Insider Trading: Dirks, Newman, Salman and Payton – Part I
This is the first of two posts on the personal benefit test for tipping and insider trading. The second will appear tomorrow.
A critical question in assessing tippee liability for insider trading is the personal benefit test first developed in Dirks v. SEC, 463 U.S. 646 (1983). While it did not appear to be of much concern to the Department of Justice and the SEC in recent years, that changed when the Second Circuit handed down U.S. v. Newman, 773 F. 3d 838 (2nd Cir. 2014). Essentially the DOJ and SEC argued the standard would inhibit insider trading tipping cases. Newman claims it only followed and applied Dirks,
The Ninth Circuit also claims to have faithfully followed Dirks in applying the personal benefit test in U.S. v. Salman, No. 14-10204 (2nd Cir. 2015) which will be heard by the Supreme Court next term. Some commentators dispute this point. And the court supposedly followed Dirks and Newman when charging the jury in SEC v. Payton, Civil Action No. 14 Civ. 4644 (S.D.N.Y.). There the SEC prevailed after trial when the jury returned a verdict in its favor. The question is what did Dirks require and how does that square with the three most recent prominent cases in which the Supreme Court’s teachings were applied?
In Dirks the High Court began by stating that “[i]n determining whether a tippee is under an obligation to disclose or abstain, it thus is necessary to determine whether the insider’s ‘tip’ constituted a breach of the insider’s fiduciary duty. All disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders . . . The test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to shareholders. And absent a breach by the insider, there is no derivative breach . . .” (emphasis added).
The Dirks Court went on to note that the question of whether there is a breach of duty “requires 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 . . . 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.”
The Court crafted this approach as a limitation on tippee liability, drawing a line between the permissible and impermissible. It went on to note that the personal benefit test is one of fact that must be determined in each case.
The Second Circuit also drew a line with its decision in U.S. v. Newman, Nos. 13-1837-cr, 13-1917 (2nd Cir. Decided December 10, 2014). The court noted at one point that there were no criminal insider trading cases were the tippees were as remote as the third and fourth tier tippee-defendants there.
The court began its analysis of the tippee question by reviewing the basic tenants of the classical and misappropriation theories of insider trading. The elements of tipping liability are the same regardless of the theory utilized, according to the court. Under Dirks the test for determining if there has been a breach of fiduciary duty, according to Newman, is “’whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty . . .’” the Court stated, quoting Dirks. (emphasis added). The tippee’s liability stems directly from that of the insider. Since the disclosure of inside information alone is not a breach, “without establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the Government cannot meet its burden of showing that the tippee knew of a breach.” (emphasis added).
In reaching its conclusion the court held that “nothing in the law requires a symmetry of information in the nation’s securities markets.” That notion was repudiated years ago in Chiarella v. U.S., 445 U.S. 222 (1980). While efficient capital markets depend on the protection of property rights in information, they also “require that persons who acquire and act on information about companies be able to profit from the information they generate.” It is for this reason that both Chiarella and Dirks held that insider trading liability is based on breaches of fiduciary duty, not on “informational asymmetries.”
Based on these principles, the elements of tippee liability are: (1) the corporate insider had a fiduciary like duty; “(2) the corporate insider breached his duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade. ..” according to the court. Since the jury instructions did not incorporate these elements they were incorrect.
Finally, in reviewing the sufficiency of the evidence, the Court gave definition to the personal benefit test. That test is broadly defined to include pecuniary gain and also reputational benefit that will translate into future earnings and the benefit one would obtain from making a gift of confidential information to a relative or friend. While the test is broad it does not include, as the Government argued, “the mere fact of a friendship, particularly of a casual or social nature.” A personal benefit can be inferred from a personal relationship but “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. In other words . . . this requires evidence of a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the latte.r” (internal quotes omitted).
Bassam Yacoub was also a remote tippee who was found guilty of insider trading. The circuit court affirmed.
Like Newman the Ninth Circuit began with Dirks. There the court concluded that imposing a duty to disclose or abstain simply because the person knowingly received inside information “could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market” the court noted (citations/internal quotes omitted). The Dirks Court then went on to hold that “’the test is whether the insider personally will benefit, directly or indirectly, from his disclosure,’” quoting Dirks at 662 (emphasis added). In that case the insider has breached his fiduciary duty and the tippee is equally liable if “’the tippee knows or should have known about that breach,’’ Id. at 660, i.e. knows of the personal benefit.” This applies equally to cases based on the misappropriation theory, the Court held.
Key here, Judge Rakoff, sitting by designation, wrote for the court is what constitutes a personal benefit. Quoting Dirks the court held that it includes “a pecuniary gain or a reputational benefit that will translate into future earnings . . . [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.” (emphasis omitted).
This statement from Dirks governs here, the Court held. The tipper disclosed the information knowing it would be used to trade, making it a Dirks gift to a relative. Indeed, there was testimony to that effect and the source of the information for Mr. Salman admitted he told him his source. In addition, “[g]iven the Kara brothers’ close relationship [original source of the information], Salman could readily have inferred Maher’s intent to benefit Michael [his brother-in-law who tipped him]. Thus, there can be no question that, under Dirks, the evidence was sufficient . . .”
Mr. Salman argued that “because there is no evidence that Maher received any such tangible benefit [as described in Newman] in exchange for the inside information, or that Salman knew of any such benefit, the Government failed to carry its burden.” The Court responded, stating: “To the extent Newman can be read to go so far, we decline to follow it.”
Tomorrow: Part II