Dirks v. SEC established the fraud claim for tipping as part of the insider trading prohibition in the federal securities laws. An essential element of the claim was proof that the insider personally benefited from disclosing confidential information to the tippee.
A paragraph in Dirks explained the personal benefit test. The paragraph said that an insider needed to receive cash, reciprocal information, or other things of value but went on to say that certain fact patterns often created an inference that the insider expected to receive a personal benefit. Those fact situations included the insider’s gift of information to a trading relative or friend or a relationship between the tipper and the tippee suggesting the insider’s intention to benefit the tippee (the “fact situations”).
My recently posted paper, forthcoming in volume 58 of the American Criminal Law Review, explains that the personal benefit element has been misunderstood. As the SEC, criminal prosecutors, and courts applied the personal benefit element in enforcement cases after Dirks, the test expanded and became easier to meet. Dirks referred to the insider’s gain and receipt of cash or things of value, but over time less tangible and more remote, speculative, and immaterial returns to the insider satisfied the test. A panel of the Second Circuit in United States v. Martoma, 894 F.3d 64, 76 (2d Cir. 2018), said the “evidentiary bar is not a high one.”
The fact situations took on a life of their own. None of them called for evidence that the insider received anything, yet courts and authorities read Dirks to mean that proof of a fact situation constituted proof of the insider’s receipt of a personal gain. A well-known example is the gift theory the Supreme Court applied in Salman v. United States, 137 S. Ct. 420 (2016). Another is the Second Circuit’s Martoma conclusion that the government may satisfy the personal benefit element with proof that an insider intended to benefit a tippee, even a total stranger. In these cases, the personal benefit requirement disappeared.
Is this the state of the law Dirks contemplated? The drafting history of the majority opinion in Dirks in the papers of its author, Justice Lewis Powell, sheds light on questions about the personal benefit element and reveals that the current wide interpretations of personal benefit in tipping cases are not consistent with the test the Court intended.
The drafting history tells us that comments from Justice Sandra O’Connor pushed the concept of personal gain to the forefront late in the drafting of the opinion. Personal gain became the main element for proof of tipping liability, and it was to be objective and concrete and was to be receipt of cash or tangible value. This was consistent with Powell’s goal of providing market participants and law enforcement authorities with a limiting principle of reasonable certainty and predictability.
The drafting record tells us the source of the gift theory and the other fact situations. They came from an article about the Dirks case that a practitioner, Leonard Chazen, published in the Legal Times a week before the oral argument. The article did not cite authority for the fact situations.
The drafting history highlights that the fact situations were not proof or examples of personal benefit. The Court deliberately set the situations apart from the government’s need to prove that an insider received cash or something of value to meet the personal benefit test by saying that they were types of circumstances that often could lead a fact finder to infer that the insider received or expected a personal benefit. The critical word for the fact situations was “infer” or “inference.” The practitioner’s article in the legal periodical said a court could infer the ultimate standard for liability from proof of a fact situation, and every draft of the Dirks opinion used the word “infer” or “inference” with the fact situations.
Powell was careful about using the word “inference.” Before he wrote Dirks, Powell had written several opinions discussing the differences between inferences and types of presumptions. He was attuned to those differences and deliberately chose to use the word “inference” in Dirks. He wanted the fact situations to create an inference of personal benefit and not a presumption or ultimate liability. According to Powell’s other opinions, an inference was a permissible but not mandatory logical deduction for a fact finder. A jury was not bound to accept the correctness of an inference. A presumption was different. It was mandatory and necessarily shifted the burden of producing contrary evidence. An inference did not have the legal effect of shifting the burden of production, although it had that practical effect. Neither an inference nor a presumption shifted the ultimate burden of persuasion. Therefore, in Dirks, evidence that the insider received cash or something of value was proof of personal benefit and breach of a fiduciary duty. Evidence of a fact situation created an inference of personal benefit but did not establish it.
These lessons from the drafting history and Powell’s earlier opinions show that Salman wrongly applied the gift theory as sufficient proof of personal benefit. A disclosure to a close relative as a gift or proof of another fact situation does not establish that the insider received a personal benefit. The proper understanding of the fact situations in Dirks is that, if the government introduces evidence of the predicate facts in one of the fact patterns, such as a disclosure as a gift to a trading relative or friend, and the defendant does not introduce evidence to rebut the predicate facts and does not introduce evidence to counter the inference that the tipper received a personal gain for disclosing confidential information to an outsider, the issue of personal gain may be submitted to the jury or fact finder. The fact finder is permitted, but not required, to conclude that the insider received a valuable personal gain. The fact finder is permitted to draw other reasonable inferences from the evidence. The inference does not change the burden of persuasion, which remains with the government. The government must present evidence beyond a reasonable doubt in a criminal case and a preponderance of evidence in a civil case.
Following this approach likely would have changed the outcome in Salman. Evidence in the case had rebutted that the insider received a benefit from disclosing information to his brother.
The Dirks drafting history resolves a critical point disputed between the majority and dissent in Martoma. The Martoma majority was wrong in its construction of the fact situation referring to an intention to benefit. A relationship between the insider and the tippee is needed before an intention to benefit is relevant. A tip to a stranger is not sufficient.
The drafting history and lessons of Dirks have vitality today. They improve our understanding of obscure parts of Dirks that the courts have misinterpreted and that continue to matter in government enforcement cases. Although the question about the use and relevance of internal judicial records is controversial, the Supreme Court used a draft opinion at least once, and the reliance of the U.S. legal system on the doctrines of precedent and stare decisis depends on the best, most accurate understanding of an applicable judicial decision.
This post comes to us from Andrew Vollmer, senior affiliated scholar at the Mercatus Center at George Mason University and former deputy general counsel of the Securities and Exchange Commission. It is based on his recent paper, “Explaining Dirks,” available here.