The Evolution of Insider Trading
Daniel M. Wiesenfeld
In Salman v. United States, 137 S. Ct. 420 (2016), the Supreme Court resolved a circuit split on a key insider trading issue. The Salman Court affirmed the Ninth Circuit’s conviction of a tipee who traded on a relative’s inside information, broadening the scope of insider trading. The Court’s path to this decision has been long and bears review for those in white collar practice.
Modern American insider trading law began in the 1960’s, when the SEC promulgated Rule 10b-5. The SEC wrote 10b-5 as an anti-fraud statute. Federal courts interpreted Rule 10b-5 to impose a duty on company insiders to disclose material corporate information or refrain from trading on it. The broad language of Rule 10b-5 allowed Federal Courts to use it as a powerful tool against insider trading. However, Courts still had to assess the scope of insider trading law. Courts grappled with the difficult task of determining who, outside of corporate insiders, can be prosecuted for insider trading. It may be easy to argue that the CEO who trades on material, non-public information can be convicted under Rule 10b-5. The waters become murkier when we started inquiring about “company outsiders” who can be as familiar with the intimate details of a company as its “insiders” are. Does the scope of Rule 10b-5 reach professional advisers to the company, such as outside legal counsel and investment bankers, who trade on material, non-public information?
The Second Circuit initially interpreted Rule 10b-5 to extend to these professional advisers—and to Joe Schmo and anyone else who could get ahold of a broker and trade securities on the open market. Promoting the “equal access theory” of insider trading, the Second Circuit held that the essence of Rule 10b-5 is that anyone who has “access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone” may not take advantage of the informational edge they hold over the investing public. The Second Circuit’s policy rationale for prohibiting anyone and everyone from trading on insider information was the belief that all investors should have “equal access to material information.”
However, the Supreme Court would eventually reject this first attempt at understanding the contours of insider trading. In United States v. Chiarella, 445 U.S. 222 (1980), the Supreme Court began to think about the scope of insider trading in terms of duty as opposed to equity. Rejecting the “equal access” theory, the Court in Chiarella used the concept of fiduciary duty to limit the previously expansive scope of insider trading under Rule 10b-5. In Chiarella, the Court overturned the criminal conviction of a financial printer who bought stock in the target company of a pending takeover bid based on inside information he did not disclose prior to trading. The Defendant got wind of the takeover bid because documents announcing the takeover bid were sent to his printer with the names of both companies blocked out. However, the Defendant was able to deduce the name of the target company from other information in the documents.
The Court in Chiarella held that insider trading stems from a duty to disclose, which only arises when “one party has information that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them.” The Court found that Defendant was not a corporate insider of the takeover company, nor did he receive confidential information from the takeover company. Therefore, he did not owe a fiduciary duty to the takeover company that would subject his trade to insider trading under Rule 10b-5. The Court further repudiated the “equal access” theory by emphasizing that Defendant does not have a duty to disclose to those he bought stock from because he was a “complete stranger who dealt with the sellers only through impersonal market transactions.” In other words, the Court expressed skepticism at the implicit assumption of the “equal access theory,” namely that all investors have a general duty to the market as a whole to refrain from trading on material, nonpublic information. The Court was reluctant to formulate such a broad duty to disclose, which did not require any kind of specific relationship between the two parties, in the absence of congressional intent to affect such a broad rule of insider trading liability. In Dirks v. S.E.C., 463 U.S. 646 (1983), the Supreme Court extended this narrower duty to disclose to professional fiduciaries, such as “accountants, lawyers, and consultants”, acting on behalf of the corporation and its shareholders.
The Supreme Court’s “fiduciary duty” theory of insider trading liability came to be known as the “classical theory” with the emergence of the “misappropriation theory”. In U.S. v. Carpenter, 484 U.S. 19 (1987), the Supreme Court expanded the scope of insider trading liability by convicting the Defendant even though he did not trade in the stock of the company from which he received the confidential information. The Defendant learned of the confidential information about certain stocks from his employer for the purpose of doing his job and not for trading on such information. Thus, an employee’s breach of confidentiality can serve as the fraud for finding an insider trading violation, even if the employee does not trade in the employer’s stock.
What would have happened if instead of trading on the confidential information, Carpenter instead tipped someone else about the information, who then traded on it? The Second Circuit in U.S. v. Newman, 773 F.3d 438 (2d Cir. 2014), fleshed out the legal standard for tipper-tippee liability. In Newman, the Government alleged that analysts received information from insiders at Dell and NVIDIA disclosing those companies’ earnings numbers before they were publicly released. These analysts then tipped their portfolio managers, the Defendants, who, in turn, traded and earned millions of dollars for their funds. The Government argued that it was not required to prove that the defendant tippees knew that the tippers received a personal benefit in order to be found guilty of insider trading. However, the Second Circuit relied on Dirks in exonerating the Defendants. The Second Circuit used Dirks’ legal reasoning that the tippee’s liability derives only from the tipper’s breach of a fiduciary duty, not from trading on material, non-public information. The tipper can only breach his fiduciary duty if he receives a “personal benefit” for providing the tip. Therefore, the tippee can only be liable for insider trading if he knows that the insider tipper breached his fiduciary duty, and he can only know of such breach if he knows that the insiders received a personal benefit. Since the tippee Defendants were far removed from the insiders at Dell and NVIDIA, they could not have known that these insider tippers received a personal benefit.
Soon after the Second Circuit significantly raised the legal standard for insider trading convictions, the Ninth Circuit in Salman v. United States, 792 F.3d 1087 (9th Cir. 2015), lessened the burden on prosecutors by defining “personal benefit” broadly. In Salman, the Defendant tippee traded on inside information he received from his relative, who in turn received the information from his brother, a former investment banker at Citigroup. The Second Circuit, on the other hand, decided that Dirks does not permit a factfinder to infer a personal benefit to the tipper from a gift of confidential information to a trading relative or friend, unless there is “proof of a meaningfully close personal relationship.” The Ninth Circuit created a circuit split by holding that a tipper receives a personal benefit, and the tippee knows of such a benefit, when the tipper made “a gift of confidential information to a trading relative.”
Faced with a Circuit split and two conflicting interpretations of Dirks, the Supreme Court in Salman sided with and affirmed the prosecutor-friendly holding of the Ninth Circuit. The Supreme Court held that the Ninth Circuit properly applied Dirks to affirm Salman’s conviction. After the decision in Salman, the jury could infer under Dirks that the tipper personally benefited from making a gift of confidential information to a trading relative.
Questions remain in the aftermath of Salman: how close does the tipper-tippee relationship have to be to carry a presumption of the tipper receiving a personal benefit? Granted, close blood relatives qualify under Salman. But what about more distant relatives? How about close friends? Federal courts may encounter such questions in the not-too-distant future. In the meantime, cousins and friends everywhere aspiring to keep themselves out of federal prison and and their names out of future casebooks would be wise to refrain from sharing inside information with each other.
Daniel M Wiesenfeld is a Quorum Editor and a J.D. candidate, Class of 2018, at N.Y.U. School of Law.