United States: Second Circuit Court Of Appeals Expands Insider Trading Liability

On August 23, 2017, the Second Circuit Court of Appeals affirmed the insider trading conviction of Matthew Martoma, a former portfolio manager for SAC Capital Advisors LLP ("SAC Capital"). In doing so, the court overturned part of United States v. Newman and expanded the scope of insider trading liability. This is the third time in less than three years that a major court decision has shifted the balance on the scope of insider trading liability. See United States v. Martoma, No. 14-3599 (2d Cir. Aug. 23, 2017), applying Salman v. United States, 137 S. Ct. 420 (2016) to further limit United States v. Newman, 773 F.3d 438 (2d Cir. 2014).

Courts have repeatedly recognized that not all trading on material, nonpublic information runs afoul of insider trading law. Insider trading liability includes instances when a corporate insider (tipper) breaches a fiduciary duty and discloses confidential corporate information to a recipient (tippee) in exchange for a personal benefit. The personal benefit to the tipper can take the form of a financial or reputational benefit. Prior to Martoma, fact-finders in the Second Circuit were permitted to infer that "gifts" of inside information, (i.e., disclosures of information made without a financial gain to the tipper), provided the requisite personal benefit only if there was a "meaningfully close personal relationship" between the tipper and tippee. The court in Martoma eviscerated this limitation, holding that the personal benefit test is satisfied whenever (i) inside information is disclosed with the expectation that the tippee would trade on the information, and (ii) the disclosure resembles trading by the tipper followed by a gift of the profits to the tippee, regardless of whether or not there was a meaningfully close personal relationship between tipper and tippee.

It is unclear how lower courts will apply the new personal benefit test. Moreover, the ruling could be reversed by an en banc review or by the Supreme Court. However, if the ruling stands, Martoma likely gives prosecutors and regulators more latitude to charge insider trading cases when they cannot prove a quid pro quo financial arrangement between a tipper and a tippee.

The Personal Benefit Test Prior to Martoma

In Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court held that tippees will be liable for insider trading only when "the insider receives a direct or indirect personal benefit from the disclosure" of the material nonpublic information at issue. To determine liability under this test, Dirks directed courts to examine "objective criteria," such as whether the tipper's disclosure resulted in a "pecuniary gain or a reputational benefit that will translate into future earnings." A quid pro quo arrangement between a tipper and tippee to disclose confidential information in exchange for financial compensation obviously meets this test. The Court observed that liability under this standard could also attach when "an insider makes a gift of confidential information to a trading relative or friend," since the "tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient." Yet, Dirks acknowledged that "[d]etermining whether an insider personally benefits from a particular disclosure, a question of fact, will not always be easy for courts."

In December 2014, the Second Circuit, in United States v. Newman, adopted a narrow reading of the Dirks personal benefit test, holding that a tipper's "gift" of inside information to another person will give rise to liability only when there is "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 [for the tipper]." Just nine months ago, the Supreme Court, in Salman v. United States, rejected Newman to the extent it held that the personal benefit test required "at least a potential gain of a pecuniary or similarly valuable nature[.]" Salman explained that an insider who gifts information to "a trading relative or friend[,]" as was the case in Salman, receives a sufficient personal benefit to establish a breach of a fiduciary duty, without any additional pecuniary benefit, because "giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds."

In Salman, both the Ninth Circuit and the Supreme Court held that Dirks itself decided that "the personal benefit test" for liability is met in the particular case "when an insider makes a gift of confidential information to a trading relative or friend." To the extent that the Second Circuit in Newman applied some additional requirement in the case of a gift to family or friends, Salman declined to follow it. At the same time, Salman had no occasion to consider whether the "meaningfully close personal relationship" specified by Newman was in fact required to make an insider liable for other gifts of material non-public information.

The Martoma Case

In 2014, Matthew Martoma, a former portfolio manager at SAC Capital, was convicted and sentenced to nine-years in prison for insider trading. Martoma obtained material, non-public information from two doctors who were working on clinical trials for an experimental drug to treat Alzheimer's disease. One of the doctors gave Martoma advance notice of data that indicated the drug was not as effective as previously believed. SAC Capital owned stock in the two pharmaceutical companies that were jointly developing the drug. Martoma caused SAC Capital to short the stocks of the two pharmaceutical companies in advance of the public disclosure of the negative news, resulting in an $80.3 million gain and the avoidance of a $194.6 million loss.

SAC Capital paid the doctor who disclosed the negative information to Martoma for approximately 43 consultations at a rate of $1,000 an hour. SAC Capital did not pay the doctor for the specific conversations and meetings with Martoma that resulted in the disclosure of the negative inside information at issue. Martoma appealed his conviction, arguing, among other things, that he did not have "a meaningfully close personal relationship" with the doctor as required by Newman to allow the jury to infer that the doctor obtained a personal benefit from the disclosure that could give rise to insider trading liability.

The Second Circuit's Decision

In a 2-1 decision, the Second Circuit affirmed Martoma's conviction, holding that the Supreme Court's reasoning in Salman "abrogated Newman's 'meaningfully close personal relationship' requirement."1 The court explained that "when confidential information is given as a gift, it is 'the same thing as trading by the tipper followed by a gift of the proceeds' and is thus the functional equivalent of a cash gift." The court found no reason to distinguish between gifts to individuals with whom the tipper shares a close personal relationship, and gifts to those with whom the tipper does not share such a relationship. To illustrate its point, the court proffered a hypothetical example of a corporate insider, who instead of giving cash to his doorman at the end of the year, gave a tip of inside information with instructions to trade on the information. The court explained that this example was a clear violation of insider trading law despite the absence of a "meaningfully close personal relationship" between the tipper and tippee. The court, citing Salman, explained that regardless of whether there is a close personal relationship between the tipper and tippee, a fact-finder can infer that a tipper obtained a personal benefit from a disclosure of confidential information when the disclosure is made "with the expectation that [the recipient] would trade on it, and that the disclosure resemble[s] trading by the insider followed by a gift of the profits to the recipient[.]" The court declined to describe the outer boundaries of when a jury was entitled to rely on circumstantial evidence to infer that a particular disclosure met the new personal benefit test.

Judge Pooler dissented from the court's opinion, writing that "the majority strips the long-standing personal benefit rule of its limiting power." Judge Pooler further wrote that the new test announced by the court is vague and subjective and that "[a]ny disclosure of material, non-public information clearly resembles a gift, in that it provides the recipient with something of value." Judge Pooler expressed her concern that "[j]uries, and, more dangerously, prosecutors, can now seize on this vagueness and subjectivity. The result will be liability in many cases where it could not previously lie."

Takeaways and Implications

While somewhat vague and ill-defined itself, the "meaningfully close personal relationship" requirement of Newman provided a more objectively verifiable limitation on when gifts could provide a basis for insider trading liability than the new test announced by Martoma. The requirement was met in Salman with the close relationship between brothers. It was not met in Newman, where a tipper and tippee were acquaintances from school and work but were not "close." Where courts would have ultimately drawn the line between "meaningfully close personal relationships" and other types of relationships was uncertain. Nevertheless, the nature of relationships could have been established by objective evidence of interactions between individuals over the course of the relationship. This is in contrast to the new personal benefit test, which requires prosecutors to establish a tipper's state of mind at a particular moment. This can be done through direct evidence, such as admissions by the tipper, or communications (emails or recorded conversations) that show the tipper's expectation at the time of the disclosure. However, prosecutors may bring a case based solely on circumstantial evidence to show a tipper's state of mind. This circumstantial evidence may be limited to the circumstances surrounding the disclosure of information and the nature of the relationship between tipper and tippee, which need not rise to any specified level. This gives prosecutors more leeway to charge insider trading cases. 

Although the Martoma case was a criminal case, its holding will apply in the context of civil insider trading cases as well. The SEC, unlike criminal prosecutors, may rely upon a tipper's recklessness to meet its lower burden of proof in any litigation. Thus, while criminal prosecutors must prove that the tipper actually had the expectation that the tippee would trade on the disclosed information, the SEC need only prove that the tipper was reckless in not knowing the tippee would trade on such information. With its lower burden of proof, the SEC may be even more aggressive in pursuing the outer boundaries of insider trading liability.

The goal for business entities and individuals should be to avoid being investigated in the first instance. Once initiated, government investigations can take on a life of their own, moving across subject-matters and jurisdictions, at great cost in terms of money, time and resource diversion, to the subjects of the investigation. Public disclosure of an investigation, even without formal charges, can seriously damage the reputation of an entity or individual.

With this in mind, the changing theories of liability for insider trading should not drive how entities or individuals handle confidential corporate information. The goal should be avoiding questionable activity that could lead to a government investigation. Business entities should implement and enforce policies around the handling of confidential corporate information with this goal. To use the court's hypothetical (and New York-centric) example, corporate insiders should not be tipping doormen with inside information at any time, regardless of the Martoma decision. The government has more tools than ever before to detect insider trading, and the chances of engaging in aberrational trading and escaping investigation are lower than they ever have been.

Conclusion

It remains to be seen if Martoma will survive en banc or Supreme Court review. If it does, Martoma gives prosecutors and regulators more leeway to charge insider trading cases when they cannot prove a quid pro quo financial arrangement between a tipper and tippee. Companies should make certain they have adopted and implemented policies that will prevent and detect conduct that could trigger a government investigation.

Footnote

1 The court also ruled that the evidence at trial was sufficient to prove that the doctor's disclosure of confidential information was part of a pecuniary quid pro quo relationship between the doctor and Martoma based on the 43 prior consultations for which the doctor received compensation. The court explained that "having the opportunity to yield future pecuniary gain, constituted a personal benefit giving rise to insider trading liability."

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.