Insider Trading: Does Payton Begin the Erosion of the Newman Tipping Test?
The Second Circuit’s decision in U.S. v. Newman, 773 F. 3d 438 (2nd Cir. 2014) regarding the personal benefit test in insider trading either radically altered the law or just reaffirmed the Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1983) which had been eroded over the years by the SEC and the Government, depending on your point of view. Regardless, under Newman it is not debatable that to establish liability for illegal tipping under either the classic or misappropriation theory of insider trading the following elements must be established: 1) the corporate insider or the person entrusted with the confidential information had a fiduciary or similar duty; 2) the duty to maintain confidentiality was breached by disclosing the confidential information to a tippee in exchange for a personal benefit that is in the nature of a quid pro quo; 3) the tippee knew of the tipper’s breach; and 4) the tippee traded.
While the Newman elements are not difficult to list, their application can be more problematic. The recent decision by Judge Rakoff in SEC v. Payton, Civil Action No. 14 civ 4644 (S.D.N.Y. Opinion issued April 6, 2015) is instructive. There the SEC brought an insider trading action centered on the IBM acquisition of SPSS against two brokers, Daryl Payton and Benjamin Durant. Defendants Payton and Durant moved to dismiss based on Newman.
The claimed tip in Payton traces to attorney Michael Dallas, an associate in a New York law firm assigned to work on the deal. Mr. Dallas was close friends with broker Trent Martin. The two men had a history of sharing confidential information. Beginning in the spring of 2009 Mr. Dallas told his friend about the SPSS deal. Over time he provided updates. Both men understood that the information they shared regarding their work was non-public and confidential. Both expected that confidentiality would be maintained.
Mr. Martin was roommates with Thomas Conradt, an attorney employed at another New York brokerage firm. They had a close, mutually dependent financial relationship with a history of personal favors. Mr. Martin told his roommate about the SSPS deal. Mr. Conradt purchased shares of SPSS prior to the deal announcement on July 28, 2009.
Defendants Payton and Durant were co-works of Mr. Conradt. The three men had discussions about Mr. Conradt’s roommate – Trent Martin. Each knew that Mr. Martin worked at a brokerage firm. Mr. Conradt told his co-workers that he learned about the SPSS acquisition from his roommate. Messrs. Payton and Durant did not ask more about the roommate. They did purchase shares of SPSS just prior to the public announcement of the deal.
The SEC charged Messrs. Payton and Durant with insider trading. The defendants moved to dismiss based on Newman. The Court denied the motion.
Judge Rakoff began by noting that there is a difference between criminal and civil cases. In the former the “court is obliged to define unlawful insider trading narrowly, so as to provide the fair notice that due process requires . . .” In the latter, typically brought by the SEC, “the court is inclined to define unlawful insider trading broadly, so as to effectuate the remedial purposes behind the prohibition of such trading.”
Nevertheless, to properly plead tippee liability the SEC must set forth facts in its complaint which are sufficient to meet the Newman test. Those facts must be construed in favor of the SEC.
Under Newman the first question is whether the SEC has sufficiently alleged that Mr. Martin, the tipper, received a personal benefit when furnishing the inside information to his friend, Mr. Conradt. That requirement has been met because the SEC alleged that Mr. Conradt had a mutually dependent financial relationship, a history of personal favors and their expenses were “intertwined.” Mr. Conradt “took the lead” in organizing and initially paying for shared expenses. He also assisted his friend with a criminal charge. Later the two men had a conversation in which, according to the complaint, “Martin thanked Conradt for his prior assistance with the criminal legal matter and told Conradt he was happy that Conradt profited from the SPSS trading because Conradt had helped him.” These allegations support an inference of a quid pro quo relationship, the Court found.
The second critical question is whether the defendants knew of the benefit. Here again, the allegations of the complaint are sufficient, the Court concluded, when all inferences are drawn in favor of the SEC. Those allegations demonstrate that the defendants knew Messrs. Conradt and Martin were friends and roommates and that Mr. Conradt assisted with the criminal matter. “This is enough to raise the reasonable inference that the defendants knew that Martin’s relationship with Conradt involved reciprocal benefits,” according to Judge Rakoff. This inference is bolstered by the fact that Mr. Durant repeatedly asked Mr. Conradt if additional information could be obtained from his roommate – and it was.
Finally, the two defendants took steps to conceal their trading activity while avoiding any discovery of the circumstances surrounding the tip between Messrs. Martin and Conradt. The latter is evidence of “conscious avoidance of details about the source of the inside information and nature of the initial disclosure,” according to the Court. Collectively, these allegations are sufficient to survive a motion to dismiss based on Newman.
The critical question raised by Payton is whether the decision begins the erosion that many claim took place following Dirks and continued until Newman. To be sure the introductory discussion of the difference between criminal and civil cases by Judge Rakoff at least suggests the possibility. While the Court’s discussion of criminal and civil cases is presented as basic, indisputable legal principles it ignores the fact that SEC enforcement actions are a different kind of civil case since they can result in the imposition of severe sanctions and penalties as Gabelli v. SEC, 133 S.Ct. 1216 (2013) acknowledged. Payton does, however, faithfully quotes and analyzes the Newman elements of tipping liability, including the quid pro quo requirement.
In the end, it is difficult to read the analysis of the SEC’s allegations as anything but reaching for every possible inference to avoid dismissal. While the SEC’s claims may support an inference of a quid pro quo between Messrs. Martin and Conradt, the allegations regarding the defendants’ knowledge of the benefit are thin at best. Tested against the fact record in Newman which the Court referencedwhere there was no evidence on the point – which of course is not the test — and viewed in the context of giving the SEC the benefit of each inference on a motion to dismiss, the issue is perhaps debatable.
For those who think Newman is new law cut from whole cloth, the decision is no doubt correct and perhaps a relief. For those who think Newman is the restoration of Dirks there is undoubtedly concern that the erosion has begun. Perhaps the true test is whether Payton can survive dispositive motions and, if so, trial.