The Second Circuit, in U.S. v. Newman raises likely insurmountable burdens for prosecutors to pursue remote tippees. Newman causes even greater harm to the public interest in fair capital markets by making it impossible to pursue the true violator, the tipper. To understand this conclusion, consider the following hypothetical that is intended to illustrate the Supreme Court’s reasoning in Dirks v. Securities and Exchange Commission.
Kenneth Darke, a geologist with Texas Gulf Sulphur Company, rode into history as one of a large group of corporate insiders who purchased TGS shares on their advance knowledge of a unparalleled visual assay of a single core drilling in Timmins Ontario. The core sample suggested an extraordinary mineral discovery. Telephoning the results to TGS executives in New York, the muddy team was told to withdraw the drilling rig, conceal their tracks, and stay quiet until TGS could, concealing its identity, purchase all neighboring property. Darke and others did their own secret purchasing, acquiring shares and options in TGS and thus became defendants in the groundbreaking en banc decision of the Second Circuit that established an early version of the “disclose or abstain” rule that applies to trading and tipping while in possession of inside information.
But what if Darke had not traded, but chose instead to sound an alert among the neighboring farmers, telling all who he could reach that they were sitting on extremely valuable land. Like a modern day Paul Revere, we can imagine him crisscrossing the Ontario plains warning of those bearing false gifts, pointedly stating that the farmers would (as they were) be approached by TGS representatives concealing that connection and offering to buy their properties. As a result of Darke’s warnings, competitors also began to purchase land in the area so that ultimately, in order to reap the full advantage of its search and discovery, TGS had to invest many millions of dollars more than if Darke had not provided his warning to the farmers and others. Finally, assume Darke’s independence from TGS was fed by the fact that he really didn’t need the work; his spouse was Madonna so that he shared a modest fortune that would make him a worthy target of any suit to hold him accountable for any misconduct.
Under the above hypothetical, can we doubt for a moment that Darke breached his state law fiduciary relationship to TGS and that TGS would be able to hold him financially accountable under orthodox agency principles for the additional costs TGS had to incur to develop its mineral discovery? Moreover, under state corporate fiduciary law, if Darke profited from his knowledge, such as purchasing TGS shares, the profits would also have been recovered. Nonetheless, under Dirks v. Securities and Exchange Commission, 463 U.S. 646 (1983), neither the farmers alerted by Darke who thereafter purchase TGS shares nor Darke himself violate the securities laws because of his selective disclosure of material inside information. Dirks surprisingly held that a tip does not violate the antifraud provision unless tipping “constituted a breach of fiduciary duty” and then proceeded to provide a narrower definition that the law of agency or corporate law considers to be such a breach: “[a]bsent some personal gain there has been no breach of duty to the stockholders.” Id. at 662. Dirks also provided that for a tippee to violate the antifraud provision the tippee must know “or should know that there has been a breach.” Id. at 660. We can therefore see that the reach of the federal antifraud provision into tipping is not nearly as encompassing as the law of agency or corporate law that do not condition breach upon evidence the company has suffered an injury. The greater breadth of state fiduciary law was confirmed by no less than the Delaware Supreme Court in Kahn v. Kohlberg Kravis Roberts Co., 23 A.3d 831, 837-840 (2011).
Against the above tapestry, the result of U.S. v. Newman might be thought to be unremarkable. But things are not always as they seem and this suggestion is no more apparent than a close consideration of Newman.
Newman is actually a tale of two opinions. The bulk of the decision is devoted to explaining why the district court incorrectly instructed the jury on the law of tipping. Having found that the jury was incorrectly instructed, a more prudential panel would have simply reversed the case so that the matter could be retried with the correct instruction. Had the panel done this, we could expect the evidence introduced by the prosecution would have been more sharply focused on the gains likely expected by the tippers than occurred the initial trial. This likelihood makes all the more problematic the panel’s holding and scolding tone that the government lacked sufficient evidence. Newman undertook this part of its analysis on the assumption that had the jury been properly instructed the evidence would not support a conviction.
In weighing the sufficiency of the evidence, the panel appears not to have read Dirks closely. Throughout Newman there is closer attention given to the Second Circuit’s own precedents than to considering just what drove Dirks to have such a narrow construction of a fiduciary breach. Dirks states not only that it required objective evidence of a breach but also that such objective evidence of a breach was necessary to foster an environment for financial analysts to “ferret out” information. 463 U.S. at 559. Dirks clearly held that a payment for a tip as such objective evidence, but more broadly embraces tips to friends and relatives. Most importantly, Newman, and the Second Circuit precedents that it relied upon, treat, on the one hand, evidence that a tip was for a cash payment and, on the other hand, a tip to either a relative or friend as fungible, in the sense that Newman requires more than such a family or friendship relationship but also weighs the magnitude of the benefit received. This was not what Dirks intended. That is, we wonder what the Second Circuit would now hold were the evidence that the CEO, instead of giving his brother’s family the typical Christmas goose as the seasonal holiday present instead selectively disclosed that the company would soon announce a large earnings increase. In considering this hypothetical, note that Newman’s analysis weighs the magnitude/expected value of the gain each tipper derived from his respective tippee. For example, having found that the benefits tipper Ray received in the form of mentoring and guidance from his former business school classmate on matters that included the content of his resume, Newman held there was no violation ala Dirks because the benefit derived by Ray was not all that significant. This stands in sharp contrast to Dirks where the Supreme Court emphasized the relationship itself to a friend or relative with the view the tip can thus be understood as “an intention to benefit a particular recipient . . . by a gift of profits to the recipient.” Dirks does not condition the breach on the relative magnitude or materiality of the benefit derived by the tipper. Newman thus gives the tipper a substantial pass and weakens the prosecution’s ability to prosecute the source of the violation, the tipper!
Dirks clearly requires knowledge on the part of the tippee. Thus, remote tippees such as those in Newman pose serious evidentiary problems for the prosecution. It is simply going to be too rare an instance in which the circumstances are such that a jury can conclude beyond a reasonable doubt that a tippee three or four levels beyond the source of the tip, as was the situation in Newman, not only knew or should have known the information was the product of a breach of fiduciary duty but knew or suspected as well that the inducement for that tip was friendship or cash as contrasted with benign loose lips. Newman’s holding thus meshes poorly with practices that occur too frequently in today’s capital markets. As documented by the lower court decisions directly referenced by Newman, remote tippees have been before the courts many times before. Moreover, all studies of significant corporate events document that a significant portion of the market movement associated with corporate events occurs before the event is announced; for example, forty-fifty percent of the price gain associated with a merger or takeover occurs before the transaction’s announcement. See Eisenberg & Cox, Business Organizations 944 (11th ed. 2014)(reviewing studies). One can thus surmise not only that corporate insiders are not very good about keeping secrets but that their tippees are delighted that they do not. That is, remote tippees are likely both pervasive and truly are insidious. Newman pours gas onto this raging fire.
It may be difficult to address the lacunae Newman has created for prosecuting remote tippees. But Newman’s true pernicious contribution is the pass it essentially provides the source of the tip. As seen, Second Circuit precedent, now fully underscored in Newman, holds that selective disclosures based on family relation or friendship are not alone a breach unless there is some realized or expected objective material financial gain on the part of the tipper. As seen above, this is not a correct reading of Dirks. Throughout its reasoning, the Supreme Court sought objective evidence of a disclosure being improper. Cash payment is such, but similarly an existing friendship or family relationship also provided the desired objective evidence. As discussed above, Dirks sought objective evidence so as to avoid what would otherwise be dangerous terrain for individuals trading on information believed to be material and non-public but not knowing if it is the product of a breach. While protecting remote tippees in this context may well be the natural result of Dirks because of the difficulty, as illustrated in Newman, of establishing the requisite scienter, Newman and the Second Circuit by trivializing the role that family relationship and friendship play have thrown the truly dirty culprit, the tipper, out with the bathwater.
The preceding post comes to us from James D. Cox, the Brainerd Currie Professor of Law at the Duke University School of Law.