The US Supreme Court will today hear oral arguments in Salman v. U.S., an insider trading case where the court will revisit a topic it last considered in its famous 1983 decision Dirks v. SEC. In Dirks, the Court held that insiders “tipping” their firms’ material non-public information (MNPI) cannot be found guilty of insider trading unless they take some “personal benefit” in doing so. In Salman, the court will again consider the requirements for establishing such a personal benefit.
As Dirks is still the leading US case on when insiders’ selective disclosures will activate the insider trading framework, it may be useful to briefly summarize it. Raymond Dirks was an investment analyst who was informed by a former employee of Equity Funding (EF, a public firm) that its assets were fraudulently overstated. The whistleblower told Dirks that various regulatory agencies had failed to act on similar allegations and encouraged him to verify the fraud and publicly disclose it. Dirks visited EF’s offices, where employees confirmed the allegations, and disclosed the information to his clients and investors who sold EF stock. The SEC censured Dirks on the basis that he had aided and abetted insider trading, but the Supreme Court reversed. Emphasizing that insider trading requires fraudulent behavior, the Court rejected the SEC’s theory that any recipient of MNPI would be barred from trading on such information. Instead, it held that tipping should be construed as derivative of the main insider trading offense, which precludes insiders from trading on their firms’ MNPI for personal gain. Tipping will thus only be unlawful if its purpose is to circumvent this principle, which means that MNPI recipients (such as financial analysts) are free to monetize selectively disclosed information as long as the disclosing insider did not personally benefit from the disclosure. To guide future cases, the Court set out three situations where an insider would receive a personal benefit from tipping: “a pecuniary gain”, “a reputational benefit that will translate into future earnings”, and “a gift of confidential information to a trading relative or friend”; this last situation was included since it was the functional equivalent of gifting the profits of insider trading to a selected recipient.
This principle solved Dirks itself – since the tippers did not receive any benefit from their disclosures to Dirks, their disclosures were legitimate and Dirks could use the MNPI freely. However, two recent appellate cases—U.S. v. Newman and U.S. v. Salman—have offered different interpretations of the “personal benefit” requirement, leading the Supreme Court to revisit the issue.
In the Second Circuit’s 2014 Newman decision, two hedge fund managers were accused of trading on MNPI leaked by insiders of two public firms. The Second Circuit held that the Government had not established that either of the insiders received personal benefits that satisfied Dirks, which meant that there was no tipper wrongdoing from which to derive tippee liability. The Court held that the career advice received by one of the alleged insider tippers was only what could be expected from a casual acquaintance, and the fact that the other insider knew his alleged tippee from church was similarly insufficient to meet the Dirks standard. Instead, the Court required “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”. While noting that this quid pro quo did not need to be immediately pecuniary, the Court emphasized that it “must be of some consequence”.
The Ninth Circuit’s 2015 Salman decision was written by Judge Rakoff, sitting by designation. Judge Rakoff is ordinarily based in a federal district court in New York where he is bound by the Second Circuit’s precedents, including Newman, but was in Salman free to interpret the Dirks personal benefit requirement on behalf of the Ninth Circuit. In Salman, an investment banker regularly provided information about upcoming takeovers to his brother, who in turn tipped Salman who traded and profited. It was established that the insider intended to benefit and provide for his brother and that Salman was aware of the source of the information, and Salman was duly convicted in the district court. Following Newman, however, Salman appealed his conviction to the Ninth Circuit on the grounds that the evidence was insufficient to find that the insider received a personal benefit under the Newman standard or that he, as the ultimate tippee, knew of such a benefit. Judge Rakoff affirmed Salman’s conviction, holding that “To the extent Newman can be read … to hold that evidence of a friendship or familial relationship between tipper and tippee, standing alone, is insufficient to demonstrate that the tipper received a benefit …, we decline to follow it.”
While the Supreme Court declined the opportunity to consider Newman itself, it will now review the Newman standard in the context of Salman. The parties’ briefs are available here and a transcript of the oral arguments will be published on the Supreme Court’s website later today.
Recent commentary on tipping issues includes the following. Nagy has argued that the Salman court should affirm the Ninth Circuit’s decision, reject the Newman standard, and adopt an expanded approach to insider trading that would render unlawful any knowing or reckless use of wrongfully obtained MNPI. Guttentag has proposed that the Court should restate insider trading law so that a finding of personal benefit to the tipper would be a sufficient, but not necessary, requirement for establishing a violation of the securities laws through selective disclosure. Finally, I have suggested that the SEC could itself remedy the problems it faced in Newman by redrafting its Regulation Fair Disclosure to accept the Supreme Court’s view that corporate MNPI is the firm’s property, consider selective disclosures to be transactions in that property, and require such transactions to be publicly reported, in order to allow investors to monitor how corporate managers use their firms’ valuable information.
Martin Bengtzen is a DPhil Candidate at the Faculty of Law and the Oxford-Man Institute of Quantitative Finance, both at the University of Oxford.