Insider Trading Before the Supreme Court: Dirks and Salman, Part I
One of the most closely watched cases of the coming Supreme Court term is Salman v. U.S., No. 15-628, the Ninth Circuit’s insider trading decision penned by Judge Rakoff. The issue for decision is the meaning of the “personal benefit” test established by the High Court in Dirks v. SEC, 463 U.S. 646 (1983). While case is important because of its potential impact on the liability of remote tippees, it takes on added significance in view of the Second Circuit’s pre-Salman decision in U.S. v. Newman, 771 F. 3d 438 (2nd Cir. 2014), cert. denied., No. 15-137 (U.S. Oct. 5, 2015). There the court used Dirks to draw a line in the sand as to remote tippee liability which the Manhattan U.S. Attorney’s Office and the SEC have decided as significantly undermining insider trading enforcement.
Petitioner Salman and the U.S. have filed their opening briefs. This article examines the arguments presented by Mr. Salman. Future articles will analyze the brief of the Government and the Reply by Petitioner, the argument and the Court’s decision.
The case centers on three relatives: Brothers Michael and Maher Kara and their brother-in-law Bassam Salman. Maher secured a position with Citigroup’s healthcare group as a vice president. He advised biotechnology and pharmaceutical companies on mergers, acquisitions and financing strategies. He rose to the position of director and was based largely in New York. Michael operated a hazardous waste business in California, home turf for the family. Mr. Salman worked as a grocery wholesaler in Chicago throughout the relevant period. He traded stocks as did Michael.
The insider trading charges center on four transactions: 1) the sale of Bone Care International, Inc. to Genzyme Corporation in the spring of 2005; 2) the acquisition of Andrx Corporation in early 2006; 3) the acquisition of United Surgical Partners International, Inc. by a private equity firm in mid-2006; and 4) the purchase of Biosite Incorporated in early 2007.
The two brothers had a complex relationship. When Maher first joined the Citi healthcare group he had no experience in the sector. He periodically sought Michael’s advice because of his college science background. As his career progressed Maher continued to discuss business with his brother, using him as a sounding board. Maher repeatedly gave his brother clear instructions that the information they discussed was confidential.
Over time Michael began asking more pointed questions. In 2005 and 2006 he pestered his brother about healthcare companies. At times Maher avoided the phone calls. At times his nagging was so persistent that Maher disclose information to him to “get him off my back.” Periodically Maher would remind his brother that the information was confidential. Michael never disclosed that he was trading on the information.
Michael and his brother-in-law began discussing stocks in late 2004. Michael furnished Mr. Salman with recommendations based on his own research as well as information from his brother. Mr. Salman’s trading essentially paralleled that of Michael.
Maher and Michael testified at the trial of Mr. Salman on behalf of the government. Michael testified that his brother told him Bone Case would be acquired. Maher was working on the deal. Michael traded and advised Mr. Salman to invest. Maher also worked on the Andrex deal. After he was removed from the deal by his supervisor, he told Michael that he was extremely upset. Michael then invested in Andrex, without the knowledge of his brother. He also recommended that his brother-in-law purchase shares. Mr. Salman bought call options. Maher also told Michael about the USPI deal after persistent questioning; Michael traded and told Mr. Salman about it. He also traded. Finally, Maher told Michael about the Biosite deal after being implored to do him a favor. When Maher told his brother not to trade Michael responded “don’t worry.” He then traded and told Mr. Salman who also traded. There is no evidence that Maher knew the information was shared by Michael with anyone.
At the conclusion of the trial court instructed the jury that to convict Mr. Salman of insider trading it needed to find that (1) insider Maher personally benefitted from the disclosure of material, nonpublic information and (2) that Mr. Salman knew that the insider had personally benefitted from the disclosure. The term “personal benefit” was defined to include “the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend.” The court informed the jury that it was not required to find that Mr. Salman knew “the specific benefit given or anticipated by the insider in return for disclosure of inside information; rather, it is sufficient that [Salman] had a general understanding that the insider was improperly disclosing inside information for personal benefit.” The jury returned a verdict of guilty on all counts.
The Ninth Circuit affirmed. On appeal Mr. Salman argued that Newman required the reversal of his convictions. Specifically, he claimed that under Dirks and Newman ththe personal benefit instruction given by the district court was insufficient. Since there was no evidence that Mr. Maher engaged in an exchange with Michael that yielded even a potential pecuniary gain, under Newman the verdict should be set aside. The Ninth Circuit rejected this claim, holding that to the extent Newman went that far the circuit declined to follow.
Petitioner asks the Court to draw a clear line demarking illegal tipping, an argument that evokes the underpinnings of Dirsk and Newman. The issue for decision is framed this way: Whether Dirks requires “proof of an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” or “is it enough that the insider and the tippee shared a close family relationship . ..” The approach is backstopped by the rule of lenity, limitations on the power of the federal courts in the area of defining criminal conduct and the constitutional due process notice and separation of powers provisions.
Petitioner begins with the familiar canon that only Congress can define criminal conduct. The Court has repeatedly held that Section 10(b) does not create any general duty to refrain from trading on inside information or entitle investors to a parity of information. Under the Court’s approach the “line between lawful trading and criminal activity . . . is determined by whether the insider . . . disclosed the information to obtain some personal benefit. If he did not, there was no Section 10(b) violation, and the ‘tippee” was free to trade.” In drawing this line the focus was on the “improper exploitation of a fiduciary relationship for personal profit.”
Section 10(b) does not specifically address the question of insider trading. This has been an important limiting principle since the Court first addressed the question of Section 10(b) and insider trading in Chiarella v. U.S., 445 U.S. 222 (1980). There, in drawing a line between the legal and the prohibited the Court eschewed a parity of information theory, recognizing that “’not every instance of financial unfairness constitutes fraudulent activity under Section 10(b).’” Id. at 232. The Court then concluded that the judicially implied insider trading offense “applies only where the person who trades has a fiduciary relationship with the issuer of the securities.”
Dirks built on that determination three years later, emphasizing that “’only some persons, under some circumstances, will be barred from trading while in possession of material nonpublic information.’” Dirks at 657. The Court went on to hold that since a tippee generally owes no duty to the company, trading only violates the statute if the insider breached his fiduciary duty and the tippee knew it. But not every breach of fiduciary duty violates the statute. Rather, there is a violation only when the breach was for personal benefit or gain the Dirks Court concluded. This rule provides a “guiding principle” for market participants.
The test for assessing the benefit is an objective one in keeping with the notion of establishing a guiding principle. The focus is on pecuniary gain or a reputational benefit that will translate into future earnings. As examples the Court cited “’cash, reciprocal information, or other things of value.’” Dirks at 664. In citing these examples Petitioner argued that Dirks viewed the term “gain” as synonymous with “benefit,” focused on the idea that the insider is exploiting corporate information for “profit.” Thus the “quid pro quo” of the exploitation is for tangible benefits potentially flowing to the insider, not those which are intangible. The fraud thus turns on the insider’s pecuniary motive. This approach is consistent with the Court’s later Section 10(b) jurisprudence as well as cases under provisions like the honest services fraud statute. See, e.g. McNally v. U.S., 483 U.S. 350 (1987).
This case does not involve securities fraud, according to Petitioner: “Maher did not trade on the information, and he did not provide it to get a kickback. On the contrary, Maher gained nothing of value from his disclosures, and had no financial motive. His motive was to get a bullying brother “off his back.” Indeed, the government has conceded that Maher’s ‘breaches of fiduciary duty were in large part the result of Michael Kara’s persistence in seeking inside information.’” While their relationship was one of love and trust, Michael also manipulated and deceived his brother.
Defining personal benefit as pecuniary gain is consistent with the Court’s earlier decisions as well as constitutional limitations, according to Petitioner. First, it has long been held that criminal statutes must be construed strictly under the due process clause as well as the rule of lenity. Second, it would be a violation of due process to take someone’s life, liberty or property using a criminal standard that was vague and fails to give ordinary people fair notice. Third, to the extent the personal benefit concept incorporates intangibles, it is ambiguous and that vagueness must be resolved in favor of Petitioner. This is consistent with the Court’s jurisprudence limiting the scope of the implied right of action under Rule 10(b)-5 which are grounded in constitutional separation of powers principles, citing Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) and Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008).
Finally, the standard used by the Ninth Circuit in thus case undermines the Dirk’s limiting principle: “Any suggestion that the personal benefit requirement could be established by psychic gratification, such as the satisfaction derived from giving a gift, would render the requirement impermissibly vague.” In this case “[a]ny benefit Maher might have received is purely emotional, and it is unclear what that benefit could have been.” Indeed, using the gift concept as a proxy for the personal benefit element fails to give law enforcement a minimal guideline. This is evident from the over three decades of cases following Dirks in which the DOJ and the SEC “effectively nullified the personal benefit requirement by invoking the ‘gift’ talisman whenever there is no tangible economic benefit to the tipper.” Enforcement on this basis results in the kind of arbitrary and discriminatory actions the due process clause was designed to prevent. “In sum, a pecuniary benefit is the paradigmatic benefit described not only in Dirks but also in this Court’s other insider trading cases . . .” The decision of the Ninth Circuit should be reversed.
Next: The brief of the government.