee. Instead it focuses on intent, with which criminal law is accustomed to dealing. An insider who tips to a family member, occasional golfing buddy, or stranger on the street does not act for any proper corporate purpose. All such disclosures violate the insider’s duty to refrain from using corporate information for some personal end. Tippee liability based on gifts of information is unlikely to be limited to close friends and family. Anyone who believes Salman leaves them free to act on improper tips from casual acquaintances will likely find that prosecutors and courts disagree. The Supreme Court’s reaffirmation of Dirks and rejection of Newman signify that it remains very comfortable with a robust theory of insider trading liability. And as for that errant brother-in-law, tell him you’d rather have a nice sweater or something -- and ask him to pass the eggnog. Note: This post is adapted from a commentary I published in the George Washington Law Review's "On the Docket." You can find that commentary here.
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