Salman v. United States and Insider Tipping: What Could be Decided?

In Salman v. United States,[1] the Supreme Court will revisit Dirks v. SEC[2] and likely resolve the uncertainty as to personal benefit and insider gifts of confidential information that followed the Second Circuit’s decision in United States v. Newman.[3]  The case involves a young investment banker’s gifts of information about unannounced client transactions to his brother, who, in turn, shared the tips with their relative by marriage, the defendant Bassam Salman.

Salman will also be the first time that the Court decides the liability of a downstream insider trading tippee.  A decision will therefore likely need to address a gap in Dirks and explain the circumstances under which secondary tippees can be deemed participants in the tipper’s fraud.  One possible outcome is a theory of liability that requires some incenting or concealing act, perhaps minimal, by the remote tippee.

Supreme Court review, in addition, opens the door to interpretation of past insider trading decisions.  Given that four current justices have been receptive to relatively broad views of Section 10(b) in the past,[4] Salman could conceivably expand, rather than restrict, potential liability.

Personal Benefit, Gifts of Confidential Information, and Breach of Duty.  Salman’s petition is largely based on Newman’s ruling on the sufficiency of evidence of tipper personal benefit.[5]  This part of Newman is commonly, though not universally, read to hold that tips of confidential information only violate the law on insider trading if exchanged for a pecuniary or similar quid pro quo, at least absent a high value relationship.  Salman, moreover, appears to go beyond Newman, effectively arguing that gifts of inside information should be per se legal.

Insofar as the banker’s tips to his brother are concerned, Salman’s Newman personal benefit argument will likely face significant difficulties.  There would not seem to be any question that gifts of recognizably sensitive information were made, and that these contravened the banker brother’s duty of loyalty.  In contrast to the Newman tippers,[6] Maher Kara testified at trial as to his motives, stating that they included the intent to benefit his brother.  Salman’s certiorari petition and earlier Ninth Circuit brief in fact state that this testimony established that the tips were gifts.[7]  The tips appear to be an undisclosed misappropriation of client deal information for personal ends, similar to what occurred in O’Hagan.

Dirks of course stated that tips such as those by Maher Kara – gifts of confidential information to a trading relative or friend – would breach an insider’s duty of loyalty.[8]  Limiting illegality to pecuniary or tangible exchanges, more fundamentally, overlooks that the purpose of  “personal benefit” in Dirks was to indicate a personal motivation at odds with the duty of loyalty.[9]  What seems important under Dirks is not the type or quantum of benefit, but rather why a tipper disclosed confidential information to a particular tippee.[10]  Salman’s Newman argument fails to recognize that intended gifts of confidential information – to relatives, friends, hoped for friends, or persons able to return a favor – can conflict with a fiduciary’s duty even though no cash is exchanged.

The Supreme Court obviously has the authority to limit or overrule Dirks and other prior decisions.  But, while guidance as to evidence of tipper intent to make a gift is possible, Salman’s facts make the case a difficult vehicle for restricting liability.  Moreover, the past positions of the three justices from the O’Hagan majority and then Judge Sotomayor in Falcone – already a near majority while the Court remains at eight members – suggest that a significant pushback on insider trading law is unlikely.

The Need to Explain Downstream Tippee Liability.  The personal benefit and self-dealing issue only determines the tipper’s liability. More is needed to explain why a secondary tippee such as Salman should be liable.

Dirks’ primary focus was on the tipper’s motive and whether the predicate breach of duty occurred.  The Court was also only faced with deciding the liability of an immediate tippee, the analyst Dirks.  Dirks did state that a tippee could be “a participant after the fact”.[11]  But the opinion offered only limited explanations for this in a footnote,[12] and did not mention secondary or remote tippees.  Dirks thus presents a gap with regard to tippees, particularly downstream tippees, that are passive beneficiaries of violations primarily intended to benefit the tipper or another tippee.[13]

A secondary or other downstream tippee would obviously be a co-conspirator if he or she acts in concert with an active primary tippee or induces the tipper’s breach of duty indirectly through intermediaries.  Salman arguably falls within this category, given his coordination with Michael Kara and efforts to conceal his trades and source of information.  However, there are other remote tippees who, though recipients of information, play no role in causing, incenting or concealing the tipper’s misappropriation or other breach of duty.  Passive downstream tippees of this sort are arguably only incidental beneficiaries and not participants in fraud or deception.

If it affirms Salman’s conviction, the Court will therefore need to state the circumstances under which a remote tippee can be subject to criminal or civil penalties.  One obvious approach is to distinguish between remote tippees that indirectly, though knowingly, induce the breach or assist its concealment, and those that are passive and incidental beneficiaries.  Emphasis on a downstream tippee’s actions, moreover, would not only provide a theory of participation but also limit liability in a more plausible way than focusing on the value or tangibility of the tipper’s personal benefit.

An active-passive demarcation, however, could create gaps in enforcement.[14] But such gaps could be managed if indirect or minimal acts to incent or provide a “market” for illegal tips, or assist in concealment of an illegal source were deemed sufficient complicity.  This might arguably stretch Section 10(b)’s language as to the “use or employ” of deceptive devices, but would be justified if one viewed market integrity as a statutory purpose, as the O’Hagan majority did when it endorsed the misappropriation theory.[15]

The Bases and Purpose of Insider Trading Law.  A criticism of insider trading law, common both before and after Newman, is that it is malleable and essentially court and SEC made law.  This view results from not only the lack of reference to insider trading in Section 10(b) but also apparent shifts by the courts, and, despite the O’Hagan statement, lack of consensus as to what purpose a ban on undisclosed insider trading serves.[16]  A Salman decision’s discussion of insider trading law would provide an obvious opportunity to remedy this.

There are two areas where, in my view, comment would be especially welcome.  One is a response to the lenity and separation of powers concerns raised in Justice Scalia’s concurring opinion (joined by Justice Thomas) in the denial of certiorari in Whitman v. United States.[17]  While Justice Scalia’s arguments against insider trading law in criminal cases were similar to those made by his and Justice Thomas’ separate partial dissents in O’Hagan (and, in my view, likely to remain a minority view), they would support arguments against penalizing passive tippees.  Responding to the Scalia-Thomas legislative supremacy argument in particular would also begin to address the objection that insider trading law is more the creation of the courts and SEC than Congress.  The second area deserving comment is the fiduciary duty basis of insider trading law.  Although O’Hagan still adhered to a duty-based view, it was a shift from the more restricted views of Chiarella and Dirks.[18]  Addressing both the separation of powers concern and the extent to which insider trading theory relies on breach of duty, particularly when explaining remote tippee liability, could result in a definitive restatement of Section 10(b)’s purpose and how insider trading law furthers it.

Conclusion.  Salman should resolve the uncertainty as to personal benefit and gifts of information that followed Newman.   But its significance could be greater.  The decision will need to address the gap in Dirks’ treatment of tippee liability, and explain when downstream tippees become participants after the fact.  Supreme Court review also potentially puts prior Court statements on insider trading in play.  If O’Hagan and Falcone are in fact indicative of a possible Court majority’s views, then a Salman decision, in discussing insider trading and Section 10(b), could further emphasize market fairness considerations, potentially resetting the path of insider trading law.

ENDNOTES

[1]136 S. Ct. 899 (Jan. 19, 2016), granting cert. to U.S. v. Salman, 792 F.3d 1087 (9th Cir. 2015).

[2] 463 U.S. 646 (1983).

[3] 773 F.3d 438 (2d Cir. 2014), cert.  denied, 136 S. Ct. 242 (2015).

[4] Justices Kennedy, Breyer, and Ginsberg remain from the majority in U.S. v. O’Hagan, 521 U.S. 642 (1997), with Justice Ginsberg writing the opinion.  Justice (then Judge) Sotomayor wrote the opinion in U.S. v. Falcone, 257 F.3d 226 (2d Cir. 2001), a misappropriation and remote tippee case.

[5] Salman is one of a number of post-Newman tipping cases where defendants have argued (unsuccessfully in most cases to date) that personal benefit was absent.

[6] The tippers in Newman did not testify.  Evidence of their motives was largely circumstantial, and dependent on inferences from casual relationships with the immediate tippees.  The tipped earnings-related information was also highly similar to authorized leaks by the companies to favored institutional investors.

[7] Salman v. U.S., 15-628, Petition for Writ of Certiorari at 8 (filed Nov. 10, 2015); U.S. v. Salman, No. 14-10204, Supplemental Brief Concerning U.S. v. Newman at 7 (filed April 7, 2015).

[8] 463 U.S. at 664.

[9] The term “personal benefit” was first used in In re Cady, Roberts & Co., 40 S.E.C. 907, 912 (1961) (“information intended only for a corporate purpose and not for the personal benefit of anyone”).  The Cady, Roberts language was later used verbatim in In re Merrill, Lynch, Pierce, Fenner & Smith, 43 S.E.C. 933, 936 (1968), which Dirks subsequently quoted and cited. 463 U.S.at 654.

[10] Dirks’ citation of Professor Brudney’s 1979 Harvard Law Review article reinforces the view that the Court contemplated the possibility of intangible personal benefits.  See 463 U.S. at 663-664; Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws, 93 Harv. L. Rev. 322, 348 (1979) (benefits to a tipper could include not only “cash, reciprocal information, or other things of value” but also “possibly prestige or status or the like”).

[11] This term was quoted from a footnote in Chiarella v. U.S., 445 U.S. 222, 230n12 (1980).

[12] The Dirks footnote suggested that the law of restitution and unjust enrichment supports tippee liability.  463 U.S. at 660n.20.  However, a restitution-constructive trust argument would only explain liability for trading profits, not criminal conviction or SEC penalties.

[13] But see Langevoort, Insider Trading: Regulation, Enforcement and Prevention §4.8 at 4-28 (Thomson Reuters, April 2016) (Dirks’ gift language implies liability for passive tippees).

[14] See Langevoort, Insider Trading, §4.10 at 4-34 (not penalizing unintended remote tippees means that intermediate tippees would not be liable as secondary tippers).

[15] The O’Hagan Court stated:

“The [misappropriation] theory is also well-tuned to an animating purpose of the Exchange Act: to insure honest securities markets and thereby promote investor confidence…..Although informational disparity is inevitable in the securities markets, investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law.”

521 U.S. at 658-659 (internal citation omitted).

[16] See, e.g., Newman, 773 F.3d at 449 (insider trading law aims to protect property rights to information in a way that promotes market efficiency).  It may also be noted that, in contrast to O’Hagan, neither Chiarella nor Dirks discussed the purpose of insider trading law.

[17]135 S. Ct. 352 (2014).  Justice Scalia’s Whitman comment viewed Section 10(b) as giving inadequate notice of the elements of insider trading.   Moreover, according to Justices Scalia and Thomas, even where notice was adequate, separation of powers mandated that only Congress, not the SEC or the courts, could define crimes.  Salman’s brief on the merits relies on similar lenity and separation of powers arguments.  See generally Salman, No. 15-628, Brief for Petitioner (filed May 6, 2016).

[18] SEC v. Dorozhko, 574 F.3d 42 (2d Cir. 2009) and SEC Rule 10b5-2 arguably represent further departures from a strictly fiduciary duty view of insider trading after O’Hagan.

The preceding post comes to us from Daniel N. Sang, a private investor and member of the New York and California bars.  The author was previously a senior analyst at several hedge funds and bank proprietary trading desks.