On August 23rd, the Second Circuit issued its much-anticipated opinion in U.S. v. Martoma, affirming the 2014 insider trading conviction of S.A.C. Capital Advisors portfolio manager Matthew Martoma. In doing so, it clarified an important point regarding what is required to convict a person who trades on a tip received from an insider. We believe this decision will have an immediate impact on how hedge fund portfolio managers and other investment advisers interact with third party resources.
Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder prohibit insider trading. The basic elements of insider trading are: (i) engaging in a securities transaction, (ii) while in possession of material, non-public information, (iii) in violation of a duty to refrain from doing so.
Under the classic theory of insider trading, a corporate insider trades in shares of his employer while in possession of material, non-public information (e.g., advance notice of a merger). In addition to the classic theory of insider trading, case law has extended the liability to persons who receive tips from insiders (i.e., individuals whose duty to refrain from trading is derived or inherited from the corporate insider’s duty). Thus, not only may insiders be liable for insider trading, but those to whom they pass tips, either directly (tippees) or through others (remote tippees) may be liable if they trade on such tips.
The seminal case involving tippee liability is Dirks v. SEC. In Dirks, the U.S. Supreme Court held the following:
In determining whether a tippee is under an obligation to disclose or abstain, it is necessary to determine whether the insider’s “tip” constituted a breach of the insider’s fiduciary duty. Whether disclosure is a breach of duty depends in large part on the personal benefit the insider receives as a result of the disclosure. Absent an improper purpose, there is no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.
The question of what constituted a “personal benefit” was left ill-defined until the Second Circuit gave it shape in U.S. v. Newman. Newman held that a tipper and tippee must have a “meaningfully close personal relationship” and that the insider information be divulged in exchange for “a potential gain of a pecuniary or similarly valuable nature” for the court to find the tipper had breached his fiduciary duty to the source. For a period of time after the Second Circuit issued its opinion in Newman, it seemed that Martoma’s conviction was likely to be overturned.
Unfortunately for Martoma, the U.S. Supreme Court issued its opinion in U.S. v. Salman while Martoma’s appeal was pending. In Salman, the U.S. Supreme Court flatly rejected certain aspects of the Newman holding and called others into question. Accordingly, the Second Circuit held in Martoma that “Salman fundamentally altered the analysis underlying Newman’s ‘meaningfully close relationship’ requirement such that the ‘meaningfully close personal relationship’ requirement is no longer good law.”
In Martoma, the court held that rather than looking at objective elements of the relationship between tipper and tippee, the proper inquiry is now whether the corporate insider divulged the relevant information with the expectation that the tippee would trade on it. This is “because such a disclosure is the functional equivalent of trading on the information himself and giving the cash gift to the recipient.”