Did insider trading law almost devolve into an effort to define  what kind of relationship a tipper and tippee must have for  a defendant to be liable? And was any federal judge or jury qualified to say? Since the Second Circuit’s decisions in United States v. Newman[1] and United States v. Martoma,[2] courts, prosecutors, and regulators no longer need to figure out what a “meaningfully close personal relationship” is. Now, merely giving a tip to a complete stranger may actually violate Rule 10b-5.

Newman was the kind of case that my superiors at the Securities and Exchange Commission once warned against—pursuing remote tippees with little connection to the initial disclosure.[3] Indeed, the Second Circuit in Newman specifically referenced “the doctrinal novelty of [the U.S. Attorney’s] recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders.”[4]  Adding to the “novelty” of the prosecution was the fact that the tippers, who were corporate employees from Dell and Nvidia, were never prosecuted or subject to a civil enforcement action by the SEC.  How can there be illegal insider trading when those who passed the information, presumably the real wrongdoers, escaped scot-free?

The first part of Newman’s legal analysis was unremarkable, to say the least. The Second Circuit adopted the position that an element of a tipping case requires proof that the tippees knew of a benefit provided to the source of the information—a view that every district court except the judge who presided over the trial had adopted.[5]  If Newman had stopped there, it would have gone down as not much  more than a footnote in the history of insider trading.

It is what the Second Circuit did next that caused such consternation.[6] In deciding whether there was sufficient evidence to establish the knowledge element of the benefit, the circuit court decided to tack on another requirement for showing a quid pro quo exchange: “we hold that such an inference is impermissible in the absence of 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.”[7]

The Supreme Court rather unceremoniously gutted the second part of Newman’s requirement in Salman v. United States,[8] asserting that “[t]o the extent the Second Circuit held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends, Newman, 773 F.3d, at 452, we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.”[9]

Down goes Newman? If only the story were that simple. In its August 23, 2017,  opinion in United States v. Martoma,[10] an insider trading case involving losses avoided and gains made of over $250 million, the majority tried to consign the “meaningfully close personal relationship” language to the trash heap of history, apparently to languish there with the Fourth[11] and Eighth Circuit[12] decisions rejecting the misappropriation theory back in the mid-1990s. The majority asserted, “We hold that the logic of Salman abrogated Newman’s ‘meaningfully close personal relationship’ requirement . . . .”[13] That did create a bit of a problem because circuit court panels are not supposed to overrule prior circuit decisions,[14] at least not without clear direction from the Supreme Court. Salman only rejected the “pecuniary or similarly valuable nature” language in Newman, so the majority’s decision looked like something of an overreach.

In an Emily Litella[15] moment months later, the majority amended its prior opinion and, oddly enough, endorsed the “meaningfully close personal relationship” requirement from Newman rather than finding it negated by Salman.  But the majority then undermined this additional element, noting that the phrase was “new to our insider trading jurisprudence, and, viewed in isolation, it might admit multiple interpretations.”[16] The judges then found that evidence of a quid pro quo exchange showing an “intention to benefit” the tipper can be enough to establish a violation. Voilá!  Rather than the nature of the relationship, it was the intention of the tipper to confer something valuable on the tippee that  helped establish a violation of Rule 10b-5.  The majority went so far as to say giving information to a stranger could be enough to prove a violation:

For example, suppose a tipper discloses inside information to a perfect stranger and says, in effect, you can make a lot of money by trading on this. Under the dissent’s approach, this plain evidence that the tipper intended to benefit the tippee would be insufficient to show a breach of the tipper’s fiduciary duty to the firm due to the lack of a personal relationship. Dirks and Warde do not demand such a result. Rather, the statement “you can make a lot of money by trading on this,” following the disclosure of material non-public information, suggests an intention to benefit the tippee in breach of the insider’s fiduciary duty.[17]

Thus, the predominant requirement is that “[w]hichever way Dirks is read, it recognizes that purposely benefitting the tippee with inside information proves that the tipper has received a personal benefit in breach of a fiduciary duty.”[18]

So is Newman’s “meaningfully close personal relationship” requirement back on the trash heap? Anyone who has spent time on insider trading cases should tell you that it is not gone, although it is much less prominent than it once was.  Intention to benefit can be shown in many ways, including through a close personal relationship, but a violation is certainly not limited to circumstances involving those close personal connections.  So golfing buddies[19] and college friends[20] have to be careful once again.

An interesting question is whether the convictions in Newman of the two hedge fund portfolio managers might have survived after Martoma. The government’s lack of evidence of their knowledge of the benefit would likely defeat the prosecution, especially as they were third- and fourth-level tippees.  But the relationship between the sources of the information and the initial tippees might have been enough to establish the quid pro quo under Martoma’s analysis.  So long as there is an intention to benefit the recipient, there is unlawful tipping.

Prosecutors and the SEC do not have to show powerful feelings, like the close relationship between the brothers who were the source of the inside information in Salman.[21] Instead, the government has to show just enough to allow a jury to infer that the tipper intended to benefit the tippee, which of course can be proven by circumstantial evidence.  Will a juror believe that someone doles out confidential corporate or transactional information just for the fun of it, especially when a defendant makes what looks like a lot of money? The power of the insider trading narrative is likely to make proving this intent a fairly low bar for prosecutors and the SEC.  The prosecution of Congressman Chris Collins for tipping his son—apparently from the lawn of the White House—may show that Martoma has made life much easier for prosecutors.[22]

ENDNOTES

[1] United States v. Newman, 773 F.3d 438 (2d Cir. 2014), abrogated by Salman v. United States, 137 S. Ct. 420 (2016).

[2] United States v. Martoma, 894 F.3d 64 (2d Cir. 2017).

[3] The defendants were Todd Newman, a portfolio manager at Diamondback Capital Management, LLC, and Anthony Chiasson, a portfolio manager at Level Global Investors, L.P.  They never dealt directly with the tippers, and indeed only got the information through a group of analysts who passed along information about impending earnings at Dell and Nvidia.  According to the government, their hedge funds earned $4 million and $68 million, respectively, from their trading. Newman, 773 F.3d at 443.

[4] 773 F.3d at 448.

[5] 773 F.3d at 449  (“[W]e conclude that a tippee’s knowledge of the insider’s breach necessarily requires knowledge that the insider disclosed confidential information in exchange for personal benefit. In reaching this conclusion, we join every other district court to our knowledge—apart from Judge Sullivan—that has confronted this question.”) (footnote omitted). The district judge in the case, Richard J. Sullivan, is a former assistant U.S. attorney who has been nominated to the United States Court of Appeals for the Second Circuit. See https://www.whitehouse.gov/presidential-actions/president-donald-j-trump-announces-thirteenth-wave-judicial-nominees-seventh-wave-united-states-marshal-nominees/.  I suspect he will not take a favorable view of the Newman decision.

[6] After the Supreme Court denied the solicitor general’s petition for certiorari in the case, Preet Bharara, the United States Attorney in Manhattan at the time, said the Newman decision meant that “there is a category of conduct that will go unpunished going forward.”  Matthew Goldstein and Adam Liptak, Supreme Court Denies Request to Hear Insider Trading Case, N.Y. Times, Oct. 6, 2015, at B1.

[7] 773 F.3d at 452.

[8] Salman v. United States, 137 S. Ct. 420 (2016).

[9] 137 S. Ct. at 428.

[10] United States v. Martoma, 869 F.3d 58 (2d Cir.), opinion amended and superseded, 894 F.3d 64 (2d Cir. 2017).

[11] United States v. Bryan, 58 F.3d 933 (4th Cir. 1995), abrogated by United States v. O’Hagan, 521 U.S. 642 (1997).

[12] United States v. O’Hagan, 92 F.3d 612 (8th Cir. 1996), rev’d, 521 U.S. 642 (1997).

[13] United States v. Martoma, 869 F.3d 58, 61 (2d Cir.), opinion amended and superseded, 894 F.3d 64 (2d Cir. 2017).

[14] 869 F.3d at 83 (Pooler, C.J., dissenting) (“The majority’s rule is inconsistent with Newman’s ‘meaningfully close personal relationship’ requirement, which the majority explicitly overrules.”).

[15] For those not old enough to remember Saturday Night Live in the 1970s, check out this classic tidbit on YouTube: https://www.youtube.com/watch?v=fZLeaSWY37I.

[16] United States v. Martoma, 894 F.3d 64, 77 (2d Cir. 2017).

[17] 894 F.3d at 75.

[18] 894 F.3d at 75-76.

[19] See United States v. McPhail, 831 F.3d 1, 3 (1st Cir. 2016) (“McPhail, a tile salesman by vocation, first met Santamaria in late 2007 at the Oakley Country Club in Watertown, Massachusetts.”).

[20] S.E.C. v. Obus, 693 F.3d 276, 291 (2d Cir. 2012) (“Here, the undisputed fact that Strickland and Black were friends from college is sufficient to send to the jury the question of whether Strickland received a benefit from tipping Black.”).

[21] See Salman, 137 S. Ct. at 424 (“The evidence at trial established that Maher and Michael enjoyed a ‘very close relationship.’ Maher ‘love[d] [his] brother very much,’ Michael was like ‘a second father to Maher,’ and Michael was the best man at Maher’s wedding to Salman’s sister.”).

[22] Alan Feuer and Shane Goldmacher, New York Congressman Christ Collins Is Charged With Insider Trading, N.Y. Times, August 9, 2018, at A1.

This post comes to us from Professor Peter Henning at Wayne State University Law School.