“As a general matter, there is nothing esoteric about insider trading. It is a form of cheating, of using purloined or embezzled information to gain an unfair trading advantage. The United States securities markets . . . cannot tolerate such cheating if those markets are to retain the confidence of investors and the public alike.” (SEC v. Payton (Rakoff, DJ))
The ban on insider trading derives from Section 10(b) of the Securities Exchange Act. (15 U.S. Code § 78j) This section bans the use of any “manipulative or deceptive device or contrivance” in connection with the purchase or sale of any security. Then, 17 CFR section 240.10(b)5-1 deems trading on the basis of material nonpublic information by insiders proscribed under section 10(b).
Tippee liability is established if “the tippee knows or should know that there has been [such] a breach.” (Dirks v. SEC, 463 U.S. 646, 660 (1983); see US v. O’Hagan, 521 U.S. 642, 652–53 (1997))
Sections 10(b) and 240.10(b)(5) and Dirks form the baseline rule against insider trading. In 2014, US v. Newman, 773 F.3d 438 (2d Cir. 2014), cert. den., No. 15-137 (10/05/15). held that an exchange of information for objective, consequential, and at least a potential gain of a pecuniary or similarly valuable nature will support an insider trading conviction.
Salman is in opposition to Newman, and maintains within the Ninth Circuit, a conviction could be predicated on the insider and a tippee sharing a close family relationship alone. (US v, Salman, 792 F.3d 1087 (9th Cir. 2015))
The Ninth Circuit Salman analysis begins with Dirks. In Dirks, the whistleblower insider plied Dirks, an equities analyst, with allegations of company wrongdoing based on non-public material information. Dirks then told others, some of whom sold company stock.
The Dirks Supreme Court opinion noted that insiders often converse with stock analysts and may accidentally or mistakenly disclose material information that is not immediately available to the public.
“Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts . . . necessary to the preservation of a healthy market.” (Dirks at 658)
Obviously, insiders “may not give such information to an outsider for the same improper purpose of exploiting the information for their personal gain.” (Dirks at 659) “[T]he test is whether the insider personally will benefit, directly or indirectly, from his disclosure.” (Dirks at 662)
Salman emphasizes that Dirks defines the “personal benefit” that constitutes the breach of fiduciary duty includes “a pecuniary gain or a reputational benefit that will translate into future earnings.” (Dirks at 663) Moreover, Dirks states that “[t]he 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,” a dictum which the government used against Salman. (Dirks at 664)
In Newman, subsequent to Dirks, the defendant was the recipient of insider information through a tipping chain. Nothing material was paid to the tipper, but there were exchanges of career advice and non-intimate business and family contacts.
In Salman, subsequent to Dirks and Newman, the tipper gave his pesky brother insider information to get the brother off his back. The brother then passed the information to Salman. The Salman opinion deemed these facts constituted precisely the gift of confidential information to a trading relative that Dirks envisioned.
Salman glosses Dirks as stating that although the personal benefit standard is permissive, Dirks does not suggest that a prosecutor may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature. Instead, to the extent that “a personal benefit may be inferred from a personal relationship between the tipper and tippee, . . . 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.” (Salman, slip opn. at 12-13)
In sum, Salman denies Newman suggestion that a mere friendship can lead to an inference of personal benefit only where there is evidence that it is generally akin to quid pro quo. (SEC v. Payton, No. 14-cv-4644, 2015 WL 1538454 (S.D.N.Y. Apr. 6, 2015)) The Salman court absolutely rejected this holding of Newman. “To the extent Newman can be read to go so far, we decline to follow it. Doing so would require us to depart from the clear holding of Dirks that the element of breach of fiduciary duty is met where an ‘insider makes a gift of confidential information to a trading relative or friend.’” (Salman, slip opn. at 12-3)
Salman overturns Newman on this point and concludes:
“Proof that the insider disclosed material nonpublic information with the intent to benefit a trading relative or friend is sufficient to establish the breach of fiduciary duty element of insider trading.” (Salman, supra)
The Supreme Court review of Salman, then, will turn on whether “personal benefit is broadly defined to include not only pecuniary gain, but also, inter alia, . . . the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend.” (Newman at 452; Salman at 13) If it doesn’t, “a corporate insider . . . in possession of confidential and proprietary information would be free to disclose that information to her relatives, and they would be free to trade on it, provided only that she asked for no tangible compensation in return.” (Salman at 14)
The effect of Newman is a reduction of the number of convictions which may be had under its less inclusive standard. Newman eliminated a whole class of gratuitious tip prosecutions which, on any given set of facts, may deter the operation of security markets, a major concern in Dirks.
The variance in convictions based on any given relationship reflects the confusion created by Newman and Salman. Assuming a “gift of confidential information to a trading relative or friend” is prosecutable under Dirks, a conviction must be had when the “tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.” (Dirks at 664) Assuming no direct proof of collusion, proof of objective features of the exchange of the information, not the least being the initial selective revelation of the information, govern the outcome.
The requisite personal benefit may thus be established from “an intention to benefit the particular recipient.” (Dirks at 664) A close friendship between the tipper and the tippee can be an indication that the tip was intended to benefit the tippee. (SEC v. Warde, 151 F.3d 42, 49 (2d Cir.1998)) There are no categorical rules which distinguish the liability of tipee dentists from tippee barbers, simply the wisdom of the trier of fact. (SEC v. Sargent, 229 F.3d 68 (1st Cir. 2000); SEC v. Maxwell, 341 F. Supp. 2d 941 (SD Ohio 2004))
Judge Rakoff, a prominent New York District Court judge sitting on the Salman Ninth Circuit by designation, had denied a summary judgment motion in SEC v. Payton, supra at fn. 2, noting that there was no liability for defendants who “‘knew next to nothing’ about the tippers, were unaware of the circumstances of how the information was obtained, and ‘did not know what the relationship between the [tipper] and the first-level tippee was.’” Judge Rakoff noted that while Dirks presented quid pro quo and friendship as distinct examples of relationships that may give rise to an inference of personal benefit, Newman seemed to conflate them, suggesting that personal benefit can only be inferred from friendship “where there is evidence that it is generally akin to quid pro quo.”
Judge Rakoff held that even under the “more onerous standard of benefit” in Newman, the SEC had adequately alleged personal benefit, because, inter alia, the direct tippee provided the tipper with legal and financial assistance. As to the remote tipees, they had no specific knowledge of a personal benefit, but they knew that the tipper was the source of the inside information, that the tipper and tippee were friends and roommates, and that the tipper had legal troubles. This circumstantial knowledge was sufficient “to raise the reasonable inference that the defendants know that [tipper’s] relationship with [tippee] involved reciprocal benefits.”
The harmonization between Dirks and Newman reached in Payton was a tactful resolution which muted any dissonance between Dirks and Newman. Under Payton, only the most angelic of tippees would escape prosecution and a jury could be relied upon to sort out the guilty from the innocent.
What about the Newman opinion would cause a District Court judge to refute his own Circuit Court through his quirk appointment to the Ninth Circuit on a temporary basis? Salman Supreme Court review presents the unexpected spectacle of a New York District Court Judge squarely rejecting his own Second Circuit’s discussion of the issue and creating thereby, from the Ninth Circuit bench, a conflict between the Second and Ninth Circuits which in turn created a necessity for Supreme Court resolution.
If Judge Rakoff, in Payton, had severely limited Newman by holding that circumstantial evidence must suggest that a remote tippee had knowledge of a benefit to the tipper, a ruling consistent with Dirks and most of the pre-Newman cases, why did he deem it necessary to make a more extreme statement in Salman? Why create a rule in Salman for gratuitious tips which was defiant of Newman?
The simplest answer is that Newman had created a per se rule for gratuitious tips, a new legal rule that gratuitous tips must be materially beneficial to the tippee in order to be prosecutable, a rule in derogation of Dirks. The Salman opinion, according to the Ninth Circuit, was intended to restore the status quo ante.
Bloomberg insider trader maven Matt Levine, examining the purpose of Dirks, believes that Salman may be about drawing the line between the prosecution of research and cheating.
“So if you read a company’s financial statements . . . and otherwise do the work of obtaining information that could affect its stock price, you can go ahead and trade on that information . . . . But if you just play golf with the chief executive officer, and he tells you that the company is being acquired next week, we don’t want you trading on that information, and if you do we want you to be rewarded with prison.”
Levine’s disatisfaction arises from the failure of law to adjust the balance between research and cheating and accommodating the normal market concerns articulated in Dirks. However, Dirks was premised on a bias towards jury determination of the gratuitiousness issue. The jury is required to find a transfer of by gift as a prequisite to guilt and a case-by- case factual determination by the trier of fact seems a satisfactory, if cumbersome, resolution of the Levine quandry, in the fashion of “Caedite eos, et novit enim Dominus qui sunt eius.”
Newman, on the other hand, turning as it does on material transfer, is geared towards a bright-line determination of material benefit as a pretrial matter of law. Newman is more efficient in preserving scarce judicial resources, while Dirks and Salman address themselves to the close line between research and cheating which ultimately turns on facts and demeanor.
Judge Rakoff’s rule in Salman permits the jury to resolve where a defendant is on this divide between research and cheating as a matter of fact, while the Newman rule allows a trial judge to make that decision as a matter of law. Payton and Salman hold this decision is so fact-specific and tied to the demeanor and ultimate credibility of the defendant and tipor that it is far more appropriate to give the matter to the trier of fact. Ultimately, Salman is more consistent with Dirks than Newman and so is likely to be affirmed.
There is a nice ancillary point about the operation of the Federal justice system in Salman. It may be that Judge Rakoff, ruling in Payton, a trial case solely within the purview and appellate jurisdiction of the Second Circuit, could not countenance a Miltonic rebellion against Newman which, after all, would be reviewed on appeal under Second Circuit precedent. In practical terms, Payton, should he have been convicted, would be on appeal on a trial record and the Second Circuit would have a full factual basis for determining how gratuitious the tip was.
On the other hand, sitting in the Ninth Circuit in Salman, Judge Rakoff’s sole concern was a tabula rasa Dirks determination for that Circuit, with Newman being advisory, not precedent. While District Court Judges are not free to defy Circuit precedent, no such strictures apply when they are sitting by designation as Circuit Court judges in a different Circuit. Thus, Judge Rakoff was free to obviate Newman and return the law status quo ante Dirks. Salman thus presents exemplary and differing judicial roles in a trial and appellate court.