After Salman, Whither Outsiders and Facebook Friends in Insider Trading?

Oral argument in the insider trading case, Salman v. United States, prompted dozens of questions related to the key issue before the U.S Supreme Court: whether an investment banker personally benefitted directly or indirectly when he disclosed to his brother confidential information about upcoming mergers and acquisitions involving Citigroup clients, knowing that his brother was using that information to trade securities. The brother also relayed the information to the petitioner, who was a close friend and later an in-law, and the two profited mightily by purchasing stock and options to buy stock in four acquisition targets on the basis of the gratuitous tips. Although no justice posed them, two questions have been on my mind since I listened to the Salman argument and reviewed the transcript. First, will the traditional distinction between insiders and outsiders hold significance after Salman? And second, is a Facebook friend a “friend” for purposes of determining joint tipper-tippee liability in insider trading cases?

The government’s burden to demonstrate a “personal benefit” in tipper-tippee cases (whether criminal or civil) stems from the court’s test in Dirks v. SEC (1983), a decision which affirmed the classical theory of insider trading established in Chiarella v. United States (1980). Pursuant to the classical theory, a trader’s failure to disclose material nonpublic information in a securities transaction constitutes fraud under Exchange Act Section 10(b) and Rule 10b-5 if, but only if, the trader owes a fiduciary-like duty to the shareholders of the issuer. The classical theory thus extends to securities trading by the issuer’s officers, directors, employees, and agents (often termed temporary insiders) as well as certain tippees of such insiders. Dirks created the personal benefit test to determine whether an insider’s disclosure of entrusted information breached a fiduciary duty owed to shareholders, which would render the insider and any tippee aware of that breach jointly liable under Rule 10b-5 for the tippee’s trading.

Salman’s petitioner is urging the high court to follow United States v. Newman, 773 F.3d 438 (2d. Cir. 2014), a decision which held that an insider’s tip to a friend does not satisfy Dirks’ personal benefit test absent “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.” Id. at 1092.  The petitioner reads Newman and Dirks to require proof that the investment banker received some type of “tangible benefit” in exchange for sharing the M&A information with his brother. The government rejects this reading and is seeking affirmance of the Ninth Circuit’s ruling that proof of a tangible benefit is not required, provided there is sufficient evidence of a tipper’s intention, in the words of Dirks, “to make a gift of valuable information.” Dirks v. SEC, 463 U.S. 646, 667 (1983)).

The “complementary” approach to the classical theory from Chiarella and Dirks is the misappropriation theory, which the court endorsed in United States v. O’Hagan, 521 U.S. 642, 652 (1997). As Justice Ruth Bader Ginsburg wrote for herself and Justices Kennedy, Breyer, Stevens, O’Connor, and Souter (with Chief Justice Rehnquist and Justices Thomas and Scalia dissenting), “the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate ‘outsider’ in breach of a duty owed not to a trading party, but to the source of the information.” Id. at 652-53. As the O’Hagan court explained, the misappropriation theory is “designed to protect the integrity of the securities markets against abuses by ‘outsiders’ to a corporation who have access to confidential information that will affect the corporation’s security price when revealed, but who owe no fiduciary or other duty to that corporation’s shareholders.” Id. at 653 (internal quotes omitted).

Notably, the facts of Salman implicate not only joint tipper-tippee liability under Dirks but also misappropriation theory liability under O’Hagan. As the petitioner’s brief makes clear, Citigroup represented the acquiring company in three of the four impending acquisitions that generated the investment banker’s gratuitous tips about the securities of the acquisition targets.[1] Thus, the petitioner garnered the lion’s share of his more than $1.5 million in profits from “outsider” tipping and trading.[2] Only a fraction of the petitioner’s illicit gains resulted from a transaction in which Citigroup represented—and thereby owed fiduciary-like duties to—the target company’s shareholders.

Although the necessity of fusing Dirks with O’Hagan drew no particular attention during the Supreme Court argument in Salman, the Ninth Circuit’s opinion in the case explicitly recognized this fusion,[3] and a host of other appellate decisions in tipper-tippee misappropriation cases have addressed this blend (including then-Judge Sonia Sotomayor’s opinion in United States v. Falcone, 257 F.3d 226 (2d Cir. 2001)). The Salman Court would be creating substantial confusion were it to affirm the petitioner’s conviction under Dirks without acknowledging that the investment banker stood, with respect to most of the tips at issue, as an outsider to the shareholders of the corporation that issued the securities, akin to the attorney-defendant in O’Hagan (and, for that matter, the printer-defendant in Chiarella). But the court could also clarify insider trading law considerably by explicitly acknowledging that virtually all insider trading cases involve an information source that is deceived and defrauded through secret misappropriation, even in those classical instances when a fraud is perpetrated on the issuer’s shareholders as well.

If the Salman petitioner’s Rule 10b-5 liability turns on his willful role as a participant after the fact in his brother-in-law’s breach of a fiduciary duty owed to Citigroup and its clients (and Falcone applying O’Hagan tells us it does), then it should not also be necessary for the government to prove that the tipper personally benefitted from his disloyal disclosures. Under O’Hagan, it was the investment banker’s undisclosed “breach of a duty of loyalty and confidentiality” that deceived and defrauded those sources of their “exclusive use of that information.” O’Hagan, 521 U.S. at 652.

Accordingly, under a misappropriation theory analysis, the secret “embezzlement” of entrusted information, to facilitate someone else’s “trading profits,” constitutes deception and fraud “in connection with” securities trading, irrespective of the fiduciary’s own personal gain. Id. at 654 (citing Carpenter v. United States, 484 U.S. 19 (1987)).  While “feigning fidelity to the source of the information” in connection with a securities transaction typically involves a fiduciary’s personal benefit from the “self-serving use” of a principal’s information, it is possible to “feign[ ] fidelity” with respect to the personal gain of another.  O’Hagan, 521 U.S. at 652, 655.

Justice Alito brought this issue to light when he posed a hypothetical concerning a sad pedestrian walking down the street and a tipper who disclosed confidential corporate information in order “to do something to make this person’s day.” Salman Argument Transcript at 29. As the deputy solicitor general saw it, Rule 10b-5 would warrant a finding of liability on the part of the tipper because surreptitious trading tips, whether to relatives, friends, or strangers, breach “the basic duty of loyalty in corporate law.” Id. at 28. But several justices were clearly skeptical that a gift of confidential information to a stranger could generate a direct or indirect personal benefit for the tipper, and appeared more inclined to retain the court’s prior reference to “mak[ing] a gift of confidential information to a trading relative or friend.” Dirks, 463 U.S. at 664.

The Salman court is thus poised to decide whether a tipper’s personal benefit constitutes a necessary condition, or simply a sufficient condition, for Rule 10b-5 liability in tipper-tippee insider trading cases. To be sure, the court could act on Justice Kagan’s pragmatic suggestion by reaffirming Dirks’ gift theory in a way that “say[s] we’re not dealing with that here.” Salman Argument Transcript at 47. But if the court were to take a pass on this issue in Salman, lower courts almost certainly would continue to apply the personal benefit test in all tipper-tippee cases, whether classical or misappropriation. Thus, to not decide the issue is to decide the issue.

Which brings me back to pondering about Facebook. A decision in Salman that simply reaffirms Dirks’ observation about gifts of information “to a trading relative or friend” would disavow the view that gratuitous tips are not illegal absent a tangible benefit on the part of the tipper. But it would beg the very same line-drawing question that troubled the justices about hypothetical tips to strangers. Newman narrowly circumscribed “meaningfully close personal relationship[s],” which presumably would proscribe gifts of confidential information to immediate family members and very close friends, but would allow deliberate trading tips to friends “of a casual or social nature,” provided the tipper neither asks for nor receives anything of value in return.  Newman, 773 F.3d at 452. No justice during the argument indicated a comfort with that—and deliberate tips of market-sensitive information to golfing buddies and business cronies would undermine market integrity and investor confidence to the same extent as deliberate tips to siblings and very dear friends. In an age where most teenagers and many adults have hundreds of “friends” on Facebook, it is difficult to see why the term “friend” should continue to carry such weighty doctrinal significance.

Corporate law construes breaches of the duty of loyalty to encompass not only self-dealing but also other instances of deliberate misconduct that evidence a fiduciary’s failure to act in good faith. And a breach of the duty of loyalty standard in tipper-tippee cases would “require courts to focus on objective criteria,” as the Court sought to do with the personal benefit test. Dirks, 463 U.S. at 670. Isn’t it high time for federal insider trading jurisprudence to recognize that breaches of loyalty will not always involve a fiduciary’s self-dealing?


[1] Salman was convicted of four substantive counts of insider trading and one count of conspiracy to engage in insider trading.  See Brief for Petitioner at pp. 6, 15, The substantive counts pertained to Salman’s trades in securities of United Surgical Partners International, Inc. (USPI) and Biosite Incorporated.  Specifically, in 2006, “Citigroup was representing USPI’s largest shareholder, a private equity firm, which was interested in buying out the other shareholders;” and in early 2007, “Citigroup was representing a client that was considering purchasing Biosite.”  Id. at 13-14.  The conspiracy count pertained to Salman’s purchases of securities in those two companies as well as in Andrx Corporation (with Citigroup representing the acquirer) and Bone Care International, Inc., “an acquisition target represented by Citigroup in the company’s sale to Genzyme.” Id. at 12.

[2] According to the government, “[n]early $1 million of those profits came from [the investment banker’s] tip that Biosite was about to be acquired by a Citigroup client.”  See Brief for the United States at page 6.

[3] United States v. Salman, 792 F.3d 1087, 1092 n.4 (9th Cir. 2015) (observing that Dirks’s personal benefit test applies in a misappropriation case “like the instant case, where the fiduciary duty is owed, not to the shareholders, but to the tipper’s employer, client, or the like”) (emphasis added, citing United States v. O’Hagan, 521 U.S. at 652-53)).

This post comes to us from Professor Donna M. Nagy at Indiana University Maurer School of Law—Bloomington.  It reflects views expressed in her recent article, “Beyond Dirks: Gratuitous Tipping and Insider Trading,” which will be published later this month in the Journal of Corporation Law and is available here.