The contours of insider trading liability: Will Salman overturn Newman?

February 22, 2016

Westlaw Journals Commentary thumbThe U.S. Supreme Court recently agreed to address — and hopefully clarify — the “personal benefit” element of insider trading liability that it first articulated over 30 years ago. In Dirks v. Securities and Exchange Commission, 463 U.S. 646 (1983), the Supreme Court held that a recipient of material nonpublic information from a corporate insider who trades on such information is liable for insider trading only when the insider “personally will benefit, directly or indirectly, from his disclosure” of the tip.

In elaborating on how the personal benefit element might be proven, the high court in Dirks stressed the need to “focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary or a reputational benefit that will translate into future earnings.”

While the court acknowledged that a personal relationship could satisfy that standard, it required “objective facts and circumstances” to justify an inference of a quid pro quo or “an intention to benefit the particular recipient.” It also said that under certain circumstances, the “gift of confidential information to a trading relative or friend” could satisfy this requirement.

The 2nd U.S. Circuit Court of Appeals in United States v. Newman, 773 F.3d 438 (2d Cir. 2014), and the 9th U.S. Circuit Court of Appeals in United States v. Salman, 792 F.3d 1087 (9th Cir. 2015), have both recently considered the application of Dirks’ personal benefit requirement.

The 2nd Circuit in Newman held that inferring a personal benefit from a personal relationship between an insider and tippee requires “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,” adding that mere friendship is not enough.

This decision, which has been criticized as requiring more evidence of a personal benefit than Dirks envisioned, has led to a host of appeals, overturned a number of insider trading convictions and left lawyers to deal with the most uncertain insider trading landscape in memory.

Amid the controversy surrounding Newman and its progeny, the 9th Circuit jumped into the fray with its own interpretation by holding in Salman that an insider’s tip to his brother constituted “a gift of confidential information” that qualified as a personal benefit under Dirks.

Both decisions were appealed to the Supreme Court, and both petitions described the two decisions as contradictory. The Supreme Court denied certiorari in Newman but, three months later, granted certiorari in Salman. Assuming the two decisions truly conflict, the Supreme Court’s decision to accept certiorari in only Salman is puzzling. Although the petitions and their oppositions suggest several possible explanations, a close reading of the two cases shows they are so factually distinct that they may not be in disagreement.

As a result, the Supreme Court’s resolution of Salman may not necessarily address or impact Newman, leaving unsettled the issue of whether, and to what extent, Newman permissibly departed from Dirks.

The 2nd Circuit’s decision in Newman

In Newman defendants Todd Newman and Anthony Chiasson were so-called remote tippees, three or four levels removed from the corporate insiders who passed inside information through two separate “tipping chains.” At trial, the government established that in one tipping chain, the insider and first-level tippee attended business school together and the insider sought career advice from the first-level tippee. With respect to the second tipping chain, the government established that the insider and first-level tippee were “‘family friends’ who had met through church and occasionally socialized together.”

The government said these relationships were sufficient to prove that the insiders received the requisite personal benefit in exchange for tipping the first-level tippees.

The 2nd Circuit reversed Newman and Chiasson’s convictions for two reasons. First, it found the government failed to present sufficient evidence that the insiders received a personal benefit in exchange for their tips. It held that the receipt of personal benefit may not be proven “by the mere fact of a friendship, particularly of a casual or social nature,” because such a low standard would render Dirks’ personal benefit requirement “a nullity.”

The court further noted that “[t]o the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee … we hold that 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.”

The court said a second basis for reversal was that the government presented “absolutely no testimony or any other evidence” that the defendants knew the insiders received any benefit for their tips.

The 9th Circuit’s decision in Salman

On July 6, 2015, a panel of the 9th Circuit, which included U.S. District Judge Jed S. Rakoff of the Southern District of New York sitting by designation, decided Salman. In this case, an insider tipped his brother, with whom he “enjoyed a close and mutually beneficial relationship.” The brother then tipped the insider’s brother-in-law, Bassam Salman, with whom he had developed a close relationship. At Salman’s trial, the insider testified that “he loved his brother very much” and that he gave his brother inside information “to benefit him and to fulfill whatever needs he had.” The government also presented evidence that Salman knew about the close relationship between the insider and his brother.

Salman appealed his conviction to the 9th Circuit, relying on Newman to argue that the evidence was insufficient to establish that the insider in this case received a personal benefit in exchange for providing tips to his brother, the first-level tippee.

Affirming the conviction, the 9th Circuit noted that the case was directly governed by the following language in Dirks: “The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.” The court held the insider’s testimony clearly established that his tips were “a gift of confidential information” under Dirks.

The 9th Circuit rejected Salman’s argument that Newman required the government to prove that the insider received a “tangible benefit” in exchange for the tips. The court noted that “[t]o the extent Newman can be read to go so far, we decline to follow it. Doing so would require us to depart from the clear holding of Dirks.”

The petitions for certiorari

A few weeks after Salman was decided, on July 30, 2015, the government filed its petition for certiorari in Newman, asking the Supreme Court to consider whether the 2nd Circuit “erroneously departed from this court’s decision in Dirks by holding that liability under a gifting theory requires ‘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.’”

In its petition, the government emphasized that the Newman decision conflicts with Salman and an older 7th Circuit decision. Despite the perceived conflict between the circuits and the solicitor general’s request for review, the Supreme Court denied the government’s petition in Newman on Oct. 5.

Subsequently, on Nov. 10, Salman filed his petition for certiorari, asking the Supreme Court to address two questions, the first of which was:

Does the personal benefit to the insider that is necessary to establish insider trading under Dirks v. SEC, 463 U.S. 646 (1983), require proof of “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature,” as the 2nd Circuit held in United States v. Newman, 773 F.3d 438 (2d Cir. 2014), cert. denied, No. 15-137 (U.S. Oct. 5, 2015), or is it enough that the insider and the tippee shared a close family relationship, as the 9th Circuit held in this case?

In his petition, Salman pressed the government’s argument in the previously filed Newman petition to his own advantage, citing it to highlight why, in the government’s previous estimation, the Supreme Court should grant certiorari: the apparent conflict between Newman and Salman, and the importance of clarifying the contours of insider trading liability.

On Jan. 19, the Supreme Court granted certiorari as to the first question presented in Salman’s petition. Salman v. United States, No. 15-628, cert. granted, 2016 WL 207256 (U.S. Jan. 19, 2016).

Why yes to one and no to the other?

In light of its denial of the government’s petition in Newman, the Supreme Court’s grant of Salman’s petition has been the subject of much commentary. If the circuit split existed at the time the government petitioned in Newman, why would the court deny that petition, only to grant certiorari three months later on the same issue?

Indeed, in opposing Salman’s petition, the government argued that “no meaningful developments have taken place in the short space of time since this court considered and denied the Newman petition.”

There are, however, key differences between Newman and Salman that could explain the Supreme Court’s grant of Salman’s petition and denial of the government’s petition in Newman. First, as Newman argued in his opposition to the government’s petition for certiorari, the procedural posture of Newman rendered the case inappropriate for Supreme Court resolution.

As explained above, the 2nd Circuit reversed the defendants’ convictions on two grounds: insufficient evidence of personal benefit to the insiders, and insufficient evidence of the defendants’ knowledge of the personal benefit to the insiders.

The issue presented in the government’s petition appealed the 2nd Circuit’s ruling only as to the insufficiency of evidence of personal benefit. Thus, Newman argued, even if the Supreme Court had reversed the 2nd Circuit on this issue, “the ultimate disposition of this case” would not have changed because of the insufficient evidence of the defendants’ knowledge of the insiders’ personal benefit.

Because “the Supreme Court does not grant review to issue advisory opinions,” Newman urged the court to deny the government’s petition.

Salman used Newman’s argument for his own use when he asked the Supreme Court to grant his petition: He argued that, unlike Newman, which was a “poor vehicle for resolving the definition of ‘personal benefit,’” Salman’s case presented “the ideal vehicle” for addressing the same issue because “resolution of the question is indisputably outcome-determinative.” It is therefore possible that the Supreme Court believed the question presented in Newman was worthy of its consideration but the case was not in the right procedural posture for determination.

Because resolution of the issue could result in the reversal of Salman’s conviction, that same argument did not apply in his case.

Additionally, the government’s Newman petition argued that the ostensible circuit split between the 2nd Circuit and 9th Circuit “raises the specter of uneven enforcement of the securities laws against individuals who are all participating in the same nationwide capital markets.” While the Supreme Court may not have been persuaded by this argument in Newman, where “uneven enforcement of the securities laws” arguably disadvantaged the government, it may very well have considered the argument in Salman, where such “uneven enforcement” resulted in Salman’s imprisonment in the 9th Circuit for conduct for which he would not have been convicted under the law in the 2nd Circuit.

The potential impact of Salman

Both the government’s Newman petition and Salman’s petition emphasized the circuit split between the 2nd and 9th circuits. Indeed, the question presented in Salman’s petition expresses the holdings of the two cases as direct alternatives to one another. However, commentators have questioned whether the two decisions are actually in conflict, given crucial factual differences between the two cases.

The evidence in Newman was, in the words of the 2nd Circuit, “simply too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips.”  The relationships between the insiders and first-level tippees were so casual that it was unreasonable to infer a quid pro quo or an intention to gift the inside information to the first-level tippees.

In contrast, in Salman the 9th Circuit determined that the sibling relationship between the insider and first-level tippee, coupled with the insider’s testimony that he wished to benefit his brother, with whom he had a close relationship, sufficiently “resemble[d] trading by the insider himself followed by a gift of the profits to the recipient” under Dirks.

Because of these key differences between the cases, the Supreme Court could simply affirm Salman, which found that evidence of a close family relationship sufficiently established a personal benefit to the insider, as a straightforward application of the clear language in Dirks.

Such a decision, based on the facts in Salman, would not necessarily impact Newman, which required more than simple evidence of a casual relationship to meet Dirks’ personal benefit requirement. Alternatively, the court could embrace the characterization of Newman and Salman as a circuit split and address both decisions’ legal interpretation of the personal benefit requirement. A decision by the high court to pursue the latter path would certainly have more far-reaching potential implications for insider trading liability.

Whether the Supreme Court addresses only Salman on its facts, or also chooses to wrestle with the more controversial Newman opinion, its decision in Salman will provide much-needed guidance regarding the contours of insider trading liability.