In United States v. Newman, 773 F.3d 438 (2^nd Cir. 2014), the Second Circuit overturned the insider trading convictions of two hedge fund managers who received material nonpublic information from public companies via an extended tipping chain. The Newman court was required to interpret the Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1983), to answer the question: What must tippees know about the disclosure of non-public information by the tipping corporate insider in order to sustain a conviction?

Dirks, in an opinion written by Justice Lewis F. Powell, Jr., held that there was no violation of Rule 10b-5 absent a breach of fiduciary duty by the insider-tipper in providing the information. A breach of fiduciary duty required that the tipper receive “a monetary or personal benefit for revealing [corporate] secrets” or have the “purpose to make a gift of valuable information.” Either would satisfy Dirks’ test: “whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders.” Absent a “direct or indirect personal benefit from the disclosure” there could be no deception, and therefore, no fraud under Rule 10b-5.

The Newman court rejected the government’s argument — based on the Second Circuit’s prior decision in SEC v. Obus, 693 F.3d 276 (2^nd Cir. 2012) — that it was sufficient that the tippee know that the information had been revealed by the tipper in breach of a duty of confidentiality. The Obus court based its holding on Dirks’ language that the tippee inherits the insider’s duty only when “the tippee knows or should know that there has been a breach,” which the Obus court suggested “sounds somewhat similar to a negligence standard.” The Newman court rejected a negligence standard in a criminal context, instead holding that “in order to sustain a conviction for insider trading, the Government must prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.” The Newman court went on to also hold that the government must prove that the personal benefit to the tipping insider involved “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. … 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 [latter].’”

In my article Dirks and the Genesis of Personal Benefit, I trace the “judicial history” of Dirks’ personal benefit requirement, following its evolution through successive drafts of the opinion by Justice Powell. Based on that judicial history, I conclude that in order to show a violation of Rule 10b-5, the government needs to prove: 1) that both the tipper and tippee acted with scienter in breaching their duties; and 2) that the tipper disclosed material non-public information for the purpose of acquiring an indirect personal benefit by making a gift to the recipient, which requires a relationship of some substance.

In Justice Powell’s view, breach of a duty of confidentiality was insufficient to allege an insider trading violation; breach required exploitation of information. The history of the personal benefit standard demonstrates that Powell was addressing the question of duty, not state of mind, in formulating that standard. Powell had no intention of departing from the established 10b-5 requirement of scienter. This distinction between duty and scienter sheds light on the “knows or should know” language from Dirks quoted in Obus; “should know” is sufficient to demonstrate participation in a breach of duty by the insider. The government, however, must also show the tippee’s scienter — intent to defraud — to satisfy the elements of Rule 10b-5. The Obus court went astray in adopting a negligence standard because it ignores that the Dirks personal benefit test requires not just that the tipper receive a personal benefit, but that they disclose confidential information for that purpose. In order to show a breach of fiduciary duty, the SEC must prove that the tipper’s purpose in disclosing was to receive a personal benefit. The absence of a personal benefit will end that inquiry, but the presence of one is not dispositive: purpose must still be shown.

The personal benefit duty requirement is distinct from scienter. To be sure, the breach of duty and state of mind inquiries will sometimes overlap. Dirks tells us that: “Scienter in some cases is relevant in determining whether the tipper has violated his Cady, Roberts duty.” Dirks does not suggest, however, that the scienter requirement should not apply to the element of personal benefit, and a disclosure cannot be deceptive under Dirks unless a personal benefit was the object of the disclosure. Simply breaching a duty of confidence does not constitute “deception” under Dirks; the disclosure must be made for an improper purpose. How can a tippee be a participant after the fact in that breach of fiduciary duty if the tippee does not know of the improper purpose?

The Newman court also adopted a narrow definition of “personal benefit.” The mere fact of friendship between a tipper and tippee was not enough; there had to be “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 my view, Newman is faithful to Powell’s understanding of the personal benefit test and the requirement that the tippee be a participant in the insider’s fraudulent breach of fiduciary duty. Powell crafted his Dirks opinion carefully to exclude careless breaches, and Newman construed personal benefit in that light. The personal benefit element requires the government to prove that the tipping insider disclosed the information for the purpose of receiving a personal benefit, direct or indirect. Would the existence of a casual friendship or acquaintance warrant the inference that the insider breached a duty of confidentiality for the purpose of bestowing a gift? Although some people may be committing random acts of kindness when they bestow information on a stranger, it seems more likely that they have been careless in disclosing. To phrase it differently, the gift needs to be exploitation, not waste. The standard is self-dealing: the gift needs to be an indirect personal benefit, which suggests a close relationship, not a casual one. Tying the gift prong to the presence of a friend or relative – and requiring the government to satisfy a non-trivial quantum of proof with respect to that relationship – restricts the SEC from coming up with strained theories of gifting by insiders. Newman’s interpretation of personal benefit is at least consistent with Powell’s requirement of purpose in Dirks.

My account raises a challenging question: How much legal weight does this judicial history deserve? The conventional answer is none. On the other hand, Powell was engaged in a quasi-legislative task. Section 10(b) and Rule 10b-5 say nothing about the topic of insider trading. In the absence of rulemaking by the SEC, Powell was tasked by his fellow justices with drafting a doctrinal solution to the problem. Powell told his colleagues what he was doing and why: he was promulgating a rule that prohibited the exploitation of non-public information by insiders, while at the same time constraining the SEC from inventing novel theories of liability. Should a court ignore the history leading up to the promulgation of the personal benefit rule when presented with a case that requires its interpretation?

The preceding post comes to us from Adam C. Pritchard, the Frances and George Skestos Professor of Law at the University of Michigan Law School. The post is based on his recent article, which is entitled “Dirks and the Genesis of Personal Benefit” and available here.