by T. GormanPosted on Posted in SECActions

Insider Trading: Dirks, Newman, Salman and Payton – Part II

This is the second of two posts on the personal benefit test for tipping and insider trading. The first appeared yesterday.

The first segment of this post reviewed the Supreme Court’s decision in Dirks, the Second Circuit’s ruling in Newman and the Ninth Circuit’s opinion in Salman. This concluding segment begins with jury instructions in Payton, an SEC enforcement action presided over by Judge Rakoff who is also the author of the opinion in Salman and concludes with a discussion of the cases.

Payton

In Payton the court was also presented with a remote tippee case. Judge Rakoff denied a motion to dismiss the complaint based on Newman. Following discovery and trial each party proposed jury instructions that centered on Dirks and Newman.

SEC

The SEC proposed the following instructions, listing first the elements and then defining personal benefit:

“First, Martin was provided with material nonpublic information by Dallas [attorney working on the deal];

Second, that Martin breached a duty of trust and confidence to Dallas and benefited when Martin tipped, that is disclosed, material nonpublic information to Thomas Conradt.

Third, Conradt provided material nonpublic information to the defendant, and that defendant then bought SPSS securities [takeover target] on the basis of that information.

Fourth, that the defendant knew, or should have known, that Martin had violated a relationship of trust and confidence for a personal benefit . . .”

The Commission proposed to define personal benefit as follows:

“Benefit is established if there was a relationship between Martin and Conradt that suggests that Martin disclosed the information as part of a quid pro quo (meaning ‘something for something’), or Martin had an intention to benefit Conradt, or Martin made a gift of confidential information to Conradt. Such a gift is sufficient only if you find that Martin and Conradt had a meaningfully close personal relationship that generated an exchange that was objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” (emphasis added).

Defendants

Defendants Payton and Durant proposed the following instruction regarding personal benefit:

“If you find that Mr. Martin disclosed material nonpublic information to Mr. Conradt, you must then determine whether the SEC proved by a preponderance of the evidence that Mr. Martin received a personal benefit in exchange for his disclosure of the information that IBM was planning to acquire SPSS to Mr. Conradt . . . The benefit received does not need to be financial or tangible in nature; it could include, for example, maintaining or furthering a meaningfully close personal relationship if the maintenance or furtherance of that relationship generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature . . . The SEC may prove that Martin received a personal benefit in one of two ways: (1) that Martin tipped Conradt as part of a quid pro quo in which Mr. Martin provided the information in exchange for specific benefits Mr. Conradt provided to Mr. Martin or (2) that Martin and Conradt had a meaningfully close relationship and that Martin tipped Conradt to further or maintain that relationship.” (emphasis added).

The court

The court defined personal benefit as follows:

“’Personal benefit’ is broadly defined to include not only monetary gain, but also, among other things, the benefit one would obtain from simply making a gift of confidential information to a trading friend. However, a personal benefit may be inferred from a personal relationship between Martin and Conradt only if there is proof that they had a meaningfully close personal relationship that generated an exchange that was objective, consequential, and represented at least a potential gain to Martin of a pecuniary or similarly valuable nature. In other words, the SEC may not prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature. Instead, the SEC must prove a relationship between Martin and Conradt that supports the conclusion that the information was given in return for Martin’s receiving something from Conradt or that Martin in giving the information had an intention to benefit Conradt.” (emphasis added).

Analysis

In Dirks the Supreme Court made it clear that a line was being drawn – the passage of inside information was not necessary illegal. To the contrary, that act only constitutes illegal insider trading under specific circumstances. The question really hinges on the breach of duty by an insider to obtain a personal benefit for himself or herself. Thus if the insider, who is entrusted with material, non-pubic information to be used for a corporate purpose diverts that information to his or her personal use or benefit, that act constitutes a breach of duty. That breach of duty is evidence of the deception element that is required to violate Section 10(b).

The Dirks court gave two examples of the type of evidence that would suffice. One is a quid pro quo and the other is a gift. Either has to be based on objective, established evidence.

Newman faithfully reproduces the Dirks test, focusing on the benefit to the insider and a quid pro quo or gift. The court’s discussion of the required relationship between the tippor an tippee is more concrete that in Dirks but appears to be consistent with the decision.

Salman also adopts the basic principles of Dirks. Indeed, the court’s opinion repeatedly cited Dirks rather that Newman as the predicate for its holding. Yet the ninth circuit seems to have redefined the benefit test used by Dirks and Newman. When analyzing the evidence the court states that the initial tip from the insider was a gift. Later in discussing the question of benefit, however, the court credits the fact that the “Kara brothers’ close relationship [one Kara brother was an insider and tipped the other], Salman could readily have inferred Maher’s intent to benefit Michael.” This has the benefit flowing not to the insider as part of the breach of duty as in Dirks but to the tippee. The inference also appears to be less than substantial, particularly for a criminal case. In any event, the benefit is supposed to be part of the breach, not something that goes to the tippee. The tippee presumably always benefits since he or she trades and makes profits. If there is no benefit to the insider then there is no breach as Dirks made clear. And, the tippee, here Mr. Salaman, would need to know about the breach, including the benefit received by the insider. That requirement appears to be missing, contrary to Dirks and Newman.

Payton appears to have adopted the broader reading of benefit from Salman. There the SEC proposed a definition of benefit that would permit it to prevail if the benefit flowed to the insider or the outsider, although in reciting the elements of insider trading the agency correctly listed benefit as part of the breah. In contrast the defendants proposed a standard that was consistent with Dirks on the definition of benefit but omitted the notion of a gift which is present in Dirks, Newman and Salman.

The court appears to have followed the lead of the SEC and Salman. Under the court’s charge, the SEC could prevail if either the insider or the outsider received the appropriate type of benefit. That appears to be inconsistent with Dirks and Newman.

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by T. GormanPosted on Posted in SECActions

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?

Dirks

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.

Newman

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).

Salman

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

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