For years courts, prosecutors and SEC lawyers have twisted themselves into knots trying to figure out when those who leak insider information (“tippers”) benefit from the leak and thereby violate the securities laws based on the decision in Dirks v. S.E.C., 463 U.S. 646 (1983). Cases have run the gambit from insiders receiving bags of cash to cheating husbands getting the psychic benefit of knowing that their girlfriends were profiting on their tips. The Second Circuit has been one of the leading voices in the debate about the “personal benefit” element of the offense of insider trading, and it has just recently spoken again on the subject, ruling (with one judge dissenting) that the benefit need not be the result of a “meaningfully close personal relationship” between a tipper and someone (“a tippee”) who trades on the tipper’s leak.'
In United States v. Martoma, No. 14-3599 (2d Cir. Aug. 23, 2017), the Second Circuit again addressed the intersection of insider trading and expert networks. Matthew Martoma was an SAC. Capital Advisors ("SAC") portfolio manager who specialized in pharmaceutical and healthcare companies. As part of his investment research, Martoma used expert network firms to consult Alzheimer specialists about a promising drug for treating Alzheimer's disease called bapineuzumab. Martoma extensively consulted Dr. Sidney Gilman - the tipper in this case - approximately 43 times at the rate of $1,000 per hour. Dr. Gilman had a critical role in bapineuzumab's clinical trial and was naturally obliged to keep the drug trial information confidential. Nevertheless, he violated his confidentiality obligations and shared material non-public information ("MNPI") with Martoma. Martoma established a long position in two pharmaceutical companies, Elan and Wyeth, in his portfolio, and encouraged SAC's principal, Steven A. Cohen, to also invest in these stocks for SAC's largest portfolio.
On June 17, 2008, the drug companies issued positive statements about the drug trial, and promised that more information would be forthcoming at a conference scheduled for July 29, 2008. Predictably, Elan's and Wyeth's share prices increased following this announcement. A few weeks before the conference, Dr.Gilman learned that the trial results were actually worse than expected, and he immediately informed Martoma about the bad news, providing him with extensive data about the problems. SAC subsequently reduced its long positions in the drug companies and shorted the stock. The companies' share prices started dropping during Gilman's presentation of the poor results at the conference on July 29. By the end of the next trading day, Elan's share price was down by 42% and Wyeth's was down by 12%. The trades SAC executed after Martoma learned of the unexpectedly bad results earned it $80 million and averted losses of $195 million.
The Second Circuit's Decision
Martoma was convicted after a four week jury trial in September 2014 of one count of conspiracy to commit securities fraud and two counts of securities fraud. After his conviction, the Second Circuit handed down its much -awaited decision in United States v. Newman, 773 F.3d 438 (2d Cir. 2014). Martoma then appealed his convictions to the Second Circuit. He argued that the evidence at trial was insufficient to support his convictions and that the jury instruction was contrary to the Newman decision. While Martoma's appeal was pending, the U.S. Supreme Court decided Sa/man v. United States, 137 S. Ct. 420 (2016). Both Salman and Newman grapple with the legacy of Dirks, with the Supreme Court in Salman rejecting some of the key arguments that won the day in the Second Circuit in Newman. Martoma is effectively the Second Circuit's do -over in interpreting Dirks.
Dirks Through the Lens of Newman and Salman
Dirks established a test to determine when a non-insider who receives MNPI (a "tippee") from an insider (a "tipper") is liable for insider trading. The conceptual bedrock of insider trading liability is that tippee liability derives exclusively from an insider's breach of fiduciary duty. For a tippee to be liable for insider trading, the tipper must have provided MNPI in breach of the tipper's fiduciary obligations to preserve the information's confidentiality.1 To determine whether a tipper has violated his or her fiduciary duties by providing confidential information to a tippee, Dirks requires proof that the tipper benefitted personally, whether directly or indirectly, from the disclosure. If the tipper has benefitted personally, then the tippee potentially faces insider trading liability. But what exactly does this all mean?
At Martoma's trial, the jury was instructed that the tipper's benefit "may, but need not be, financial or tangible in nature; it could include obtaining some future advantage, developing or maintaining a business contact or friendship, or enhancing a tipper's reputation." This is plainly a very broad definition of "benefit" and Martoma was convicted.
In Newman, the Second Circuit held that, where there is a "gift"2 of inside information to a "trading relative or friend," a tipper breaches his or her fiduciary duties only ifthere is a "meaningfully close personal relationshipthat generates an exchange that is objective,consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature."3 The Newman standard is much more restrictive than Martoma's jurycharge, and naturally formed the centerpiece of Martoma's appeal to the Second Circuit.
In Salman, the defendant argued that a tipper must receive a pecuniary benefit or something of tangible value for the tipper to have violated his or her confidentiality obligations. The Supreme Court disagreed. It said that the Second Circuit was wrong in Newman: any requirement for the tipper to have received something pecuniary in return for the tip is inconsistent with Dirks. Where a tip is given to a "trading relative or friend", "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. "4 The Supreme Court in Salman obviously rejected Newman insofar as it required a tipper to receive something pecuniary in return for inside information; but what does the Salman decision mean for the Second Circuit's other requirement of a "meaningfully close personal relationship"?5 This is the question that the Martoma Court addressed.
The Dirks Do-over: Martoma
In a 2:1 split, the Second Circuit dismissed Martoma's appeal. Chief Judge Katzmann and Judge Chin decided in an opinion authored by Chief Judge Katzmann that a "meaningfully close personal relationship" between tipper and tippee is not required for insider trading liability in cases where MNPI is gifted by an insider to a "trading relative or friend." To the extent that Newman stated otherwise, it is no longer good law. Judge Pooler dissented.
For the majority, the critical aspect of Salman is the Supreme Court's view that the gifting of MNPI by an insider to a tippee is the functional equivalent of a trade by the tipper, followed by a gift of the proceeds to the tippee. The majority announced broadly (at least at first) that "we hold that an insider or tipper personally benefits from a disclosure of inside information whenever the information was disclosed with the expectation that [the recipient] would trade on it[.]"6 The majority emphasized that its holding "reaches only the insider who discloses information to someone he expects will trade on the information. "7
However, that was not the end of the majority's analysis. In response to Judge Pooler's concerns8, the majority declared that the holding in Martoma "does not eliminate or vitiate the personal benefit rule; it merely acknowledges that it is possible to personally benefit from a disclosure of inside information as a gift to someone with whom one does not share a 'meaningfully close relationship."'9
What does MARTOMA mean for traders and their lawyers?
The broad language of the majority opinion raises two basic questions for practitioners and traders alike. First, how should this opinion change trading behavior Should we be telling clients who trade that the rules have gotten tighter again and they need to be more careful? And second, what, if any, defenses on"personal benefit" remain for those caught up in investigations or prosecutions of insider trading?
The answer to the first question is simple: anyone who thought the holding in Newman ushered in a new era of leniency with respect to the rules was sadly mistaken even before the Salman and Martoma decisions. The rules are simply too vague and the discretion of prosecutors and SEC lawyers has always been so great that traders with MNPI simply had to, and still have to, abstain from trading. Period. That is the advice we have always given our clients and it has always been the only sound approach to this amorphous area of the securities laws.'?10
But the question of what defenses on "personal benefit" remain is still quite open, notwithstanding the apparent breadth of some of the language in the majority opinion in Martoma. In asserting in response to the dissent that its opinion "merely acknowledges" that it is "possible" that a tipper can personally benefit by leaking MNPI to someone with whom he or she does not have a "meaningfully close personal relationship,"11 the majority has hinted that it did not mean to say that whenever there is a leak to anyone whom the tipper knows will trade, the law is always violated. Instead, the majority opinion left the matter open for debate between government lawyers and defense counsel, and ultimately commits the decision on personal benefit to juries.12 That decision still involves a mixed question of law for courts and lawyers and fact for juries. Therefore the debate will continue on what is a "gift" and when a tipper "personally benefits" by giving it. We have learned from the majority opinion that there need not be a "meaningfully close personal relationship" between tipper and tippee, but we will all continue to struggle to figure out what is and isn't a "personal benefit."13
It is right and proper that this issue should be decided on a case-by-case basis, and it must be driven by the facts. A blanket rule does not work when it comes to what is or is not an intangible "personal benefit." However, in the end, it should not cause us to continue to tie ourselves into knots. The simple and fundamental question is: did the tipper display some form of self dealing, whether or not it was for his or her own direct financial gain? That said, the majority decision in Martoma again expands the considerable discretion enjoyed by government lawyers in these cases, but the Newman decision and the dissent in Martoma may still serve as fair warning to them not to push the definition of "personal benefit" too far.