On September 6, 2012, the Second Circuit vacated summary judgment in favor of the defendants in a civil SEC enforcement action alleging insider trading in violation of Section 10(b) and Rule 10b-5. SEC v. Obus, 2012 WL 3854797 (2d Cir. Sept. 6, 2012) (Obus II) (Walker, Jr., J.). The Second Circuit’s decision addressed the standard for tipper and tippee liability in insider trading actions brought under the misappropriation theory.3

Background

The SEC claimed that Thomas Bradley Strickland, an assistant vice president and underwriter at General Electric Capital Corporation (“GE Capital”), “learned material non-public information” concerning Allied Capital Corporation’s planned acquisition of Sunsource, Inc. “in the course of his employment” at GE Capital. Id. at *1. Strickland allegedly “revealed” this information to Peter F. Black, a hedge fund analyst who was also a friend of Strickland’s from college. Id. “Black in turn [allegedly] relayed the information to his boss,” Nelson J. Obus, who then allegedly “traded on the information.” Id.

Following a trial, the Southern District of New York “granted summary judgment in favor of the defendants on both the classical and misappropriation theories of insider trading.” Id. The SEC appealed the district court’s ruling “only with respect to the misappropriation theory.” Id. at *5.

The Second Circuit Addresses the Standard for Tipper Liability in Misappropriation Cases

The Second Circuit held that “tipper liability requires that (1) the tipper had a duty to keep material non-public information confidential; (2) the tipper breached that duty by intentionally or recklessly relaying the information to a tippee who could use the information in connection with securities trading; and (3) the tipper received a personal benefit from the tip.” Id. at *10. “[T]he tipper must know that the information that is the subject of the tip is non-public and is material for securities trading purposes, or act with reckless disregard of the nature of the information.” Id. at *8. “[T]he tipper must [also] know (or be reckless in not knowing) that to disseminate the information would violate a fiduciary duty.” Id. The Second Circuit noted that “a deliberate tip with knowledge that the information is material and non-public” “can often be deduced from the same facts that establish the tipper acted for personal benefit.” Id.

Significantly, “a defendant cannot be held liable for negligently tipping information.” Id. (citing Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 & n. 12 (1976) (Powell, J.)). While “[t]he line between unactionable negligence and actionable recklessness is not a bright one[,]” the Second Circuit emphasized that “a tipper cannot avoid liability merely by demonstrating that he did not know to a certainty that the person to whom he gave the information would trade on it.” Id. “‘One who intentionally places such ammunition in the hands of individuals able to use it to their advantage on the market has the requisite state of mind.’” Id. (quoting Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 167 (2d Cir. (1980) (Mansfield, J.)).

The Second Circuit Finds the SEC Presented Sufficient Evidence of Tipper Liability to Survive Summary Judgment

The Second Circuit held that the SEC had “presented sufficient evidence to survive summary judgment” with respect to its claims against Strickland. Id. at *10. First, the court found it “undisputed that Strickland, an employee of GE Capital, owed GE Capital a fiduciary duty.” Id. The court also determined that there was “sufficient evidence that Strickland knew he owed GE Capital a duty to keep information about the SunSource/Allied acquisition confidential and not to convert it for his own profit.” Id.

Second, the court concluded that “[a] rational jury could reasonably infer from the SEC’s evidence that Strickland did tell Black that SunSource was about to be acquired” and that “Strickland knew the material non-public information [was] ‘ammunition’ that Black was in a position to use.” Id. at *12 (citing Elkind, 635 F.2d at 167). The Second Circuit held that “[t]his evidence easily supports a finding of knowing or reckless tipping to someone who likely would use the information to trade in securities.” Id.

Third, the court found it “readily apparent that … if the tip occurred, Strickland made the tip intentionally and received a personal benefit from it.” Id. “Personal benefit to the tipper is broadly defined: it includes not only ‘pecuniary gain,’ such as a cut of the take or a gratuity from the tippee, but also a ‘reputational benefit’ or the benefit one would obtain from simply ‘mak[ing] a gift of confidential information to a trading relative or friend.’” Id. at *7 (quoting Dirks v. SEC, 463 U.S. 646, 663-64 (1983) (Powell, J.)). “Here,” the Second Circuit held that “the undisputed fact that Strickland and Black were friends from college is sufficient to send to the jury the question of whether Strickland received a benefit from tipping Black.” Id. at *12. “This same evidence … is sufficient for a jury to conclude that Strickland intentionally or recklessly revealed material non-public information to Black, knowing that he was making a gift of information Black was likely to use for securities trading purposes.” Id.

Finally, the Second Circuit held that “the district court [had] erred by requiring the SEC to make an additional showing of ‘deception’ beyond the tip itself.” Id. at *13. “[E]mployees who misappropriate confidential information ‘deal in deception.’” Id. (quoting U.S. v. O’Hagan, 521 U.S. 642, 653 (1997) (Ginsburg, J.)). “If the jury accepts that a tip of material non-public information occurred and that Strickland acted intentionally or recklessly, Strickland knowingly deceived and defrauded GE Capital.” Id. “That is all the deception that [S]ection 10(b) requires.” Id.

The Second Circuit Addresses the Standard for Tippee Liability

The Second Circuit held that “[t]ippee liability requires that (1) the tipper breached a duty by tipping confidential information; (2) the tippee knew or had reason to know that the tippee improperly obtained the information (i.e., that the information was obtained through the tipper’s breach); and (3) the tippee, while in knowing possession of the material non-public information, used the information by trading or by tipping for his own benefit.” Id. at *10.

In Dirks, the Supreme Court held that a tippee has a duty to abstain from trading (or to disclose the information to the source) “‘only when the insider has breached his fiduciary duty … and the tippee knows or should know that there has been a breach.’” Id. at *9 (quoting Dirks, 463 U.S. at 660) (emphasis added by the Second Circuit). “The parties dispute[d] whether the Dirks rule [was] in conflict with Hochfelder’s holding that negligence does not satisfy [S]ection 10(b)’s scienter requirement because the ‘knows or should know’ rule … sounds somewhat similar to a negligence standard.” Id.

The Second Circuit “reconcile[d]” the holdings in Dirks and Hochfelder by “recogniz[ing] that the two cases were not discussing the same knowledge requirement when they announced apparently conflicting scienter standards.” Id. “Dirks knows or should know standard pertains to a tippee’s knowledge that the tipper breached a duty … by relaying confidential information.” Id. “This is a fact-specific inquiry turning on the tippee’s own knowledge and sophistication, and on whether the tipper’s conduct raised red flags that confidential information was being transmitted improperly.” Id. “Hochfelder’s requirement of intentional … conduct pertains to the tippee’s eventual use of the tip through trading or further dissemination of the information.” Id. “Thus, tippee liability can be established if a tippee knew or had reason to know that confidential information was initially obtained and transmitted improperly (and thus through deception), and if the tippee intentionally or recklessly traded while in knowing possession of that information.” Id.

The Second Circuit explained that cases involving “chains of tipping … follow [this] same basic analysis[.]” Id. at *10. “The first tippee must both know or have reason to know that the information was obtained and transmitted through a breach, and intentionally or recklessly tip the information further for her own benefit.” Id. “The final tippee must both know or have reason to know that the information was obtained through a breach, and trade while in knowing possession of the information.” Id.

The Second Circuit Determines the SEC Presented Sufficient Evidence of Tippee Liability to Survive Summary Judgment

The Second Circuit held that the SEC had “presented sufficient evidence to send the question of Black’s liability to a jury.” Id. at *13. First, the court found sufficient evidence for a jury to conclude that “Strickland [had] breached a duty to his employer in tipping Black” and that “Black inherited Strickland’s duty of confidentiality.” Id.

Second, the court determined that there was sufficient evidence for a “jury to conclude that Black knew or had reason to know that any tip from Strickland on SunSource’s acquisition would breach Strickland’s fiduciary duty to GE Capital.” Id. “Black, a sophisticated financial analyst, testified that he knew Strickland worked at GE Capital, which provided loans to businesses; that he knew Strickland was involved in developing financing packages for other companies and performing due diligence; and that information about a non-public acquisition would be material inside information that would preclude someone from buying stock.” Id.

Third, the court held that “a jury could find that by passing along what he was told by Strickland, Black hoped to curry favor with his boss” and thus “derived some personal benefit from relaying the tip.” Id. “In light of the broad definition of personal benefit set forth in Dirks,” the Second Circuit explained that the bar for establishing a personal benefit “is not a high one.” Id.

Finally, the Second Circuit held that “the SEC ha[d] established genuine questions of fact about whether Black’s boss, Obus, knew that Strickland had breached a duty to GE Capital and whether Obus traded in SunSource stock while in knowing possession of the material non-public information that SunSource was about to be acquired.” Id. at *14. The court found the evidence “sufficient to allow a jury to infer that Obus was aware that Strickland’s position with GE Capital [had] exposed Strickland to information that Strickland should have kept confidential.” Id. The court also determined that the evidence was “sufficient for the jury to find that Obus subjectively knew he possessed material non-public information” when he purchased SunSource shares prior to Allied’s acquisition of SunSource, regardless of “whether or not his purchase was directly caused by his knowledge of the pending acquisition.” Id.