Stock traders who thought they could trade freely on gifts of inside information so long as the givers were not their close friends should rethink their strategy. The U.S. Court of Appeals for the Second Circuit this week closed the window it had opened three years ago in the law of insider trading that created greater leeway for trading on such tips.
In United States v. Martoma, the Second Circuit on August 23 affirmed the 2014 conviction of hedge fund trader Michael Martoma, who, through well-timed short sales of two drug companies’ stock, generated millions of dollars in profits and avoided losses. He made those trades based on tips from a doctor who chaired confidential clinical trials for an Alzheimer’s disease drug.
Martoma’s appeal was based, in essence, on the proposition that he was not a close friend of the doctor/tipper, and that he had to have been one in order to be liable for insider trading. It was a line of argument that appeared viable under a Second Circuit decision that came after Martoma’s trial and conviction, United States v. Newman, 773 F.3d 438 (2d Cir. 2014).
But in its decision this week, the Second Circuit ruled that the key holding of Newman itself was no longer viable in light of a more recent U.S. Supreme Court decision, Salman v. United States, 137 S. Ct. 420 (2016). The court concluded that the law did not require a “meaningfully close personal relationship” between tipper and tippee, as Newman required, for a tippee like Martoma to be liable for trading on a tip provided as a gift.
The Martoma decision, while significant, may not be the last word on the issue. Judge Rosemary Pooler wrote a lengthy dissent from the majority opinion by Judge Robert Katzmann, who was joined by Judge Denny Chin. An appeal to the entire Second Circuit for en banc review seems likely. And further consideration by the U.S. Supreme Court, either in Martoma’s case or some other matter, seems possible as well.
But for now, at least, the Newman decision’s close personal relationship element, which appeared three years ago to pose a significant barrier to insider trading cases by the U.S. Attorney and the SEC, offers no defense to insider trading defendants.
The key underlying issue in Newman, Martoma and Salman is what is required to impose insider trading liability on a recipient of a tip, who by definition is not an insider. The answer from the Supreme Court is that the tippee’s culpability derives from the tipper’s. The tippee can be liable when the tipper breached a duty and the tippee knows or should know about that breach. And the test for whether the tipper is in breach is whether the tipper will personally benefit from making the disclosure to the tippee (as distinct, for example, from making a disclosure to expose wrongdoing).
Criminal prosecutors and civil regulators from the SEC argue for a broad definition of personal benefit, defense lawyers for a narrow definition. A payment in exchange for the information would clearly be a personal benefit. But, what about where the information was given other than in exchange for payment, as a kind of gift? In Newman, the Second Circuit gave a narrow definition of personal benefit under these circumstances. It required “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.”
That requirement, however, was thrown in doubt by the Supreme Court’s ruling in Salman, where the court found that Newman’s requirement that a tipper receive something of “pecuniary or similarly valuable nature” did not apply. Salman relied on an earlier Supreme Court case, Dirks v. SEC, 463 U.S. 646 (1983), where the court noted that a tip to a friend or relative could be tantamount to trading on a tip and then making a gift of the cash proceeds. The language of that case, the Supreme Court said, clearly controlled the outcome in Salman, which involved tips between two brothers who were very close.
The question that remained was whether the logic of Salman also vitiated Newman’s requirement of a meaningfully close personal relationship in a situation where the giver and recipient were not family members or close personal friends, the situation in Martoma. The Second Circuit gave a clear answer, holding that “the ‘meaningfully close personal relationship’ requirement is no longer good law.” So long as the tipper expects the tippee to trade on the information disclosed as a gift, that is sufficient. (The court did not challenge Newman’s requirement regarding the tippee’s knowledge of the tipper’s breach).
While the opinion focused on the closeness of the relationship element, the majority opinion also held that the evidence showed that the tipper received “substantial financial benefit” in exchange for providing confidential information to Martoma. It based this finding on the fact that the doctor/tipper had acted as a consultant to Martoma’s hedge fund, and received consulting payments for 43 sessions at a $1,000 an hour. That the consultant did not bill for the specific conversations where he divulged the critical information from the drug trials, the court said, did not alter the conclusion that there was a quid pro quo of payment for confidential information, rather than a gift.
As noted above, there may well be further judicial attention to all of these issues. But unless some higher authority issues a clear opinion to the contrary, trading based on gifts of inside information even from remote acquaintances will remain highly risky activity.