The Supreme Court’s decision last December in Salman v. United States[1] settled important issues concerning Rule 10b-5’s reach over trades based on a tip of confidential material information. One important question, however, remains unanswered: In tipping cases based on the misappropriation theory, is it necessary, as some courts have stated, to show that the tipper enjoyed a personal benefit of which the trader was aware? There are commentators who assume the need for such a showing,[2] but in fact the lower courts have split on the issue and the Supreme Court in Salman explicitly said that it was not reaching the matter.[3] In our view, inserting the personal benefit requirement into the misappropriation theory is seriously misguided as a matter of both doctrine and policy. Doing so needlessly leaves many socially undesirable trades unpunished and hence undeterred.   A misappropriation case up for appeal in the Second Circuit, SEC v. Payton,[4] raises this issue again and presents the opportunity for the court to address it squarely and hold that a personal benefit is not required for liability in tipping case based on the misappropriation theory.

I. Supreme Court Jurisprudence Concerning Insider Trading

The necessary starting point to our inquiry is a brief trip back to the early days of Supreme Court jurisprudence concerning the application of Rule 10b-5 to insider trading cases, reviewing the origins of the classical and misappropriation theories and the personal benefit requirement. This review makes clear that the personal benefit test was developed in the context of the classical theory and that the reasons for its creation are related to features present only in those cases for which the classical theory is the relevant approach.

A. The Classical Theory and Its Relation to the Personal Benefit Test

The seminal Supreme Court case concerning when trading on non-public material information violates Rule 10b-5 is Chiarella v. United States,[5] in which Justice Powell’s opinion sets out the so-called “classical theory.” This theory applies “‘when a corporate insider’ or his tippee ‘trades in the securities of [the tipper’s] corporation on the basis of material, nonpublic information.’”[6] It is premised upon “a relationship of trust and confidence between the parties to a transaction,”[7] which Powell finds to exist between an insider of an issuer and its shareholders.[8]

This formulation poses a problem in a tipping case, even one involving information originating inside the corporation whose shares are being traded. Unlike a case where an issuer insider is the trader, in tipping cases the person doing the trading has no special relationship of trust with the persons with whom he trades. In his Chiarella opinion, Justice Powell, in dictum, finds an inventive workaround to this problem. He suggests that the insider tipper, who is deemed to be in such a relationship, breaches her duty to the issuer’s shareholders by providing the information to an outsider likely to trade on it, and the recipient tippee, by trading on the information, becomes a “participant after the fact” in the source’s breach.[9]

Three years after Chiarella, this participant-after-the-fact idea became the basis of the Supreme Court holding in Dirks v. SEC, [10] a classical theory case based on information coming from within the corporation whose shares were being traded. But the majority opinion in Dirks, also authored by Powell, adds an additional wrinkle that goes beyond his dictum in Chiarella. He concludes that a breach of duty to the shareholders requires that the tipper “personally . . . benefit, directly or indirectly, from [her] disclosure,”[11] not just that the insider tipper’s transfer of information was in violation of the issuer’s determination that it be kept confidential.

Importantly, the Court indicates that it added the personal benefit requirement to avoid chilling analyst interviews with corporate insiders, which both the Court and the SEC regarded as socially beneficial and “necessary to the preservation of a healthy market.”[12] The requirement that corporate insider tippers personally benefit in order to breach their duty to shareholders protects market analysts who can continue to meet and question corporate insiders in order to “ferret out and analyze information”[13] without fear of liability.[14] At the same time, it would allow punishment of corporate insiders who provide information to outsiders in return for favors or as a “gift” to a friend or relative, as well as punishment of the tippee who trades if she was aware of the breach including the personal benefit.[15]

B. The Misappropriation Theory and the Personal Benefit Test’s Irrelevance

In contrast to the classical theory, where liability arises out of a duty of trust and confidence between the trading parties, the misappropriation theory, approved by the Supreme Court in United States v. O’Hagan,[16] premises liability on a “duty of trust and confidence” owed to the source of the material, non-public information. [17] The idea is that a misappropriating fiduciary deceives the source of the information by trading based on the confidential information, thereby “defraud[ing] the principal of the exclusive use of that information.”[18] This deceit is a violation because, as required by Rule 10b-5, it is “in connection with the purchase or sale of any security.”[19] This alternative to the classical theory allows application of the rule in situations where the information originally comes not from within the company whose shares are being traded, but from within some other entity. It permits, for example, the imposition of Rule 10b-5 liability on an insider who trades based on the knowledge that his company has a still unannounced plan to acquire a target firm. The theory can also be used to impose such liability on an insider of this potential acquirer’s law firm, investment bank, or financial printer. Where any of these insiders purchases shares of the target, liability cannot be based on the classical theory. This is because the purchaser is the insider of an entity other than the issuer, and hence is not in a relationship of trust and confidence with shareholders of the target company, who are the counterparties to his trade.[20] Most relevant for the question being explored in this blog post, the misappropriation theory also allows imposition of Rule 10b-5 liability on such an insider if she tips instead of trading and gives the information to someone she has reason to believe will trade on it. And, using the participant-after-the-fact rationale, it allows imposing such liability on her trading tippee as well.[21]

In this context, adding the requirement that the tipper must personally benefit in order to find a breach of a duty of trust and confidence does not make much sense. If a tipper owes a duty of trust and confidence to another, say through a written non-disclosure agreement, the tipper breaches the non-disclosure agreement (and thereby breaches the duty of trust and confidence) by simply telling the information to another, whether or not the tipper received a personal benefit. And if the tipper has reason to believe that the recipient will trade on the tip and in fact he does so, this breach is in connection with the purchase or sale of a security. By telling the information to another person, the tipper has defrauded the principal of the exclusive use of that information.

The risk of chilling market analysts—the policy concern that drove the Court to adopt the personal benefit test in Dirks—is not applicable in the misappropriation setting. Market analysts frequently question and receive information about issuers from their corporate insiders. Such interviews are, as a general matter, beneficial for the source of the information—the issuer and its shareholders—and, by increasing share price accuracy, for society more generally. In contrast, stock analyst interviews involving confidential information concerning an issuer’s stock value that are conducted with officials of a different entity are far less common. Where insiders of another entity possess material, non-public information about an issuer, for example information relating to a potential future acquisition, it is usually contrary to the interest of the entity to share this information with market analysts because their trading would drive up the share price of the potential target. More generally, entities such as financial printers, law firms, and investment banking firms do not give socially valuable interviews to market analysts about the future prospects of companies about which they have confidential knowledge. Nor does a spouse sharing a confidence with her mate, another situation that can give rise to a misappropriation claim, have anything to do with analyst interviews. Moreover, adding the personal benefit test to the misappropriation theory involves a significant downside: It leaves many socially undesirable trades beyond the reach of Rule 10b-5’s prohibitions for no good reason.

II. Lower Court Treatment of the Test in Misappropriation Cases

The lower courts have been split on whether the personal benefit test needs to be inserted into misappropriation cases, but there appears to be an unfortunate drift toward imposing the test. Much of the action with regard to this issue has been in the Second Circuit. In United States v. Musella, a 1989 Southern District of New York case, the court stated that “[t]he misappropriation theory of liability does not require a showing of a benefit to the tipper.”[22] In United States v. Chestman, a 1990 misappropriation case involving a husband passing on non-public information that he learned from his wife to his broker, who predictably traded on it, the Second Circuit focused exclusively on whether a marital relationship by itself created a duty of confidentiality which is breached when the recipient of the information uses it to tip.[23] The court made no mention that the husband needed a personal benefit for his tip to the broker to be a violation. The Second Circuit in United States v. Libera suggested that Chestman supported the notion that the personal benefit was not required for misappropriation case.[24] More recently, however, in United States v Newman,[25] the circuit seems to have shifted, although only in dicta and without any real analysis. That opinion states, “[t]he elements of tipping liability are the same, regardless of whether the tipper’s duty arises under the ‘classical’ or the ‘misappropriation’ theory.”[26]

In terms of other circuits, the First Circuit has, in its own words, “dodged the question.”[27] In each misappropriation tipping case where it identified the issue of whether or not the personal benefit test applied, the court found that it did not need to resolve the issue, because the evidence was sufficient to show that if the test should be applied, it was satisfied.[28] The Eleventh Circuit, however, has come down squarely in favor of applying the test in misappropriation cases, stating, in United States v. Yun, “the SEC must prove that a misappropriator expected to benefit from the tip.”[29] Unlike the Second Circuit’s offhand dicta in Newman, the court in Yun engaged in a lengthy analysis of the problem.

The court in Yun provides a number of reasons for taking this position, “perhaps most importantly,” according to the court, “that nearly all violations under the classical theory of insider trading can be alternatively characterized as misappropriations.” [30] Accordingly, it suggests, failing to insert the test in misappropriation cases “would essentially render Dirks a dead letter.”[31] The court’s logic is unconvincing. In resolving the issue of whether the personal benefit test needs to be inserted in such cases, it would be very simple for a court to rule that in any situation that fits under the classical theory, the personal benefit must be proven even if the situation could also be characterized as fitting under the misappropriation theory. Any situation that fits only under the misappropriation theory, however, would not require that the personal benefit test be satisfied.

Consider the application of this approach to tippee trades in three different situations, each involving an initial tipper who is an insider of Corporation A. In the first situation, the tip involves confidential information material to the value of the shares of Corporation B, and the potential defendant tippee, whether a direct or indirect recipient of the tip, trades in shares of B. This case can only be prosecuted under the misappropriation theory, because the original tipper owed no duty to B’s shareholders. Under the suggested approach, the personal benefit test would not need to be satisfied. In the second situation, the tip instead involves confidential information material to the value of the A’s shares, the potential defendant tippee, whether a direct or indirect recipient of the tip, trades in shares of A, and liability is based on the breach of the initial tipper, who is an insider of A. This case can be prosecuted under the classical theory, because the first tipper owes a duty to the shareholders of Corporation A, as explained in Dirks. Under the suggested approach, the personal benefit test would need to be satisfied, even though the breach by the initial tipper might also be characterized as a misappropriation. The third situation is identical to the second except that liability is based on a breach of duty by an indirect tippee to a preceding tippee in the chain. This case can only be prosecuted under the misappropriation theory because the breached duty is to another tippee, not to the shareholders.

Beyond this concern that failing to insert the personal benefit test in misappropriation cases would render Dirks a dead letter, the theme of the court’s arguments in Yun is that it is desirable to have consistency in insider case law.[32] It suggests that imposing the personal benefit test only in cases based on one of the two theories would construct an “arbitrary fence” between the two.[33] According to the court, the fence would be arbitrary because, in its view, each theory premises liability on breaching a duty of loyalty and confidence and the harm to the marketplace under each is identical.[34] The problems with this view are that the two theories in fact involve different kinds of breaches and that enforcement under the two theories protects against different harms. The core points are as follows. All trading based on non-public information is harmful to the trading public, who lack this information. We only make a fraction of such trades illegal under Rule 10b-5. These are ones that fit under the classical or misappropriation theories. The reason for doing so—the harm being protected against—differs depending on which theory applies.

Consider three more scenarios. In the first, unknown to the public, Corporation C, through analysis, views Corporation D’s shares as underpriced or its management inept. As a result, C plans a premium takeover bid for D. C authorizes its agent U to disclose these plans to an outsider V in return for good consideration. C has good reason to believe that V will trade on the information and he does. C would not have violated Rule 10b-5 if C itself had gone into the market and anonymously purchased shares of D.[35] For the same reason, there is no violation by C, U or V where U, authorized by C, discloses the information to V and V trades upon it. In each case, neither classical nor misappropriation theory applies. These legal outcomes make sense even though the trades in both examples come at the expense of other traders: C’s expected gain from trading itself, or from tipping, is a reward for engaging in the hard work of analysis that can help make share prices more informed or increase the likelihood that productive assets make their way into the hands of those who can use them to create the most value.[36]

In the second scenario, W, another insider of C, also learns through his job of this plan for a premium takeover of D. In this scenario without C’s authorization, W discloses this information to X, who is an outsider that W has good reason to think will trade on it. X does trade on it. Under the misappropriation theory, it would be a violation of Rule 10b-5 if W had purchased the shares himself. The same is true of W’s disclosure to X, and of X’s trade if X knows that the disclosure involved a breach by W.   The reason for imposing liability would not be because of the resulting harm to the trading public, which would be just as severe as when, in the preceding scenario, V traded after the tip from U. Rather, in the words of the majority opinion in O’Hagan, whether W trades himself or tips X, he “defraud[s] the principal[, in this case C,] of the exclusive use of that information,”[37] thereby eroding C’s reward for its socially useful hard work and analysis.

In the third scenario, Y, an insider of E corporation, learns through his job that E is going to announce a substantial dividend increase. In advance of its public announcement, Y, without E’s consent, tips news of the dividend increase to Z. Y has good reason to believe that Z will trade on it, and Z does trade on it. Under the classical theory, it would be a violation of Rule 10b-5 if Y had purchased the shares of E herself.   The same would be true of Y’s tipping the information to Z, and, if Z knew of Y’s breach, of Z’s trading. This time, though, the reason would be the harm to members of the trading public who do not know the information. This is because Y, as an insider, owes a duty to the persons with whom he trades, who are E shareholders.

In this third tipping scenario, involving the classical theory, settled law imposes an exception shielding the various parties from liability where Y enjoys no personal benefit. The personal benefit test serves a purpose here, because it avoids chilling analyst interviews. Having E subject to such interviews can be of benefit to the shareholders of E, which is the group that Rule 10b-5 is intended to protect in classical theory cases. This is not so in the second scenario, the one involving the misappropriation theory. There, C corporation, the party that Rule 10b-5 is intended to protect in such a case, is just as damaged from the loss of its exclusive use of the information whether W, the insider tippee, gains a personal benefit or not. Unlike classical theory tipping cases, requiring a showing of personal benefit in misappropriation tipping cases serves no useful purpose that can improve the functioning of the capital market. It simply makes cases worthy of prosecution more difficult to bring successfully.

III. SEC v. Payton

S.E.C. v. Payton, currently under appeal to the Second Circuit, provides a concrete example of the added complexities and shortcomings associated with applying the personal benefit requirement in a tipping case based on the misappropriation theory. The allegations in Payton are as follows. Dallas, an associate at a law firm representing IBM in its acquisition of SPSS,[38] confidentially shared information about the pending acquisition with his friend Martin.[39] Martin was a person with whom Dallas had a history of sharing similar confidential information that gave rise to an obligation by Martin to Dallas to keep the news of the pending acquisition confidential.[40] Martin, in breach of this duty of trust and confidence, then tipped the information to his roommate Conradt, a lawyer and registered representative associated with a broker in New York.[41] Conradt in turn tipped his brokerage colleagues Payton and Durant, who, like Conradt, purchased shares of SPSS. In a civil enforcement action, the SEC charged Payton and Durant with insider trading.[42] The case had to be brought under the misappropriation theory because neither Dallas, nor any of the others involved, owed any duty to the shareholders of SPSS. Even if Dallas were considered a constructive insider of IBM,[43] he was a “complete stranger” to the shareholders of SPSS.[44]

In a motion to dismiss, the defendants made the argument that the personal benefit test applied to misappropriation cases. If so, Payton and Durant, tippee trading defendants, would not be able to be found liable without a showing that Martin derived a personal benefit from tipping Conradt and that Payton and Durant knew or had reason to know of Martin’s benefit, facts that defendants claimed had not been adequately alleged in the complaint. The SEC, in its opposition to the motion to dismiss, argued that the personal benefit requirement did not apply to misappropriation cases and, in the alternative, that even if it did apply, the complaint adequately alleged the needed facts. In support of its argument concerning the inapplicability of the personal benefit test, the SEC cited the older Second Circuit cases discussed above.[45] It dismissed the brief discussion to the contrary in Newman as mere dictum,[46] and went on to say,

A misappropriation case requires no showing of a personal benefit to the tipper, because the breach is inherent in the tipper’s theft of confidential information. The theft alone, in violation of the source of information’s property right to the information, is a breach of the person’s duty to the source of the information.[47]

Judge Rakoff denied the defendants’ motion to dismiss, but did so on the basis of the SEC’s alternative argument—that the complaint adequately alleged Martin’s personal benefit and that Payton and Durant knew or had reason to know of the this benefit. As for the SEC’s argument that such a showing was not necessary in a misappropriation case, he stated, “[w]hatever the abstract merits of this argument, the Second Circuit, in Newman, stated unequivocally that ‘[t]he elements of tipping liability are the same, regardless of whether the tipper’s duty arises under the “classical” or the “misappropriation” theory.’”[48]

At trial, a jury found Payton and Durant civilly liable.[49] Payton and Durant filed a motion for judgment as a matter of law or for a new trial, arguing, among other things, that there was insufficient evidence that Martin received a personal benefit in connection with making the initial tip and that Payton and Durant knew or had reason to know of Martin’s personal benefit. Judge Rakoff denied the motion, deciding that there was sufficient evidence for a rational jury to conclude both that there was a personal benefit and that the defendants knew or had reason to know of it. Payton and Durant have now appealed to the Second Circuit the denial of their motion.

The evidence cited by Judge Rakoff with regard to whether the defendants knew or had reason to know of the personal benefit is instructive. This is evidence to the effect that (1) the defendants were experienced securities industry professionals who knew a great deal about insider trading law, (2) they made no inquiries about whether the initial source of the tip received a personal benefit, and (3) once they had traded and the SPSS acquisition was announced, they took precautions to try to avoid a successful legal action against them.[50] Based on this, Judge Rakoff concludes,

There was in short plentiful evidence from which the jury could have concluded defendants deliberately chose not to ask Conradt questions about the circumstances in which Martin told him about the confidential SPSS information, because they understood that there was a high probability that they would have learned of Martin’s personal benefit.[51]

The fact that the case turns on this evidence with regard to tippee knowledge shows the difficulties that can arise from inserting the test in misappropriation cases.[52] To start, not every jury in a case with this kind of evidence would necessarily find that the tippee knew or had reason to know that the tipper enjoyed a personal benefit just because the tippee did not inquire about the matter. Moreover, even where, as here, a jury in such a case does make this finding, it is not clear that the Second Circuit will agree with Judge Rakoff that the jury’s finding is based on sufficient evidence.[53] In any event, it is very unlikely that such evidence would support a finding of tippee knowledge of the tipper’s personal benefit in a criminal proceeding,[54] the threat of which provides much of Rule 10b-5’s deterrent power with respect to insider trading.

The personal benefit test will often give rise to these sorts of evidentiary problems. These problems impose substantial obstacles in the way of imposing legal sanctions on both tippers and tippees generally, and especially on indirect tippees. As argued above, for misappropriation-based cases, these obstacles are completely unnecessary in terms of the doctrines laid down in Chiarella, Dirks, and O’Hagan, the seminal Supreme Court Rule 10b-5 insider trading cases. Nor are they necessary to support the test’s policy rationale laid out in Dirks, where the test originated. Assume, for example, that Martin in fact did not receive any personal benefit for tipping or, if he did, that Payton and Durant were unaware of it. Martin’s tipping should be a violation as long as there was a breach a duty of trust and confidence by Martin to his source, Dallas, and Martin had reason to believe the information would be used for trading. Payton and Durant’s trading should be violations as long as, in addition, they “know or should know”[55] that they received the information, albeit indirectly, as the result of such a breach.[56]

Based on the facts alleged in the complaint and the findings of the jury, Martin breached this duty of trust and confidence to Dallas the moment that he shared the information with Conradt, thereby depriving Dallas’ client, IBM, of the exclusive use of that information. There are no redeeming social benefits associated with employees of a brokerage firm trading on material, non-public information originating from confidential communication between a law firm associate and his friend. To the contrary, such trading causes many negative costs independent of whether Martin received a benefit.   The prospect of trading like that of Payton and Durant diminishes the incentive of entities such as IBM to search out good takeover targets because of mismanagement, undervaluation or their synergy potential. This is because such trading can raise the price that the potential acquirer would have to pay. More generally, for no good reason, the prospect of such trading also decreases the incentive of stock analysts to expend resources to discover information about issuers with publicly traded stocks, because such trading results in analysts and their customers experiencing a higher cost of trading, thereby reducing the accuracy of share prices. [57] In sum, unlike the concern over analyst interviews that in Dirks gave rise to the personal benefit test in classical theory tipping cases, it is difficult to imagine any socially beneficial scenario where a law firm associate shares material, non-public information about a future acquisition of a client that is subsequently traded upon by direct or indirect recipients.

ENDNOTES

[1] See e.g., Salman v. United States, 137 S. Ct. 420 (2016).

[2] See, e.g., Elizabeth Williams, 14 A.L.R. Fed. 2d 401 (2017); Donald C. Langevoort, Tippers and Tippees, 18 Insider Trading Regulation, Enforcement and Prevention § 6:13 (2017).

[3] Salman, 137 S. Ct. at 425 n.2 (“We do not need to resolve the question [of whether the personal benefit test applies to the misappropriation theory]. The parties do not dispute that Dirks’s personal-benefit analysis applies in both classical and misappropriation cases, so we will proceed on the assumption that it does.”).

[4] No. 17-290 (filed Jan. 30, 2017).

[5] Chiarella v. United States, 445 U.S. 222 (1980)

[6] Salman, 137 S. Ct. at 425 n.2 (quoting United States v. O’Hagan, 521 U.S. 642, 651–52 (1997)).

[7] Chiarella, at 230.

[8] Id.

[9] 445 U.S. at 230 n.12.

[10] 463 U.S. 646, 660 (1983) (“a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing his information to the tippee and the tippee knows or should know that there has been a breach.” (citation omitted).

[11] Id. at 662. For an extensive discussion of the genesis of the personal benefit test, see Adam C. Pritchard, Dirks and the Genesis of Personal Benefit, 68 SMU L. Rev. 857 (2015).

[12] 463 U.S. at 658–59.

[13] Id.

[14] The concern here appeared to relate to the possibility that, although an issuer would intend that only non-material non-public information be conveyed in such an interview, there is always the possibility that a material piece of information is accidentally included as well. If the issuer’s spokesperson and the analyst feared that if this happened and the tip of, and trade on, the material piece of information were considered illegal under Rule 10b-5, the practice of analyst interviews would be chilled.

[15] See 463 U.S. at 664.

[16] United States v. O’Hagan, 521 U.S. 642 (1997)

[17] O’Hagan, 521 U.S. 642, 651–53; Salman, 137 S. Ct. at 423.

[18] O’Hagan, 521 U.S. 642, 652.

[19] Id. at 658 (quoting 15 U.S.C. § 78j(b) and 17 C.F.R. § 240.10b-5 (1996)).

[20] See Chiarella v. United States, 445 U.S. 222, 232–33, (1980) (“Second, the element required to make silence fraudulent—a duty to disclose—is absent in this case. No duty could arise from petitioner’s relationship with the sellers of the target company’s securities, for petitioner had no prior dealings with them. He was not their agent, he was not a fiduciary, he was not a person in whom the sellers had placed their trust and confidence. He was, in fact, a complete stranger who dealt with the sellers only through impersonal market transactions.”).

[21] See, e.g., SEC v. Yun, 327 F.3d 1263, 1270 n. 15 (11th Cir.).

[22] SEC v. Musella, 748 F. Supp. 1028, 1038 n.4 (S.D.N.Y. 1989) aff’d, 898 F.2d 138 (2d Cir. 1990 (finding an indirect tippee liable without a finding as to whether the tipper enjoyed a personal benefit or whether the indirect tippee knew of a personal benefit). See also SEC v. Willis, 777 F.Supp. 1165, 1172 n.7 (S.D.N.Y.1991) (another tipping case based on the misappropriation theory, rejecting a motion to dismiss without an analysis of whether the complaint alleged facts indicating that the tippee enjoyed a personal benefit).

[23] United States v. Chestman, 903 F.2d 75 (2d Cir. 1990).

[24] United States v. Libera, 989 F.2d 596, 600 (2d Cir. 1993) (“In Chestman, we noted that the misappropriation theory requires the establishment of two elements: (i) a breach by the tipper of a duty owed to the owner of the nonpublic information; and (ii) the tippee’s knowledge that the tipper had breached the duty. . . . We believe these two elements, without more, are sufficient for tippee liability.”).

[25] United States v. Newman, 773 F.3d 438 (2d Cir. 2014).

[26] Id. at 446. This statement is dictum because the case involves information coming from within the issuer whose shares were being traded and there was no allegation that the tippee owed any duty of confidentiality to the tipper. Thus, the case is clearly based on the classical theory. Accordingly, the issue of whether or not the personal benefit test needs to be included in misappropriation based tipping actions was not an issue. See also SEC v. Obus, 693 F.3d 276. (2d Cir. 2012), a misappropriation tipping case where the court, while reversing the district court’s grant of summary judgment for the defendant, stated, also in dictum, “[t]he Supreme Court’s tipping doctrine was developed in a classical case, Dirks, but the same analysis governs in a misappropriation case.” The court again provided no analysis in support of this statement, instead simply citing United States v. Falcone, 247 F.3d 226, 233 (2d Cir. 2001). While the opinion in Falcone mentions the personal benefit test in its review of Dirks, which it describes as involving a holding under the “traditional theory,” i.e. classical theory, 247 F.3d at 229, it does not, contrary to what is implied by the citation in Obus, address whether the personal benefit test should be imposed in misappropriation tipping cases.

[27] United States v. Parigian, 824 F.3d 5, 15 (1st Cir. 2016).

[28] SEC v. Sargent, 229 F.3d 68, 76–77 (1st Cir. 2000); SEC v. Rocklage, 470 F.3d 1, 7 n.4 (1st Cir. 2006).

[29] SEC v. Yun, 327 F.3d 1263, 1275 (11th Cir. 2003). A California district court also implied that the personal benefit was required for misappropriation cases, but there is no serious analysis of the issue. See SEC v. Trikilis, No. CV 92-1336-RSWL(EEX), 1992 WL 301398, at *3 (C.D. Cal. July 28, 1992), vacated sub nom. SEC v. Trikilis, No. (EEX), 1993 WL 43571 (C.D. Cal. Jan. 22, 1993).

[30] Yun, 327 F.3d at 1279.

[31] Id.

[32] Id. at 1276.

[33] Id. at 1275–76.

[34] Id. at 1276–77.

[35] Under the Exchange Act, its only constraint in doing so is the requirement under Section 13(d) that within 10 days of its reaching a 5 percent ownership in B, it must file with the SEC a form indicating this fact and setting out its intentions going forward.

[36]Another example of a situation similar to this hypothetical is when an activist hedge fund tips other hedge funds in advance of a public announcement of its stake in a corporation, an announcement that can be expected to result in a price jump in the corporation’s shares. The activist fund does so with the hope that the other funds will purchase shares on the news and will then be available to join the activist fund in forming a “wolf pack.” Such tipping and purchases by the tippees do not violate insider-trading laws. See John C. Coffee, Jr. & Darius Palia, The Wolf at the Door: The Impact of Hedge Fund Activist on Corporate Governance, 1 Annals Corp. Governance 1, 30 (2016).

[37] O’Hagan, 521 U.S. 642, 652.

[38] See Brian Baxter, Cravath, Mayer Brown Advise on IBM, SPSS Merger, AmLaw Daily (July 28, 2009), http://amlawdaily.typepad.com/amlawdaily/2009/07/cravath-mayer-brown-advise-on-ibm-spss-merger.html.

[39] SEC v. Payton, 219 F. Supp. 3d 485, 488 (S.D.N.Y. 2016); SEC v. Payton, 97 F. Supp. 3d 558, 560 (S.D.N.Y. 2015).

[40] Payton 219 F. Supp. 3d at 488; Payton 97 F. Supp. 3d at 560.

[41] Id.

[42] Payton 97 F. Supp. 3d at 561.

[43] See Dirks v. SEC, 463 U.S. 646, 655 n. 14 (1983).

[44] See supra note 20 and accompanying text.

[45] See Plaintiff Securities and Exchange Commission’s Opposition to Defendants’ Motion to Dismiss at 4–7, SEC v. Payton, 97 F. Supp. 3d 558, 562 (S.D.N.Y. 2015).

[46] Id. at 6.

[47] Id. at 5.

[48] Payton, 97 F. Supp. at 562.

[49] No. 14 CIV. 4644, 2016 WL 3023151 (S.D.N.Y. May 16, 2016)]. Martin, Conradt, Payton, Durant, and a fifth defendant Weishaus were indicted for criminal insider trading, but these charges were dropped in early 2015. See Nolle Prosequi, United States v. Conradt, No. 12 Cr. 887 (Feb. 3, 2015).

[50] Id. at 491-492.

[51] Id. at 492.

[52] The evidence that he cites in reaching the decision concerning the sufficiency of the evidence with regard to Martin’s personal benefit from making the tip is more straightforward. Specifically there was evidence at trial that the Martin, the tipper, and the Conradt, the initial tippee, were good friends and that Martin urged Conradt to buy SPSS stock. Payton, 219 F.Supp. 3d 490–91. From this evidence, a jury could infer that the tip was the equivalent of a cash gift. Salman v. United States, 137 S. Ct. 420, 428. Where the tip is such a gift, it qualifies as a personal benefit to the tipper under Dirks. See supra note 15 and accompanying text. There was also evidence that Martin sought and obtained free legal advice from Conradt, from which the jury could conclude that the Martin received a quid pro quo for the tip, Payton, 219 F.Supp. 3d 490–91, another form of personal benefit under Dirks.

[53] A large part of the defendant’s appeal focuses on whether a reasonable jury could find that Martin received a personal benefit from tipping Conradt or that Payton and Durant knew of the breach of duty and personal benefit of Martin. Brief and Special Appendix for Defendants-Appellants, SEC v. Payton, No. 17-290, at 35–52 (Apr. 28, 2017).

[54] In formulating what the standard is for demonstrating tippee knowledge of the tipper’s personal benefit, Judge Rakoff states “in a civil case like this one, the SEC need only prove ‘that defendants knew or had reason to know of the benefit to the tipper.’” Payton, 219 F.Supp. 3d at 492 (citations omitted, emphasis added). The Second Circuit in Newman stated that for criminal cases a tippee must actually know that some personal benefit is being provided in return for the information in order to meet the mens rea requirement. See United States v. Newman, 773 F.3d 438, 448–50, 449 n.3 (2d Cir. 2014).

[55] Dirks, 4463 U.S. at 660.

[56] The defendants also argue that there was no duty of trust and confidence to Dallas, although this argument takes up a shorter amount of the brief. Brief and Special Appendix for Defendants-Appellants, SEC v. Payton, No. 17-290, at 30–35 (Apr. 28, 2017).

[57] See Merritt B. Fox, Lawrence R. Glosten & Gabriel V. Rauterberg, The New Stock Market: Sense and Nonsense, 65 Duke L.J. 191, 238 n. 106 (“Persons trading on the basis of confidential nonpublic information neither worked to develop the information, nor paid someone else to work to develop it. Whether these trades are legal or not depends on the circumstances, but legality aside, the gain the trader enjoys at the expense of other investors would be hard to justify as representing a socially useful incentive. Such information usually becomes public relatively quickly and thus would have been reflected in price soon anyway. Yet, as we have seen, the existence of the practice of trading on its basis decreases liquidity, which discourages the activities of those who trade on the basis of information that does take work to develop. So, on a net basis, trading on the basis of nonpublic confidential information that took no work to develop is, if anything, likely to be socially harmful.”). In contrast, the trading of Payton and Durant adds little to stock price accuracy, because the nonpublic information will be reflected in the stock price once the acquisition by IBM was announced. Id.

This post come to us from Professor Merritt B. Fox at Columbia Law School and George Tepe, a 2017 graduate of the law school.