United States: Second Circuit Amends But Arguably Weakens The "Meaningfully Close Personal Relationship" Test For Tips In Insider Trading Cases

Last Updated: October 30 2018
Article by Shearman & Sterling LLP

On 25 June 2018, a divided three-judge panel of the Second Circuit amended its decision in United States v. Martoma (covered previously in this newsletter), which held that the Supreme Court in Salman v. United States had abrogated the "meaningfully close personal relationship" test articulated by the Second Circuit in United States v. Newman.

The panel's amended opinion, in contrast, holds that Newman's "meaningfully close personal relationship" test is still valid for determining whether an insider tipper received a personal benefit (and thus breached a fiduciary duty), but also holds that the test will be satisfied upon a showing that (1) the "tipper and tippee shared a relationship suggesting a quid pro quo" or (2) "the tipper gifted confidential information with the intention to benefit the tippee."

As background, Martoma was convicted in 2014 on various insider trading charges. According to the government, in July 2008, Martoma learned from doctors who worked on a clinical trial of an experimental Alzheimer's drug that tests had gone poorly. At the time, Martoma was employed as a portfolio manager at SAC Capital Advisors LP (SAC), and had arranged for paid consultations with the doctors, sometimes at a rate of $1,000 per hour, which he used to learn inside information. According to the government, Martoma used this information to cause SAC to enter into short sales and other trading shortly before results of clinical trials became public, and thereby netted large gains and avoided losses. Martoma appealed his conviction on the grounds that the jury instructions were improper and there was insufficient evidence to convict him.

Under the U.S. Supreme Court's decision in Dirks v. United States, tippers can be liable for insider trading only when they receive a personal benefit. Tippee liability derives from tipper liability, and also requires a finding of a "personal benefit" for the tipper. In Newman, the Second Circuit held that the requisite personal benefit could not be inferred from friendship alone without "proof of a meaningfully close personal relationship [between tipper and tippee] that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature." Shortly thereafter, the Supreme Court, in Salman v. United States, called Newman's emphasis on pecuniary gain into question. Under the facts of Salman, where there was unquestionably such a meaningfully close relationship between the tipper and tippee, the Court held that a tipper who gives inside information to a relative or friend receives a personal benefit because "giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds."

As we previously reported, in its original opinion, the Martoma panel went further than the Supreme Court. It held not only that Newman's emphasis on pecuniary gain was inconsistent with Salman, but that the "reasonably close personal relationship" test also did not survive. Numerous commentators questioned the decision because it seemed to overturn a portion of the Newman decision without an en banc hearing or explicit support in the Salman decision. Martoma then petitioned for rehearing.

In its amended opinion, the panel revised its original decision in a way that makes clear that it no longer challenges Newman directly. Instead, the panel wrote that it "need not decide" whether Newman's interpretation of the gift theory of tippee liability survives Salman, because in any event the "meaningfully close personal relationship" test can be satisfied where the tipper and tippee share a relationship suggesting a quid pro quo, or the tipper gifted the inside information with the intent to benefit the tippee. Indeed, the panel noted that it agreed with Martoma that the jury instructions were inconsistent with Newman and therefore incorrect. The panel, however, also found that the incorrect instructions did not constitute an obvious error, and in any event did not impair Martoma's substantial rights because there was "compelling evidence" that at least one tipper received the benefit of $70,000 in consulting fees – which would suggest a quid pro quo and thus a meaningfully close relationship. It therefore affirmed Martoma's conviction.

A significant aspect of the panel's amended decision is its holding that, although Newman's "meaningfully close personal relationship" test survives, evidence of the intent to benefit a tippee alone can be enough to satisfy that test. In dissent, one judge criticized this approach for permitting the test to be satisfied without any objective evidence as to the relationship between the tipper and the tippee. The holding may thus give prosecutors another option for satisfying Newman's requirements, although obtaining a conviction will remain highly dependent on the facts of each case.

Perhaps more important, neither the original panel decision in Martoma nor the amended panel decision do anything to call into question the more significant holding in Newman – that a remote tippee cannot be convicted in the absence of proof that he or she knew of the personal benefit received by the tipper. That holding remains unquestioned and stands as a significant limitation on the government's ability to prosecute alleged remote tippees.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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