Insider Trading Liability

However, the murmurings of discord between the Second and Ninth Circuits raise issues regarding what may constitute a personal benefit under the existing case law. In United States v. Newman, 773 F.3d 438 (2d Cir. N.Y. 2014), cert. denied, __U.S.__, 136 S. Ct. 242 (2015), the Second Circuit took a narrow approach in addressing this element, holding that the government had to prove that a tippee knew the tipper received a personal benefit in exchange for the disclosure. Significantly, that tribunal ruled that “personal benefit” has to extend beyond a mere casual friendship between tipper and tippee. On the other hand, a subsequent Ninth Circuit decision, U.S. v. Salman, supra, 792 F.3d 1087 (9th Cir. 2015), now under High Court review, addressed circumstances in which a personal or familial relationship between a tipper and insider was sufficient to satisfy the “personal benefit” requirement.

The Second Circuit in Newman reiterates that liability for insider trading exists under either the “classical” or the “misappropriation” theories. The classical theory states that a corporate insider violates Section 10and Rule 10b-5 by his own trading in the corporation's securities on the basis of material, nonpublic information. See Chiarella v. United States, 445 U.S. 222, 230 (1980). In contradistinction, yet intersecting with the classical theory, the misappropriation theory encompasses those outside the executive suite who do not have a fiduciary or special relationship to a corporation or its shareholders, yet are in possession of material, non-public information about the firm. When these ostensible outsiders trade on that information to their gain, they fall under the gamut of tipper-tippee liability on the theory that, essentially, they misappropriated knowledge that does not belong to them. See United States v. O'Hagan, 521 U.S. 642, 652-53 (1997).

Tipping liability reaches situations where the insider or misappropriator in possession of material nonpublic information (the “tipper”) does not himself trade, but discloses the information to an outsider (a “tippee”), who then trades on the basis of the information before it is publicly disclosed. See Newman, 773 F.3d at 446. This was seized upon by the Second Circuit in Newman, which pointed to Supreme Court dicta holding that “[t]he tippee's duty to disclose or abstain is derivative from that of the insider's duty,” and, because “the tipper's breach of duty requires that he personally will benefit, directly or indirectly, from his disclosure, a tippee may not be held liable in the absence of such benefit.” Thus, in Newman, the tribunal held that “a tippee may be found liable only when the insider has breached his fiduciary duty ' and the tippee knows or should know that there has been a breach.” Id. (internal quotation omitted).

Second Circuit Limits

In Newman, the Second Circuit overturned the conviction of two individuals charged with insider trading. Significantly, this decision sets forth the outer boundary at which the court will uphold tippee liability by holding that, inter alia, the existence of a casual friendship alone does not satisfy the personal benefit requirement of insider trading liability.

Relying upon the Supreme Court's holding in Dirks, the Newman defendants argued that the government failed to present sufficient evidence that the tippers received either a direct or indirect “personal benefit” from the disclosure. See Dirks v. S.E.C., 463 U.S. at 662. Specifically, they asserted that innocuous career advice given to one tipper did not rise to the level necessary to satisfy the “personal benefit” leg of the analysis laid out in Dirks. The defendants further claimed that the government did not offer any evidence that the insider giving the tip received any sort of personal benefit at all.

The appellate court based its reversal upon two findings. The first was that the government failed to meet its evidentiary burden to establish that the tippee knew of the insider, and that the tipper derived a personal benefit from giving the tip. See Newman, 773 F.3d at 448. The second finding, more procedural in nature, was that the district court had committed harmful error by failing to instruct the jury regarding the government's burden of proof of those two allegations. Id. at 450.

Newman revitalized the “personal benefit” analysis of Dirks, holding that the prosecution must prove each of the following elements beyond a reasonable doubt: 1) the corporate insider was bound by fiduciary duty to the corporate issuer; 2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to the tippee (b) in exchange for a personal benefit; 3) the tippee knew of the tipper's breach, that is, he knew the information was confidential and was divulged for personal benefit; and 4) the tippee nonetheless used that information to trade in the security or tip another individual for his own personal benefit. Id. at 450.

Citing Dirks, the Second Circuit reiterated that “a breach of confidentiality is not fraudulent unless the tipper acts for personal benefit, that is to say, there is no breach unless the tipper 'is in effect selling information to its recipient for cash, reciprocal information, or other things of value for himself.'” The district court's failure to include an “in exchange for personal benefit” instruction, coupled with the government's dearth of evidence on the subject, proved to be the fatal blow to upholding the convictions. Id.

Ninth Circuit Imposes Liability

In Salman, the defendant allegedly traded upon inside information purportedly obtained through the close relationship he had with his brother-in-law, Michael Kara. Michael had obtained material, non-public information from his brother, Maher, a member of Citigroup's healthcare investment banking group. Michael was also alleged to have traded for his own account, as well as tipping Salman. The tribunal found the evidence was clear that “Salman knew full well that Maher Kara was the source of the information.” Moreover, “Michael and Maher Kara enjoyed a close and mutually beneficial relationship,” and “Salman was aware of the Kara brothers' close fraternal relationship.” Salman, 792 F.3d at 1090.

Much like its Second Circuit brethren in Newman, the Ninth Circuit in Salman correctly focused upon Dirks and its “personal benefit” requirement as an element necessary to impose liability for insider trading. Yet the western appellate court reached a markedly different result. The Salman panel chose to emphasize that portion of Dirks wherein the Supreme Court ruled that insider trading liability also “comes into existence where the insider makes a gift of confidential information to a trading relative or friend.” Id. at 1092, quoting Dirks v. S.E.C., 463 U.S. at 664. Thus, applying the Supreme Court's maxims as articulated in Dirks, the tribunal accordingly held that Maher's disclosure of confidential information to his brother, with awareness that the latter intended to trade on it, “was precisely the gift of confidential information to a trading relative that Dirks envisioned.” Id., internal quotations omitted. The Ninth Circuit declared that its ruling flowed logically from the critical facts that the Kara brothers had a “close fraternal relationship, Salman was well aware of that relationship, and thus Salman could have readily inferred Maher's intent to benefit Michael.” Id.

Providing the utmost level of clarity, the Salman court distinguished itself from the circumstances in Newman , observing that the nature of the relationship between the Newman tipper and tippee was far more nebulous than the relationship present in Salman. Employing its sister court's language, the Ninth Circuit declared as follows:

The Second Circuit held that [the] evidence was insufficient to establish that either [tippers] received a personal benefit in exchange for the tip. It noted that although the “personal benefit” standard is “permissive,” it “does not suggest that the Government may prove the receipt of personal benefit by the mere fact of a friendship, particularly of a casual or social nature.” Instead, to the extent that “a personal benefit may be inferred from a personal relationship between the tipper and tippee, ' 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.”

Salman, 792 F.3d at 1093, citing U.S. v. Newman, 773 F.3d at 452.

Based upon the Supreme Court's granting certiorari in Salman, one can logically infer that the Justices wish to clarify the evidentiary burden of the government in pursuing an insider trading case, specifically in satisfying the “personal benefit” element as found in the Dirks formulation. Given that the Second Circuit refuses to recognize that a casual friendship can satisfy the personal benefit element of the Dirks test, but at the same time the Ninth Circuit decrees that evidence of a close, familial relationship is sufficient to impose liability, it will be up to the Supreme Court to choose between these two divergent approaches or even affirm or amend its own prior extrapolations, as found in Dirks, in order to resolve this internecine controversy.

Corporate Liability

While insider trading, as a species of securities fraud, is prosecuted under Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934 (see 15 U.S.C. ' 78j(b) and 17 C.F.R. ' 240.10b-5, respectively), Section 20 of the 1934 enactment (15 U.S.C. ' 78t) authorizes both the government and private litigants to pursue those who “control” the primary violator. This is “control person” liability, and it possesses the uncanny ability to assess damages against those higher up in the corporate chain of command for neglecting to supervise, let alone aid and abet, those malefactors engaged in insider trading. If the claimant is first able to establish the liability of the primary violator, and then prove the “control” by a secondary actor, then liability shall also attach against the “control person.” To be sure, “control person” includes business entities, as well as individuals.

Given this potential for exposure to meaningful liability, those individuals and/or firms likely deemed “control persons” in a corporate setting must endeavor to establish practices that minimize the risk of liability in the context of a Section 20 action. While there is no fool proof methodology for avoiding control person liability, there are numerous active and passive steps a corporation, its directors, and its upper management may implement as strong countermeasures against eventualities of employee misbehavior. For example, a firm may protect material, non-public information with any number of physical and electronic safeguards. Taking a more proactive approach, a firm may also choose to monitor the trading activity of its employees and/or the shares of the firm itself for irregularities that may indicate the presence of misuse of inside information, by the employees themselves or their confederates.

Most importantly, however, a firm and its executives must strive to educate its employees regarding the risks of sharing confidential information with others, including close family and friends, the very persons the employee is most likely to trust with company secrets. Particularly in light of the Supreme Court's decision to grant certiorari in Salman , and the expected ruling as to how a family or other personal relationship might equate the “personal benefit” element of the Dirks test, the employee may expose the corporation to control person liability by a simple slip of the tongue when speaking in confidence to a family member or close friend about their work day.

Jon R. Grabowski is a partner and Michael A. Sabino is an associate at Ford Marrin Esposito Witmeyer & Gleser LLP in New York City. Grabowski focuses his practice on commercial litigation and Sabino concentrates on litigation and appeals, and writes on financial services industry law. They can be contacted at [email protected] and [email protected], respectively.

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