A case heading to the Supreme Court could dramatically change insider trading law that bars trades by recipients of stock tips. In consenting earlier this year to hear the defendant’s appeal in United States v. Salman, 792 F.3d 1087 (9th Cir. 2015), the Court agreed to consider a case that raises the question of whether a trade based on an inside tip is permitted so long as the tipper was motivated to tip by familial love rather than monetary gain.
Both government regulators and defense attorneys are closely following the case. A decision in favor of the defendant could mean that prosecutors will not be able to pursue a category of insider trades long thought to be subject to prosecution. By contrast, an affirmance of the conviction could curtail some of the defense arguments that have gathered momentum in the wake of the Second Circuit’s prominent 2014 Newman decision narrowing the liability of tippees.
Tippee liability concerns the liability of an individual who receives a tip of nonpublic, material information from an insider (or someone else with inside knowledge who has a duty not to exploit it). The liability of the recipient for trading on such information is one of the most hotly debated areas of insider trading law today.
The Newman Case
This debate intensified with the decision in United States v. Newman, 773 F.3d 438 (2d Cir. 2014), widely described as a major blow to the insider trading prosecution efforts of Preet Bharara, the United States Attorney for the Southern District of New York. There, the Second Circuit reversed the convictions of two hedge fund portfolio managers, who had made trades based on chains of tips originating with insiders of the companies whose shares were traded.
The defendants there were several steps removed from the source of the information. For example, defendant Newman received a tip about Dell stock from an analyst at his fund, who had received it from an analyst at a separate fund, who in turn received a tip from an employee of Dell’s investor relations department (the tipper). There was no evidence Newman knew the source of the inside information.
In overturning the convictions, the Second Circuit held that the government failed to prove that (1) the tippers disclosed confidential information to obtain a “personal benefit,” or (2) the defendant tippees knew of the personal benefit, assuming there was any. To show a “personal benefit,” the court held, the government must present evidence of a quid pro quo, i.e., payment, from the recipient to the tipper, or some other significant benefit. The court made clear that that benefit could be shown by something other than payment, but said that it had to be significant. And, in language that lawyers have been struggling to apply ever since, it said, a personal benefit cannot be inferred from a personal relationship between tipper and tippee “in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature.”
The government petitioned the Supreme Court for certiorari in Newman, but the Court denied the petition in October 2015.
Salman Takes a Different Approach
Three months later, however, the Supreme Court granted certiorari in Salman, where the court took a very different approach. In Salman, the Ninth Circuit upheld the conviction of a man who received trading tips from his brother-in-law, who, in turn, obtained insider information from the tipper, his own brother and a healthcare investment banker at Citigroup. There was no evidence that the tipper received any payment for giving the tip.
The Salman court concluded that the government need not show proof that the tipper obtained a pecuniary benefit. Rather, it was sufficient for the Government to show that the tipper and the tippee had a close personal relationship such that the jury could infer that the tipper intended to make a gift of market-sensitive information.
The jury convicted the defendant in Salman, and the Ninth Circuit affirmed the conviction. The defendant then filed a petition for certiorari, and the Supreme Court in January 2016 granted it.
The Foundations of Tippee Liability in Dirks
Both Newman and Salman attempted to ground their rulings in Dirks v. SEC, 463 U.S. 646 (1983), in which the Supreme Court addressed tippee liability.
In a six-to-three decision, the Court in Dirks held that tippees’ duties to disclose or abstain from trading derive from the duties of their tippers – the duties of corporate insiders not to “personally us[e] undisclosed corporate information to their advantage” and not to “give such information to an outsider for the same improper purpose of exploiting the information for their personal gain.” As such, a tippee “assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.” The Court explained that “[w]hether disclosure is a breach of duty … depends in large part on the purpose of the disclosure” -- “the test is whether the insider personally will benefit, directly or indirectly” from the disclosure. And thus, the personal benefit requirement of tippee liability was created.
The Dirks Court then provided some color as to what “personal benefit” means. It stated that objective factors should be considered, such as whether the insider receives “a pecuniary gain or a reputational benefit that will translate into future earnings,” or whether there is a quid pro quo relationship. The Court did not stop there, however. It added that “[t]he 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. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.” Based on this, the Court concluded that the personal benefit element was not satisfied because (1) the tippers received no monetary benefit for revealing the confidential information to Dirks and (2) the tippers did not intend to make a gift of valuable information to Dirks.
Newman and Salman focused on different aspects of Dirks. Newman seized upon the language in Dirks that some sort of quid pro quo or pecuniary gain -- whether immediate or not -- is required. It did acknowledge the statement in Dirks that a tippee may be liable when the insider and the tippee have a close personal relationship, in which the insider makes “a gift of the profits” to the tippee. But then the Newman court said that there still must be “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of pecuniary or similarly valuable nature.” In other words, even a gift to a close personal friend or family member seems to require a pecuniary gain or other form of “exchange” involving a gain of “similarly valuable nature.”
The Salman court, however, concluded that one sentence of Dirks governed the case -- namely, the statement that the necessary elements of insider trading “also exist when an insider makes a gift of confidential information to a trading relative or friend.” To the Ninth Circuit, tipping your brother, even without any evidence of a promised tangible benefit to the tipper, is enough to satisfy Dirks.
Are Newman and Salman in Conflict?
The two cases are not expressly in conflict. The Salman court attempted to reconcile its decision with Newman, stating that Newman itself recognized the language in Dirks about obtaining a benefit through a gift to a close friend or relative. But, seeming to acknowledge that Newman could be interpreted as in conflict, the court stated that to the extent Newman held that something more is required than proof of a gift to a close friend or relative, the Ninth Circuit declined to apply this approach.
Further, despite the possibility that the two cases can be reconciled, Salman’s Supreme Court petition characterized them as being in conflict. And at the very least, there is certainly a tension between the two that would seem to warrant clarification by the Supreme Court.
In an intriguing aspect of the case, the three-judge Ninth Circuit panel that decided Salman included a visiting District Court judge from within the Second Circuit, Judge Jed Rakoff of the Southern District of New York, who as a District Judge had issued an opinion expressing some concern regarding Newman.
One could conclude that the Supreme Court denied certiorari in Newman because it viewed that case as correctly decided, whereas it granted review in Salman in order to reverse it. That is one possible outcome. But it is also plausible that the Court (which requires four votes to grant certiorari) viewed Salman as creating a conflict that made Supreme Court review appropriate, or that it believed Salman simply presented a better vehicle for review. It is by no means clear that the Supreme Court is determined to reverse Salman.
The Salman court’s holding that a gift of nonpublic, material information to a close relationship, such as a family member or a close friend, without any additional proof of pecuniary gain by the insider, seems to be supported by language in the Dirks decision. Moreover, Newman’s suggestion that such a close relationship would not itself be sufficient without some evidence of tangible gain is not tied closely to the language of Dirks, and in any event, was arguably not necessary to the opinion, since Newman did not involve a family relationship or a close friendship. Further, an affirmance of the principle that a close friendship or family relationship is sufficient without proof of pecuniary or other tangible gain would not undermine the ultimate outcome of Newman because in that case, the tippees did not even know who the insiders were.
Thus, it may be that the Court could affirm Salman without rejecting the approach of Newman. Or it could issue a broader, more definitive statement seeking to clarify the law and issues raised in both cases. While it is not clear what the outcome will be, it is clear that the stakes of the case are high. Salman will likely be of historical importance whatever the outcome for the law of insider trading.
This article was originally published in The Corporate Counselor (May 2016); republished with permission.