On August 23, in a decision with significant implications for tipping liability, the U.S. Court of Appeals for the Second Circuit affirmed the 2014 insider trading conviction of a former hedge fund portfolio manager. Following the Second Circuit’s decision in United States v. Martoma, a person who trades based on material non-public information (the “tippee”) may be liable for insider trading despite not having a “meaningfully close personal relationship” with the person who gifted them that information (the “tipper”). The majority opinion was authored by Chief Judge Katzmann, with Circuit Judge Pooler dissenting.
On September 9, 2014, Mathew Martoma was convicted in the United States District Court for the Southern District of New York of one count of conspiracy to commit securities fraud and two counts of securities fraud in connection with an insider trading scheme pursuant to which Martoma arranged paid consultations with, and obtained inside information from, doctors who were working on a clinical trial for a promising new Alzheimer’s drug. The inside information included advance notice of negative study results regarding the efficacy of the drug set to be announced at an international Alzheimer’s conference. Based on that information, Martoma’s firm entered into short-sale and options trades on securities of the two pharmaceutical companies that were jointly developing the drug. When the negative study results were announced publicly, Martoma’s firm made gains in excess of $80 million from their trades as the share prices of the two pharmaceutical companies dropped significantly.
Following Martoma’s conviction, the Second Circuit decided an unrelated tipping liability case, United States v. Newman, 773 F.3d 438 (2d Cir. 2014). Newman considered in greater detail the situation described in Dirks v. SEC, 463 U.S. 646 (1983), where a tipper gives a “gift” (i.e., without a quid pro quo) of inside information to a relative or friend who then trades on that information.
Dirks held that a tippee can be liable for trading on inside information received from a tipper “only when the [tipper] has breached his fiduciary duty to the shareholders by disclosing the information . . . and the tippee knows or should know there has been a breach.” Id. at 660. Dirks further established that such a breach would exist only where the tipper personally benefits, directly or indirectly, from the disclosure of insider information to the tippee. Id. at 662. The Dirks court gave as an example of a personal benefit the situation where a tipper makes a gift of insider information to a “relative or friend” who then trades on that information, the rationale being that the tip and trade are the equivalent of the tipper making the trade himself and then gifting the proceeds to the tippee. Id. at 664.
In Newman, the Second Circuit narrowed the potential scope of tippee liability under the Dirks “gift theory” by holding that a personal benefit to a tipper may be inferred from a personal relationship between the tipper and tippee only with sufficient 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.” Newman, 773 F.3d at 452.
Based on the Second Circuit’s decision in Newman, Martoma appealed to the Second Circuit, arguing that he did not have the requisite personal relationship with the doctors who provided him with inside information. During the pendency of that appeal, however, the Supreme Court heard and decided Salman v. United States, 137 S. Ct. 420 (2016). Salman also addressed arguments relating to the gift of insider information to relatives or friends.
Salman expressly rejected the Newman requirement that a tipper must receive something of a pecuniary or similarly valuable nature. Id. at 428. However, Salman did not specifically address the rule established by Newman that a tipper and tippee must have a “meaningfully close personal relationship” in order to infer that the tipper received a personal benefit from his or her gift of inside information. Nevertheless, the Second Circuit in Martoma “[f]ollow[ed] the logic” of Salman and held that Newman’s “meaningfully close personal relationship” requirement “is no longer good law.” The Second Circuit read Salman as “strongly reaffirm[ing]” the gift-giving analysis in Dirks that an insider personally benefits from disclosing material non-public information as a gift with the expectation that the tippee will trade on or otherwise exploit that information for gain because such a disclosure is the equivalent of the tipper making the trade and giving cash to the tippee. However, in the Second Circuit’s view, Salman does not support making any distinction between tippers making gifts of such information to tippees with whom they have a close personal relationship and those with whom the tipper does not have such a relationship. Accordingly, the majority applied Salman to reject the categorical rule that an insider could never personally benefit from disclosing inside information as a gift without having a “meaningfully close personal relationship” with the tippee.
Circuit Judge Rosemary Pooler dissented from the majority opinion, noting that Salman “left undisturbed” Newman’s “meaningfully close personal relationship” test, which should therefore not be reversed except by convening the Second Circuit en banc.
Given the divided nature of the Second Circuit’s decision in Martoma, as well as the fact that it overturns a decision previously issued by other active Second Circuit judges, it is possible that the Second Circuit, sitting en banc, or another court may have occasion to reconsider Martoma. But unless and until that occurs, the Martoma decision represents a significant victory for the government in its efforts to enforce and prosecute insider trading. The importance of the relationship between tipper and tippee has now been diminished under the law and a “meaningfully close personal relationship” is no longer prerequisite to establishing insider trading liability for “gifts” of inside information. Rather, the nature of the relationship between tipper and tippee is just one of many facts and circumstances that may be probative of the tipper’s motivation for gifting inside information to a tippee – i.e., whether the tipper disclosed the inside information with the expectation that the tippee would trade on the information.