The Martoma Insider Trading Decision – Business, Gifts and Friends
The Second Circuit split over the question of gift giving in insider trading cases, upholding the conviction of former SAC Capital healthcare stock analyst Mathew Martoma. The decision is the first circuit court case to interpret the question in the wake of the Supreme Court’s decision inSalman v. U.S., 137 S. Ct. 420 (2016) last term. U.S. v. Matoma, Docket No. 14-3599 (2nd Cir. August23, 2017).
The focus of the decision is the Second Circuit’s prior holding in U.S. v. Newman, 773, F. 3d 438 (2nd Cir. 2014). There the circuit court held that under Dirks v. SEC, 463 U.S. 646(1983) to impose liability in view of the theory of gift giving there mus be “proof of a meaningfully close personal relationship [between the tipper and tippee] that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” While both the majority and dissent agreed that the second prong of this test – the pecuniary gain requirement – was rejected by Salman, the majority concluded that “the logic of Salman abrogated the first Newman prong of the test — the ‘meaningfully close personal relationship’” test. The dissent disagreed.
The case centers on trades in the securities of Elan Corporation, plc and Wyeth in 2008. The two pharmaceutical companies had a significant new drug under development that had been in trials since 2006.
During the trials, Dr. Sidney Gilman, University of Michigan, was consultant to Elan. He also worked for, and was paid by, an expert network through which he met Mr. Martoma, at the time a portfolio manager at SAC Capital. Over a period of time Dr. Gilman provided Mr. Martoma with numerous briefings on the development of the drug which include confidential information. Mr. Martoma also met with Dr. Joel Ross, one of the principal investigators on the clinical trial. Dr. Ross provided Mr. Martoma with information about the trial.
On June 17, 2008 Elan and Wyeth jointly released top-line results of the Phase II trial for the drug. The announcement described the preliminary results as “encouraging” with clinically meaningful benefits in important subgroups. The release also stated that detailed results would be released on July 29, 2008. The market reacted positively to the release.
Dr. Gilman was selected in mid-July to present the results at a conference scheduled for July 29, 2008. At that point the firms shared the testresults with Dr. Gilman. The day after the Doctor learned the final test results he spoke with Mr. Martoma for about 90 minutes on the telephone. Two days later the two men met at the Doctor’s office at the University of Michigan. Dr. Gilman showed the power point presentation he planned to use at the upcoming meeting to Mr. Martoma. It detailed the results.
The next morning Mr. Martoma spoke on the telephone with Stephen Cohen. SAC began to reduce its position in Elan and Wyeth securities by entering into short sale and options trades that would be profitable if the two stocks dropped in price the day after the telephone call.
Following the July 29, 2008 presentation by Dr. Gilman, the shares of both firms declined significantly. The trades that Mr. Martoma and SAC made in advance of the announcement resulted in about $80.3 million in gains and $194.6 million in avoided losses for the firm. Mr. Martoma personally received a $9 million bonus based in large part on the trading in Elan and Wyeth. While SAC had been billed substantial fees for the earlier meetings with Dr. Gilman, it had not charged for the last two discussions.
Following a jury trial the court instructed the jury on the requirements of a personal benefit. Those instructions stated in part that a “finding as to benefit should be based on all the objective facts and inferences presented in the case. You may find that Dr. Gilman or Dr. Ross received direct or indirect personal benefit from providing inside information to Mr. Martoma if you find that Dr. Gilman or Dr. Ross gave the information to Mr. Martom with the intention of benefiting themselves in some manner, or with the intention of conferring a benefit on Mr. Martoma, or as a gift with the goal of maintaining or developing a personal friendship on a useful networking contact.” The jury returned a verdict of guilty.
On appeal Mr. Martoma argued that the jury instructions were incorrect an that the evidence was not sufficient to sustain his conviction because Salman did not over rule the first prong of the Newman gift test requiring evidence of a meaningful close relationship.
Dirks acknowledged, the majority noted in an opinion written by Chief Judge Katzmann, that a “tippee who knowingly trades on material nonpublic information obtained from an insider does not necessarily violate insider trading law.” That, however, does not always mean that the recipient is free to trade. Whether the recipient of the information inherits the insider’s duty to abstain from trading depends on whether the information was obtained improperly which hinges for the most part on the purpose of the disclosure. Specifically, the question is whether the insider receives
some personal benefit. Absent that benefit there is no breach of duty. The benefit can be a quid pro quo and it can arise from a gift to a trading relative or friend.
Newman added a gloss to the Dirks test, requiring that for a gift there be a “meaningfully close personal relationship.” In considering the point the Court noted that “it is not apparent that the examples in Dirks support a categorical rule that an insider can never benefit personally from gifting inside information to people other than ‘meaningfully close’ friends or family members – especially because the justification forconstruing gifts as involving a personal benefit is that ‘[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient,’” quoting Dirks.
Salman “fundamentally altered the analysis underlying Newman’s” meaningfully close test, according to the majority. While Dirks and Salman both restricted their discussion of gifts to relatives and friends, particularly in view of the fact that Salman involved two close brothers, the “straightforward logic of the gift-giving analysis in Dirks, strongly reaffirmed in Salman, is that a corporate insider personally benefits whenever inside information is conveyed as a gift if the expectation is that the recipient will trade on the basis of the inside information, obtaining pecuniary gain. This is because the “disclosure is the functional equivalent of trading on the information” by the insider and “giving a cash gift to the recipient.” The majority thus held that “we reject, in light of Salman, the categorical rule that an insider can never personally benefit from disclosing inside information as a gift without a “meaningfully close personal relationship.”
Circuit Judge Pooler dissented. The “personal benefit” test was designed as a limiting principle on liability. The rule reflects the principle that notevery disclosure of inside information is a violation of the insider trading laws as the majority acknowledges. This rule protects reporters, stock analysis and others from becoming felons or facing civil liability for communicating information that others use to trade.
Yet the “majority holds that an insider receives a personal benefit when the insider gives inside information as a ‘gift’ to any person. . . the majority strips the long-standing personal benefit rule of its limiting power.” This contrasts sharply with the past in which it has bee held that an insider receives a personal benefit “in one narrow situation. That is when the insider gives information to family or friends – persons highly unlikely to use it for commercially legitimate reasons.” Indeed, as Justice Breyer noted at oral argument, “’to help a close family member [o friend] is like helping yourself.’”
Salman did not overrule the first prong of the Newman test. To the contrary, the Court specifically left it intact, rejecting only the second prong. At the same time the Salman Court stressed the close relationship between the two brothers involved there. Yet the “majority today articulates a rule that permits an inference of a personal benefit whenever an insider makes a “gift” of information to anyone, not just to relatives or meaningfully close friends.” While the majority argues that the rule reaches only “someone he expects will trade on the information” in a civil case the actual rule is someone that “the tipper should have known” would trade. This rule does not “rescue the majority’s weakening of the personal benefit rule.” Accordingly,Judge Pooler concluded that he would hold that “an inference of personal benefit may be based on an insider’s gift to relatives or friends, but not a gift to someone else.”
The majority and dissent spar over the question of gift giving in the context of insider trading. This results in an interesting analysis which is not necessary to resolve this case.
Dirks is a case focused on limitations. Both the majority opinion and the dissent agree that Dirks made it clear that not every communication of inside information constitutes a violation of the insider trading laws. To the contrary, it is only those communications in which there is a breach of duty plus a personal benefit to the insider in which there is liability. The question of gifts, relatives and friends comes into play only when the communication is to such a person or for such a reason. In those instances the personal benefit may be inferred from the relationship. Assessing that relationship must be done based on objective facts, according to the Dirks Court.
When these basic principles were applied in Dirks, the Court concluded that there was no liability resulting from the communications about Equity Funding by insider Ronald Secrist to analyst Ray Dirks despite the fact that clients of Mr. Dirks traded. This is because the “tippers received no monetary or personal benefit for revealing Equity Funding’s secrets, nor was their purpose to make a gift of valuable information to Dirks. As the facts of this case clearly indicate, the tippers were motivated by a desire to expose the fraud,” according to the Dirks Court. Stated differently, the critical question was the reason for the communication and the lack of benefit to Mr. Secrist, not the fact that clients of Mr. Dirks traded.
Newman was also a case about limitations. There the circuit court stated that never had there been a criminal case with such remote tippees. The jury instructions failed to mention the Dirks personal benefit test; the court found the evidence on that point wanting. The Newman court crafted a limitationor evidentiary test for gifts (quoted above) in view of the potential liability of the remote traders in the case.
Salman, in contrast, was not about limitations but the center of the insider trading rules. The advocates took extreme positions. Petitioner Salman argued for a rule that there is no personal benefit “unless the tipper’s goal in disclosing inside information is to obtain money, property, or something of tangible value,” according to the Court. The Government claimed that “a tipper personally benefits whenever the tipper discloses confidential trading information for a non-corporate purpose.” In the Government’s view any communication to a person known to be a trade violates the law. The Supreme Court declined to adopt either position. Rather, the Court concluded that Dirks “easily resolves the narrow issue presented here” because the tip was between two brothers with a close relationship, falling squarely within Dirks.
Dirks also “easily resolves the narrow issue” presented in Martoma. Dr. Gilman was employed not just by the pharmaceutical firms by also an expert network. He had an obligation to maintain the inside information he obtained confidential. He met Mr. Martoma through the expert network. The Doctor knew that Mr. Martoma was seeking information to inform his trades. Unlike Ronald Secrist in Dirks, who disclosed inside information not for money, not for friendship but only to disclose a fraud, the Doctor was paid substantial sums of money for talking to Mr. Martoma while honoring his confidentiality obligations . The Doctor talked but failed to honor his obligations; the obvious happened – Mr. Martoma used the inside information to trade.
Nevertheless, the issue presented in Martoma was one of a Dirks-Newman gift. This theory is apparently based in part on the fact that the Doctor did not bill for the two conversations at the end of his relationship when Mr. Martoma was permitted to review the slides for the up-coming public presentation of the trial results. The point may draw support from the fact that over time the two men became friends.
Those facts do not, however, transform a business relationship predicated on specific limitations regarding what could be disclosed into something else. Doctor Gilman was still not authorized to release the information about the drug trials. Mr. Martoma was still a trader looking for information to aid his investment decisions. The relationship was already established; the rules of the relationship and its limitations were in place. To posit otherwise is to ignore the basic facts in an effort to transform the nature of an on-going business relationship and transaction while altering – some might argue contorting – the use of the Dirks-Newman gift idea which surely does not include parties trying to skirt the insider trading rules.
While the gift notion may have been presented as the issue in Martoma the use of the Dirks gift notion has unnecessarily resulted in the dilution of the remaining prong of the Newman evidentiary test for gifts. As that evidentiary standard fades and evaporates under the ruling of the majority, the holding tends toward that advocated by the Government in Salman which ironically,echoes the initial district court decision in Newman – no instruction or evidence on personal benefit,just trading by fourth tier tippees. This is particularly true in civil enforcement cases where a “knew or should have known” standard is applied to the question of what the information provider knew about the tippee’s intent to trade.