In the recent divided opinion in United States v. Martoma,1 the Second Circuit overturned its 2014 opinion in United States v. Newman2 regarding the test for tipper and tippee liability in insider trading cases. The majority opinion reasoned that last year’s Supreme Court decision in Salman v. United States3 is inconsistent with Newman’s requirement that, in the absence of quid pro quo, there be a meaningfully close relationship between the tipper and tippee to support an inference of a gifting of the material, nonpublic information in order for insider trading liability to attach. The majority opinion upheld the insider trading conviction of Mathew Martoma, the former portfolio manager at SAC Capital Advisors LP, despite the nonexistence of a proven close relationship between Martoma and the source of the confidential information.
The test for analyzing tipper and tippee liability can be complicated. In 1983, the Supreme Court in Dirks v. SEC4 established the test for tipper liability as “whether the insider personally will benefit, directly or indirectly from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach [by the tippee].”5 Dirks then listed factors where one can infer a personal benefit, including “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.”6
Martoma managed an investment portfolio focused on pharmaceutical and healthcare companies. Doctors who were involved in a clinical trial for two pharmaceutical companies developing an experimental drug improperly provided Martoma with confidential information about the results of the trial. Based on that information, Martoma advised his boss to trade on the securities for those two pharmaceutical companies. Those trades generated US$80 million in gains and more than US$190 million in losses avoided.
After Martoma’s conviction for insider trading, the Second Circuit reversed the insider trading convictions of two traders in Newman because the government failed to prove that the tipper who initially disclosed the material, non-public information received any personal benefit in exchange for doing so. In elaborating on the Dirks test, the Second Circuit held that a tipper does not derive a personal benefit when he gifts material nonpublic information “in the absence of proof of a meaningfully close personal relationship [between the tipper and the tippee] that generates an exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature.”7
Based on the Newman decision, Martoma appealed his conviction arguing that the jury had not been properly instructed and the evidence was insufficient. While Martoma’s appeal was pending, the Supreme Court issued the decision in Salman, which held that “Dirks specifies that when a tipper gives inside information to ‘a trading relative or friend,’ the jury can infer that the tipper meant to provide the equivalent of a cash gift. In such situations, the tipper benefits personally because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.”8 The Supreme Court rejected the Newman decision “[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, . . . this requirement is inconsistent with Dirks.”9
The Supreme Court did not address Newman’s holding that the “gift” analysis requires the existence of a “meaningfully close personal relationship” between the tipper and tippee. Nevertheless, the Second Circuit reversed its existing precedent, explaining that “following the logic of the Supreme Court’s reasoning in Salman, interpreting Dirks, we think that Newman’s ‘meaningfully close personal relationship’ requirement can no longer be sustained.” In a footnote, however, the majority stated that it did not hold that the relationship between the tipper and tippee cannot be relevant to the jury in assessing whether information was disclosed. Of course, this begs the question of what type of relationship is needed to support a valid inference that the tipper intended to provide a gift to the tippee by supplying material, nonpublic information. The Second Circuit had attempted to bring clarity to this issue in Newman but has now taken a step backward, thereby leaving it to prosecutors to fill the void. In such circumstances, over-prosecution becomes a real and meaningful risk.
In a lengthy dissent, Judge Pooler explained how the majority ignored precedent and “significantly diminishes the limiting power of the personal benefit rule and radically alters insider-trading law for the worse.”10 Those who find themselves caught in the crosshairs of an insider trading investigation will undoubtedly raise many of Judge Pooler’s points until further clarity can be obtained in the appellate courts.
1US v. Martoma, No. 14- 3599 (2d. Cir. Aug. 23, 2017).
2 773 F.3d 438 (2d Cir. 2014).
3 137 S. Ct. 420 (2016).
4Dirks v. SEC, 463 US 646 (1983). A person who provides material, nonpublic information to another who trades is a “tipper” and the recipient of that material, nonpublic information who then trades is a “tippee”.
5Id. at 662.
6Id. at 664 (emphasis added).
7United States v. Newman, 733 F.3d at 452.
8 137 S. Ct. at 428.
10US v. Martoma, No. 14- 3599 (2d. Cir. Aug. 23, 2017).