The law of insider trading is back before the U.S. Supreme Court with far–reaching implications for insider trading prosecutions in the U.S. The Court will decide whether a close friend or relative of an insider is allowed to trade on information for which the insider did not receive a “tangible benefit,” i.e., information that the friend or relative received simply as a “gift.” A recent decision in the Second Circuit, U.S. v. Newman, 773 F.3d 438 (2nd Cir. 2014), suggests that a tangible benefit, and the trader’s knowledge of the benefit, is required for a conviction. A recent decision in the Ninth Circuit, however, makes clear that a close relative or friend of an insider has a duty not to trade even if the information is provided as a gift. U.S. v. Salman, 792 F.3d 1087 (9th Cir. 2015). The Court granted certiorari in Salman to resolve the potential conflict, and to clarify the standard originally set forth in Dirks v. S.E.C., 463 U.S. 646 (1983).
The law of insider trading is notoriously murky. It is built upon SEC standards and federal case law that have evolved over the years, and as Newman and Salman exemplify, the law is both complicated and ill-defined. Yet, a defendant convicted of insider trading can face substantial prison time. The two defendants in Newman, for example, received sentences of 4.5 and 6.5 years before the Second Circuit vacated their convictions and ordered their release. When the Court granted certiorari in Salman on January 19, 2016, it signaled a willingness to clarify an important part this criminal liability standard. Perhaps the Court’s decision could spur Congress to finally address insider trading directly with legislation.
The grant of certiorari in Salman came as something of a surprise because the Supreme Court had, just three months earlier, denied certiorari in Newman even though Salman already had been decided. The question posed to the Court is whether the “personal benefit” element of an insider trading claim requires proof of “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature,” as the Second Circuit held in Newman, or is it enough that “the insider and the tippee shared a close family relationship,” as the Ninth Circuit held in Salman. Or are these two formulations of the standard originally announced in Dirks reconcilable? If the Supreme Court squarely decides that a “gift” to a friend or close family member is not enough to sustain a conviction, it will substantially narrow the government’s ability to prosecute insider trading in cases that have long been considered a violation of the law.
Newman and Chiasson
There is no federal statute that defines “insider trading” or expressly criminalizes it. (In Europe, by contrast, “insider trading” is defined and explicitly criminalized by the Market Abuse Directive of 2003.) U.S. insider trading prohibitions are entirely the result of the common law—a hodgepodge of court decisions and enforcement actions that has resulted in substantial confusion in both the markets and the courts. The basic rule is that if you are in possession of material non-public information, and the source of your information (an insider) has breached his fiduciary duty by providing it to you, you cannot trade on the information unless it is first made public. Since Dirks, the breach of fiduciary duty question has turned on whether the insider tipper disclosed confidential information in exchange for a “personal benefit.”
Following a wide-ranging investigation into the use (or misuse) of “expert networks” by sophisticated hedge funds, the federal government mounted an aggressive campaign to curb insider trading with the ostensible object of restoring or maintaining faith in the markets and combating the perception that Wall Street is a “rigged game.” The effort made headlines with high profile convictions (e.g., Raj Rajaratnam) and guilty pleas (e.g., SAC Capital).
The government prosecuted most of these cases in New York, which is in the Second Circuit. As the government’s efforts have expanded to reach increasingly remote tippees, they have run into resistance. Most notably, in late 2014 the Second Circuit decided U.S. v. Newman, 773 F.3d 438 (2nd Cir. 2014), which reversed the insider trading convictions of two hedge fund portfolio managers (Newman and Chiasson) who had received, and traded on, non-public earnings information regarding Dell and NVidia that they had received indirectly (three and four levels removed) from insiders at those companies.
Newman and Chiasson, now freed from federal custody by the Second Circuit, made a pile of money for themselves and their funds. Chiasson, who co-founded the hedge fund Level Global, was convicted after his fund made over $50 million on a single trade based on the specific Dell earnings tip for which he was prosecuted. According to tax returns cited at his sentencing, Chiasson earned prodigious sums in three successive years—$16 million, $10 million, $23 million. Newman was a smaller fish than Mr. Chiasson, but he earned more than $10 million over five years as a trader at another hedge fund, Diamondback Capital Management. The jury found that he, too, traded on the inside information about Dell, as well as inside information from the technology firm NVidia.
Newman and Chiasson had unquestionably received material non-public information (pre-announcement earnings numbers) from insiders at Dell and NVidia, but they stood at the end of very long and convoluted tipping chains. In the case of Dell, Rob Ray (a Dell investor relations employee) had tipped earnings results to Sandy Goyal (a Neuberger Berman analyst). He, in turn, provided the information to Jesse Tortora – an analyst at a different firm (Diamondback). Tortora then passed the information to his manager, Newman, and to Sam Adondakis, yet another analyst at yet another firm, (Level Global). Adondakis then passed the information to his manager at Level Global – Chiasson. This, the Second Circuit noted, put “Newman and Chiasson three and four levels removed from the inside tipper, respectively.”
In the case of NVidia, the chain was equally long. Chris Choi (an employee in NVidia’s finance unit) tipped earnings results to Hyung Lim, a technology company executive who Choi “knew from church.” Lim passed the information to Danny Kuo, (an analyst at Whittier Trust), who circulated the information to “a group of analyst friends,” including Tortora and Adondakis. They, in turn, passed the information to Newman and Chiasson.
The Second Circuit felt the length of these tipping chains was a bridge too far for an insider trading prosecution. The court criticized “the doctrinal novelty of [the government’s] recent insider trading prosecutions,” noting that they were “increasingly targeted at remote tippees many levels removed from corporate insiders.” 773 F.3d at 448. It pointed out that neither of the insiders (Ray and Choi) had been charged criminally, and that there was no evidence that either Newman or Chiasson “was aware of the source of the inside information.” Id. at 443. The court also pointed out that most of its prior insider trading jurisprudence “involved tippees who directly participated in the tipper’s breach (and therefore had knowledge of the tipper’s disclosure for personal benefit) or tippees who were explicitly apprised of the tipper’s gain by an intermediary tippee,” id., and that “the Government has not cited, nor have we found, a single case in which tippees as remote as Newman and Chiasson have been held criminally liable for insider trading.” Id. In short, the Second Circuit felt that “[b]y selectively parsing . . . dictum [from prior cases] the Government [was] seek[ing] to revive the absolute bar on tippee liability that the Supreme Court explicitly rejected in Dirks. Id. at 447.
In Dirks—decided in 1983—the Supreme Court made clear that the anti-fraud provisions of our federal securities laws (principally Section 10(b)) do not mandate parity of information in our securities markets, and they do not pose an absolute bar of trading by persons in possession of material non-public information. (That was precisely the position the SEC had advanced. See 463 U.S. at 656-57; see also Chiarella v. U.S., 445 U.S. 222, 233 (1980)). The Court did acknowledge that “[t]he need for a ban on some tippee trading is clear.” 463 U.S. at 659. But the ban it announced was, in theory, far more limited than what the SEC had sought: the Court said a tippee has a duty “not to trade on material nonpublic information only when the insider has breached his fiduciary duty . . . by disclosing the information to the tippee. . . .” Dirks, 463 U.S. at 660. The test for whether the insider has breached his fiduciary duty “is whether the insider will benefit, directly or indirectly, from his disclosure.” Id. at 662. This “personal benefit” test was to “require courts to focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.” Id. at 663. Unfortunately, the Court articulated a rather elastic and inclusive test for whether an insider received a personal benefit:
[T]here may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter or an intention to benefit the particular recipient. The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.
Id. at 664 (emphasis added).
The “gift to a trading relative or friend” language has been widely relied upon by the government in its prosecution of tippees in a wide range of insider trading cases. Ever since Dirks, the government’s position in civil and criminal cases has been that a tip to a “friend” is sufficient to satisfy the “personal benefit” test, and virtually anyone you are acquainted with is a “friend.” As a result, in practice the Dirks “personal benefit” test has not proven to be significantly more restrictive than the absolute ban the SEC had sought—until Newman.
In Newman the Second Circuit focused directly on the personal benefit test, and made two decisions that were a significant departure from prior understanding of insider trading law. First, conceding that its prior opinions on the subject had been accused of being “somewhat Delphic,” the court squarely held that for a tippee to be liable for insider trading, the government had to prove beyond a reasonable doubt not only that the tippee knew that the insider had disclosed confidential information in breach of his fiduciary duty, but also that the tippee knew “the insider disclosed confidential information in exchange for a personal benefit.” 773 F.3d 449.1
Second, the court found that the evidence presented “was simply too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips.” Id. at 451-52. Similar circumstantial evidence had widely been considered to be sufficient to establish insider trading. With respect to the Dell tip, the court said the government had shown that Ray (the tipper) and Goyal (the immediate tippee) were “friends,” but they “were not ‘close’ friends”: They had known each other for years, attended business school and worked together at Dell. Ray had sought career advice from Goyal, and Goyal had advised him on a range of topics: discussing the exams to qualify as a financial analyst, editing Ray’s resume, sending it to a recruiter. With respect to the NVidia tip, the government showed that Lim and Choi were “family friends,” who met through church and occasionally socialized together.2 Id.
The Second Circuit said that if these facts were sufficient to prove that the tippers derived a personal benefit from the tips then “practically anything would qualify.” Id. at 452. Turning to Dirks’ personal benefit test, the court first explains that the term is “broadly defined to include not only pecuniary gain, but also, inter alia, any reputational benefit that will translate into future earnings and the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend.” Id. But then the court ploughs new ground. It says that this standard does not suggest that the government may prove the receipt of a personal benefit “by the mere fact of a friendship, particularly of a casual or social nature.” Id. If that were the case, the court continues, “the personal benefit requirement would be a nullity.” Id. Rather, according to the Second Circuit,
To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades “resemble trading by the insider himself followed by a gift of the profits to the recipient,” 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.
Id. (internal citations omitted)(emphasis added).
When the Newman opinion was announced it was widely hailed as a dramatic departure from long-standing insider trading law. The government promptly sought rehearing en banc. The government argued that the Newman would “dramatically limit the Government’s ability to prosecute some of the most common, culpable, and market-threatening forms of insider trading,” and that it “arguably represents one of the most significant developments in insider trading law in a generation.” See Petition of the United States of America for Rehearing and Rehearing En Banc in United States v. Newman at 3, 22-23 (Jan. 23, 2015) (hereinafter, “U.S. Petition for Rehearing”). After rehearing was denied, the Solicitor General filed a petition seeking a writ of certiorari to the Supreme Court. In the petition, the government recounted to the Supreme Court the parade of horribles presented by the Newman decision. “[T]he effect of the new rule,” the government said, “will be to hurt market participants, disadvantage scrupulous market analysts, and impair the government’s ability to protect the fairness and integrity of the securities markets.” U.S. Cert. Pet., at 15. The government argued that the Newman decision, in the guise of interpreting Dirks, had in fact “crafted a new, stricter personal-benefit test,” and that the “new ‘exchange’ formulation erases a form of personal benefit that [the Supreme] Court ha[d] specifically identified,” id. at 18, namely, “when an insider makes a gift of confidential information to a trading relative or friend.” Dirks, 463 U.S. at 664.
Prior to the time the government filed its certiorari petition in Newman, the Ninth Circuit had decided U.S. v. Salman, 792 F.3d 1087 (9th Cir. 2015). In Salman, the Ninth Circuit considered, and declined to follow Newman to the extent Newman required a “tangible benefit in exchange for the inside information.” Id. at 1093. The government pointed to this circuit split in its certiorari petition in Newman.3 U.S. Cert. Pet., at 22-25.
In Salman, the Ninth Circuit upheld Bassam Yacoub Salman’s conviction of conspiracy and insider trading charges. The tipper in Salman was Maher Kara, an employee of Citigroup’s healthcare investment banking group. In 2004, Maher had begun discussing aspects of his job with his older brother Mounir (“Michael”) Kara. Maher suspected that Michael was trading on the information they discussed, and over time Michael “became more brazen and more persistent in his requests for inside information.” 792 F.3d at 1088. From late 2004 through 2007, Maher regularly disclosed to Michael inside information concerning upcoming mergers and acquisitions by Citigroup clients. Meanwhile, Maher Kara had become engaged to Salman’s sister. The two families grew close, and Michael Kara and Salman had become close friends. Michael began sharing the Citigroup information with Salman, who also traded on it in an account held in the name of yet another relative.
Unlike Newman, in Salman the government presented evidence that Salman knew that Maher Kara was the source of the information. The government also presented evidence that Maher Kara “enjoyed a close and mutually beneficial relationship” with his brother Michael. Id. at 1089. Michael had paid for Maher’s wedding. He stood in for their deceased father at Maher’s wedding. Maher that he loved his brother very much and that he gave him inside information to benefit him, and “to fulfill  whatever needs he had.” Id.
The appeal briefing in Salman was well underway before Newman was decided. In fact, Salman had already filed his reply brief on appeal before the decision came down. After Newman, he asked for leave to file a supplemental brief, which was granted. Salman argued that the Ninth Circuit should follow the Second Circuit, and that his conviction could not be sustained under Newman.
The Ninth Circuit decision was written by the Honorable Jed Rakoff, a senior district judge from the Southern District of New York who was sitting in the Ninth Circuit by designation. Judge Rakoff is well-known as a lonely fighter who views the 2008 financial collapse as the result of consciously fraudulent practices on Wall Street—not just negligence and imprudent risk-taking. He also views the government’s efforts to hold Wall Street accountable for the 2008 financial collapse as tepid, to say the least. His efforts often have been overturned by the Second Circuit. Thus, he must have found special gratification in authoring the Salman opinion.
Salman argued that under Newman “evidence of a friendship or familial relationship between tipper and tippee, standing alone, is insufficient to demonstrate that the tipper received a benefit,” and that the government had proven nothing more with respect to Salman. Id. at 1093. The Ninth Circuit squarely disagreed, saying
To the extent Newman can be read to go so far, we decline to follow it. Doing so would require us to depart from the clear holding of Dirks that the element of breach of fiduciary duty is met where an “insider makes a gift of confidential information to a trading relative or friend.”
Id. (quoting Dirks, 463 U.S. at 664).
All of this was put before the Supreme Court in the Newman petition for certiorari. When the Court on October 5, 2015 denied the Newman petition without comment, many took it as a signal that the eye of the Court had moved on to other issues, and that the Circuit split on the personal benefit test would remain unresolved.
That changed on January 19, 2016, when the Court granted certiorari in U.S. v. Salman. It now appears that when the Court denied Newman it merely had its eye on a different and better vehicle to consider the question. In Newman there were two grounds for decision: lack of evidence of a personal benefit to the tipper and lack of knowledge of the benefit by the defendant. This made Newman a poor vehicle for resolving the contours of the personal benefit test because even if the Court disagreed with the Second Circuit on that issue, to reverse it would have to confront the additional issue of the defendants’ knowledge.
Salman presented the personal benefit issue with no such complications. We can expect a landmark insider opinion later this spring. Don’t hold your breath for Congressional action addressing insider trading.
1. In fairness, the Second Circuit would say that this determination was not groundbreaking because in Dirks the Supreme Court “clearly defines a breach of fiduciary duty as a breach of the duty of confidentiality in exchange for a personal benefit.” Id. 449. Thus, according to the Second Circuit’s reasoning, the only way to know there has been a breach of fiduciary duty is to know that confidential information was disclosed in exchange for a personal benefit.
2. The government’s petition for certiorari describes the personal benefit facts substantially differently than the Second Circuit’s rendition. For the Dell tip, the petition notes that Goyal had other “authorized contacts” in Dell’s investor relations department “with whom he generally communicated during business hours,” but that Goyal talked to Ray only at night or on weekends. Petition of the United States of America for a Writ of Certiorari in United States v. Newman at 4 (July, 2015) (“U.S. Cert. Pet.”). Goyal and Ray “met each other’s wives, had dinner together, talked about going on joint vacations, and frequently had lengthy phone conversations.” Id. And, according to the government, when Goyal left Dell and began working in the more lucrative position of analyst, “Ray made clear that he ‘desperately’ wanted to make a similar move and desired Goyal’s help in doing so.” Id.
For the NVIDIA tip, the government says that at the time the tipping began Choi and Lim “had known each other for more than a decade. They “attended church picnics and other functions together, had lunches together, [and] knew each other’s families. Id. at 8. Lim “once bought a gift for Choi’s child.” Id.
3. Salman did not declare a split in the circuits, it declined to follow Newman “to the extent Newman can be read to go so far” as requiring proof beyond a reasonable doubt of a “tangible benefit” to show a breach of duty. Judge Rakoff wrote: “Indeed, Newman itself recognized that the ‘personal benefit is broadly defined to include not only pecuniary gain, but also, inter alia, . . . the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend.’” Salman at 792 F.3d at 1093-94 (quoting Newman 773 F.3d at 452).