After Oral Argument in “Salman v. US,” Will Supreme Court Meaningfully Limit What Counts as Insider Trading?

bainbridgeFeatured Expert Contributor — Corporate Governance/Securities Law

Stephen M. Bainbridge, William D. Warren Distinguished Professor of Law, UCLA School of Law

Over a three-year period from 2004 to 2007, Citigroup investment banker Maher Kara disclosed confidential nonpublic information about upcoming mergers and acquisitions to his brother Michael Kara. In turn, Michael disclosed the information to his close friend Bassam Salman, who then indirectly traded in the affected stocks. When Salman was tried on charges of illegal insider trading, the government offered evidence that he knew the information originated with Maher.

The case presented two issues: First, what is the basis of liability when an insider tips information to an outsider? Second, what must the government prove in order to hold a remote tippee liable when the information is passed down a chain from tipper to tippee to a tippee of that tippee and so on?

In Chiarella v. United States, 445 U.S. 222 (1980), the United States Supreme Court rejected the equal access policy. Instead, the Court made clear that liability could be imposed only if the defendant was subject to a duty to disclose prior to trading. Inside traders thus cannot be held liable merely because they have more information than other investors in the market place:

[T]he element required to make silence fraudulent—a duty to disclose—is absent in this case. No duty could arise from petitioner’s relationship with the sellers of the target company’s securities, for petitioner had no prior dealings with them. He was not their agent, he was not a fiduciary, he was not a person in whom the sellers had placed their trust and confidence. He was, in fact, a complete stranger who dealt with the sellers only through impersonal market transactions.

Chiarella at 232–33 (citation omitted).

In Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court addressed the problem that arises when an insider does not trade but rather tips information to an outsider who then trades. Under the Chiarella framework, the outsider is not an agent or other fiduciary of the company in whose stock he trades, and thus the requisite relationship does not exist. The Supreme Court nevertheless held that both a tipper and tippee could be held liable.

The tippee’s liability is derivative of the tipper’s, “arising from his role as a participant after the fact in the insider’s breach of a fiduciary duty.”  Dirks at 659.  As a result, the mere fact of a tip is not sufficient to result in liability. What is proscribed is not merely a breach of confidentiality by the insider, but rather a breach of the duty of loyalty imposed on all fiduciaries to avoid personally profiting from information entrusted to them.  See Dirks at 662–64.  Thus, looking at objective criteria, the courts must determine whether the insider personally will benefit, directly or indirectly, from his disclosure. If so, the tipper can be held liable. In turn, the tippee may be held liable if he knows or has reason to know of the breach of duty.*

A key question posed by Dirks was what constituted the requisite personal benefit. Obviously, a payment of cash would suffice, but Dirks had indicated that less tangible benefits would also suffice:

[The personal benefit test directs] courts to focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings. … There are objective facts and circumstances that often justify such an inference. For example, there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient. The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.

Dirks at 663–64.  In subsequent years, prosecutors routinely argued—and most courts agreed—that any tip between family members or friends constituted a gift. Because insiders rarely deliberately tip off complete strangers, most intentional disclosures resulted in liability. Only in rare cases in which there was a legitimate business reason for the disclosure could they escape liability under Rule 10b-5 and most of those cases are captured by other rules such as Rule 14e-3 or Regulation FD.

In its 2014 U.S. v. Newman decision, however, the Second Circuit announced a major limitation on the personal benefit test:

This standard, although permissive, does not suggest that the Government may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature. If that were true, and the Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity. To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades ‘resemble trading by the insider himself followed by a gift of the profits to the recipient,’ we hold that such an inference is impermissible in the absence of 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.

773 F.3d 438, 452 (2d Cir. 2014) (citations omitted).  In turn, Salman relied on Newman in appealing his conviction to the Ninth Circuit:

Salman reads Newman to hold that evidence of a friendship or familial relationship between tipper and tippee, standing alone, is insufficient to demonstrate that the tipper received a benefit. In particular, he focuses on the language indicating that the exchange of information must include ‘at least a potential gain of a pecuniary or similarly valuable nature,’ which he reads as referring to the benefit received by the tipper. Salman argues that because there is no evidence that Maher received any such tangible benefit in exchange for the inside information, or that Salman knew of any such benefit, the Government failed to carry its burden.

U.S. v. Salman, 792 F.3d 1087, 1093 (9th Cir. 2015) (citation omitted).  The Ninth Circuit rejected that argument, holding that evidence that Maher tipped his brother “for the purpose of benefitting and providing for … Michael” satisfied the personal benefit test because it involved a gift of information. Salman sought Supreme Court review and the Court issued a writ of certiorari. Oral argument was held on October 5, 2014 (transcript here).

At oral argument, most—if not all—of the Justices seemed skeptical of Salman’s argument that the Court should adopt the Newman standard. Justice Elena Kagan, for example, told one of Salman’s counsel that their proposed approach “cut back significantly from something that we said several decades ago, something that Congress has shown no indication that it’s unhappy with ….”

On the other hand, many Justices also seemed skeptical of the Government’s proposed standard, under which the personal benefit requirement would be satisfied whenever an insider discloses information without a corporate purpose. An exchange between Justice Samuel Alito and government counsel seems particularly significant:

JUSTICE ALITO:  It doesn’t seem to me that your argument is much more consistent with Dirks than [that of Salman’s counsel].

Now suppose someone, the insider is walking down the street and sees someone who has a really unhappy look on his face and says, I want to do something to make this person’s day.  And so he provides the inside information to that person and says, you can make some money if you trade on this.

Is that a violation?

DREEBEN: Yes. …

Justices Stephen Breyer and Sonja Sotomayor and Chief Justice John Roberts all seemed unwilling to go that far, with the latter suggesting that there is room under the law for an “area that something falls in the middle of that, that it’s—it’s not for a corporate purpose, but it also doesn’t qualify for a personal benefit.”

As a result, it seems likely that the Court will end up with a rule that tipping information to family members or close friends is a gift and meets the personal benefit requirement but that disclosures to persons outside that social circle, such as the one posited by Justice Alito, do not.

If so, however, that result makes no sense. Why is disclosure to a stranger any less objectionable than disclosure to a friend? Granted, there are unlikely to be many instances of the former, but in seeking a coherent rule there is no obvious basis for the distinction between drawn.

Part of the problem is that the Court—and the parties, for that matter—essentially conflated the two distinct issues at stake. The Justices seem to be concerned that in tipping chain cases—where the tipper discloses information to one person who discloses it to someone else and so on—that the government’s standard would capture people unaware that they were dealing with inside information. In contrast, the Justices seemed to think that compromise position of limiting liability to friends and family would avoid that problem.

The solution to that concern, however, is not to change the personal benefit test. Under current law, in tipping chains the government must prove that the ultimate 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.”  SEC v. Obus, 693 F.3d 276, 288 (2d Cir.2012).  If the concern is to protect innocent remote tippees, the Court could simply tweak existing law to require proof of actual knowledge that the initial tipper got a personal benefit for making the tip in breach of the tipper’s duties to the source of the information.

As for the personal benefit test, the Court should embrace the Newman standard. Newman was a correct application of Dirks’ personal benefit test.  Moreover, the government’s interpretation of Dirks would chill valuable analyst-insider communications that Dirks intended to protect.

As Adam Pritchard demonstrated by reviewing Justice Powell’s papers (Justice Lewis F. Powell, Jr., and the Counterrevolution in the Federal Securities Laws, 52 Duke L.J. 841 (2003)), Dirks’s approach to tipping was driven in considerable measure by Powell’s concern that insider trading laws could seriously infringe on the ability of market analysts to communicate with corporate managers.

In addition, both Chiarella and Dirks reflected a policy goal of protecting the market from the threat of prosecutorial over-reaching. In both, the government advocated a far broader liability rule than Justice Powell was willing to countenance. In both, Powell rallied a majority to smack down government overreaching.

With respect to the problem at hand, Powell fashioned the personal benefit test to provide a necessary “limiting principle” for fraud liability and a meaningful “guiding principle” for analysts, insiders, and investors. As he recognized, such definite and objective limits on the scope of insider-trading liability are necessary to protect the socially beneficial activities of market participants operating under the eye of the SEC. Without those “legal limitations, market participants are forced to rely on the reasonableness of the SEC’s litigation strategy” as their only assurance that their activities will not be subject to prosecution. And that, as he observed, “can be hazardous.”

Newman is a straightforward and correct application of Dirks. In particular, Newman correctly rejected the government’s contention that the “mere fact of a friendship” between the insider and the recipient of information is legally sufficient evidence that the insider sought a personal benefit. The function of the personal benefit test is to gauge whether a disclosure was made for an improper purpose. Unlike the personal benefit test, the fact that an analyst can be characterized as a social “friend” of the insider who discloses information does nothing to illuminate the purpose for which the disclosure was actually made.

If mere evidence of “friendship” is presumptive evidence of personal benefit, then virtually all disclosures are potentially subject to prosecution, because insiders are far more likely to be involved in discussion of their companies with people they know than with strangers. As such, analysts and insiders who are engaged in industry activity that the Supreme Court correctly understands to be normal, socially beneficial, and important to the integrity of capital markets, and that it explicitly seeks to protect, would operate at peril of prosecution for securities fraud simply because they talk regularly, have common friends with whom they socialize, or have some other point of social interaction that could lead to their characterization as “friends.”

Newman thus protects the integrity of the market by placing a meaningful and objective limit on the scope of insider trading liability, allowing investors analysts and insiders to function with reasonable certainty and security about whether their conduct violates the law. It deserves to be affirmed by the Court.

*Like the traditional disclose or abstain rule, the misappropriation theory requires a breach of fiduciary duty before trading on inside information becomes unlawful. It is not unlawful, for example, for an outsider to trade on the basis of inadvertently overheard information. SEC v. Switzer, 590 F. Supp. 756, 766 (W.D. Okla. 1984). The fiduciary relationship in question, however, is a quite different one. Under the misappropriation theory, the defendant need not owe a fiduciary duty to the investor with whom he trades. Nor does he have to owe a fiduciary duty to the issuer of the securities that were traded. Instead, the misappropriation theory applies when the inside trader violates a fiduciary duty owed to the source of the information. The Supreme Court validated the misappropriation theory in U.S. v. O’Hagan, 521 U.S. 642 (1997).

The majority view is that the Dirks personal benefit rule applies to tipping cases arising under the misappropriation theory. Compare SEC v. Obus, 693 F.3d 276, 285–86 (2d Cir. 2012) (stating that the personal benefit requirement applies both to “an insider or a misappropriator; U.S. v. Newman, 2013 WL 1943342 (S.D.N.Y. 2013) (rejecting defendant’s argument that the personal benefit test did not apply to criminal cases under the misappropriation theory); SEC v. Gonzalez de Castilla, 184 F. Supp. 2d 365, 375 (S.D.N.Y. 2002) (stating that the personal benefit requirement applies to misappropriation cases); SEC v. Lambert, 38 F. Supp. 2d 1348, 1351–52 (S.D. Fla. 1999) (same) with SEC v. Rocklage, 470 F.3d 1, 7 n.4 (1st Cir. 2006) (noting that the court’s prior precedents had “left open” the applicability of the personal benefit requirement in misappropriation cases).

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