A decision last week from the U.S. District Court for the Southern District of New York illustrates the broad reach of prosecutors and regulators in pursuing recipients of insider trading tips, despite the case-law requirement that the tipper have received a personal benefit from giving the tip.
This state of play marks a turnaround from four years ago, when it appeared that the personal benefit requirement stood to curtail substantially the government’s ability to bring insider trading charges against tippees unless the government could show a “meaningfully close personal relationship” between tipper and tippee.
Then, in United States v. Newman, 773 F.3d 438 (2d Cir. 2014), the U.S. Court of Appeals for the Second Circuit held that to establish liability the government must show a “meaningfully close personal relationship” as well as an exchange of pecuniary value between tipper and tippee. While it was not entirely clear what the Second Circuit’s words meant, it was clear that the U.S. Attorney’s Office and Securities and Exchange Commission understood Newman to be a significant obstacle to their insider trading actions.
But then came a U.S. Supreme Court decision rejecting Newman at least in part, and then a Second Circuit opinion further restricting it.
And last week, U.S. District Judge Jed Rakoff stated in a decision denying a motion to dismiss an insider trading case that “[w]hat remains of Newman therefore applies in only the rarest of cases.” United States v. Pinto-Thomaz (S.D.N.Y. Dec. 6, 2018).
The driving force behind the decline of the Newman approach was the Supreme Court’s decision in Salman v. United States, 137 S. Ct. 420 (2016). That case involved a tip from brother to brother, where the tipper had received no money or thing of similar value in return. The Court relied on its language in Dirks v. S.E.C., 463 U.S. 646 (1983), where it viewed a tipper’s gift of confidential information to a trading relative or friend as satisfying the personal benefit requirement.
The defendant in Salman attempted to rely on the Second Circuit’s Newman decision, but the Supreme Court rejected that argument, and stated: “To the extent the Second Circuit held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family and friends, . . . this requirement is inconsistent with Dirks.”
After the Salman case, the personal benefit issue came before the Second Circuit in United States v. Martoma. There, in August 2017, the appeals court not only noted that the Supreme Court had explicitly rejected (i) the pecuniary-value requirement of Newman, but also concluded that Salman had implicitly abrogated (ii) the “meaningfully close personal relationship” aspect of Newman. United States v. Martoma, 869 F.3d 58 (2d Cir. 2017) (“Martoma I”). The opinion was written by Judge Robert Katzmann and joined by Judge Denny Chin; the third panel member, Judge Rosemary Pooler, dissented. (A third holding of Newman, that the tippee had to be aware of the tipper’s personal benefit, was unaffected by Salman and remains as an important limitation on the government’s pursuit of insider trading cases).
In June 2018, the panel issued an amended opinion, with Judge Pooler once against dissenting. 894 F.3d 64 (2d Cir. 2017) (“Martoma II”). The court reached the same result as before and affirmed the conviction in the case before it. But it modified its holding that Salman implicitly overruled the “meaningfully close personal relationship” aspect of Newman. Instead, the court stated that it was not necessary to decide whether Salman entirely abrogates the “meaningfully close personal relationship” test of Newman.
Judge Katzmann emphasized that there are many ways to establish a personal benefit to the tipper, including (a) pecuniary gain, (b) a reputational benefit that will translate into future earning, (c) a relationship between the tipper and tippee that suggests a quid pro quo, (d) the tipper’s intent to benefit the particular tippee, and (e) (the scenario involved in the Salman case) a “ ‘gift of confidential information to a trading relative or friend’ where ‘[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.’ ” (quoting Dirks).
In one of the points that provoked the strongest disagreements from the dissent, the panel made clear that an intention by the tipper to benefit the tippee in question was itself sufficient to support a finding of personal benefit to the tipper, even without additional evidence of a relationship between the tipper and tippee.
Although Martoma II held that it was not deciding whether Newman’s “meaningfully close personal relationship” test had any continued vitality, it is difficult to discern when it would apply. In Pinto-Thomaz, Judge Rakoff suggested that the test “only applies, at most, to situations where a fact-finder is asked to infer an adequate personal benefit simply from the relationship between the tipper and tippee” – which he said would be “in the rarest of cases.”
Judge Rakoff in Pinto-Thomaz further attempted to build on Martoma II in defining how to understand and apply the personal benefit requirement in tippee insider-trading cases, and to simplify what he described as the needless complexity created in some of the case law since personal benefit element was adopted in Dirks.
Trading by a corporate insider on material information was understood to breach a duty to the company, and thus give rise to a violation of section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. But what about where the insider did not trade, but tipped a non-insider who did? In Dirks, the Supreme Court held that the tippee’s liability derived from the insider’s breach, meaning that the tipper had to have breached a duty and that the tippee had to have known about it for the tippee to be liable.
Dirks looked to the tipper’s personal benefit as the touchstone for determining whether the tipper had breached a duty. In that case, the alleged tipper was seen as acting to blow the whistle on corporate wrongdoing, and thus the court concluded that he was not acting for a personal benefit and thus his tipping behavior was not a breach of duty.
In keeping with its understanding of Dirks, the majority in Martoma II did not focus on the issue of personal benefit in isolation, but rather framed the question as an either/or: was the tip given for a personal benefit, constituting a breach of fiduciary duty, or a legitimate corporate purpose, which would not be a breach. The court stated: “The tipper’s intention to benefit the tippee proves a breach of fiduciary duty because it demonstrates that the tipper improperly used inside information for personal ends and thus lacked a legitimate corporate purpose.” In this view, it seems that the finding of personal benefit is most important to prove the absence of a legitimate corporate purpose, such as whistleblowing, for divulging confidential corporate information.
Judge Rakoff in Pinto-Thomaz elaborated further on the corporate purpose issue. In his view, “insider trading is a variation of the species of fraud known as embezzlement,” in which an embezzler takes property (inside information) of another (the corporation) and uses it for his or her own benefit. What matters, he stated, is the purpose for which the insider disclosed the information, whether for “personal advantage,” or “a corporate or other permissible purpose.” Indeed, Judge Rakoff suggested that the Dirks court could have “averted subsequent confusion” by using the term “personal purpose” or “personal advantage” rather than “personal benefit.” Yet he concluded that “Dirks was quite clear as to the wide breadth of its understanding of a personal benefit.”
Whether future courts will follow Judge Rakoff’s lead in setting forth the doctrinal support for insider trading cases is uncertain. And it is possible that the Supreme Court may provide further or contrary guidance. But in light of Salman, Martoma II and now Pinto-Thomaz, the law in the Second Circuit has plainly traveled a long way since Newman.
For more information about this update, or if you have any questions regarding Bryan Cave’s White Collar Defense and Investigations or Securities Litigation and Enforcement Groups, please contact Eric Rieder or Austin Campriello in New York at +1 212 541 2000.