A recent series of court decisions blurred the distinction between legal and illegal insider trading. These decisions will ultimately lead to worse outcomes for those charged with insider trading violations. What is insider trading? This conduct occurs when a person with access to non-public, material information takes that information and uses it to either buy or sell a security. ((Insider Trading, Investopedia, http://www.investopedia.com/terms/i/insidertrading.asp.)) Insider trading is a violation of § 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5, which was promulgated by the Securities and Exchange Commission (“SEC”). ((15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5.))
Both the Supreme Court and federal circuit courts of appeals continue to change the tests that determine liability under insider trading laws. ((See United States v. Martoma, 869 F.3d 58 (2nd Cir. 2017.)) Over time, courts have gone back and forth between expanding and narrowing the scope of liability. ((See id.)) These different theories and tests oscillate from vague to specific to vague. ((See id.)) Two theories have historically determined liability for insider trading: (1) the classical theory and (2) the misappropriation theory ((Id. at 63.)) Under the classical theory, an individual trading in securities of his corporation based on confidential information violates insider trading law by because there is a relationship of trust and confidence between shareholders of a corporation and the insider. ((United States v. O’Hagan, 521 U.S. 642, 651-52 (1997).)). Misappropriation theory applies when the insider misappropriates confidential information, in a breach of a duty owed to the source of the information, for trading purposes. ((Chiarella v. United States, 445 U.S. 222, 223 (1980).))
In 1983, the Supreme Court held that a tippee (the receiver of insider information) can be liable for trading on information when the insider breaches his fiduciary duty to the shareholders of the corporation by disclosing the information to the tippee, who knows that the insider breached his duty. ((Dirks v. S.E.C., 463 U.S. 646, 660 (1982).)) The Dirks court laid out an important test: there is a breach of duty if the tipper personally benefits, directly or indirectly, from the disclosure of information to the tippee. ((Id. at 662.)) Either a pecuniary gain or a reputational benefit were considered to be sufficient direct or indirect personal benefits. ((Id. at 663.))
Three years ago, the Second Circuit revisited the Dirks decision and came to its own conclusion: while the tippee still needs to receive a personal benefit, if the tipper and the tippee have a “meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of pecuniary or similarly valuable nature,” then this is sufficient to establish liability. ((United States v. Newman, 773 F.3d 438, 452 (2nd Cir. 2014); Matt Levine, Everything is Insider Trading Again, Bloomberg (Aug. 24, 12:14 PM), https://www.bloomberg.com/view/articles/2017-08-24/martoma-ruling-shows-that-everything-is-insider-trading-again.))
Last year, the Supreme Court further expanded the test for insider trader liability when it held that the tipper’s received benefit need not be pecuniary. ((See Salman v. United States, 137 S.Ct 420, 422.)) Now, when a tipper discloses inside information to a tippee, courts will treat the situation as if the tipper gave the tippee a cash gift. ((Id. at 428.)) According to Salman, this holding applies to tipping family members and friends. ((Id.)) Gifting information to a family member or friend therefore qualifies as insider trading because the tipper still ostensibly benefits from this gift. ((Id.; Levine, supra note 12.)) As the majority opinion explained, “In such situations, the tipper benefits personally because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.” ((137 S.Ct at 428.))
Although the Court came up with a new test, it did not explicitly overrule Newman. ((See id.)) The Court also neglected to define how close a relationship must be between the tipper and the tippee for the new rule to apply. ((Peter J. Henning, Insider Trading Case to be a Test of the Role of Friendship, N.Y. Times: Deal Book (Aug. 21, 2017), https://www.nytimes.com/2017/08/21/business/dealbook/insider-trading-case-will-test-the-role-of-friendship.html.)) From acquaintances to friends to close friends, anyone could, in theory, qualify a tipper given the vagueness of the language utilized by the Court. Nonetheless, this decision remains good law.
Under the Salman decision, does a tipper need to have a close personal relationship with the tippee? The Second Circuit finally answered this question last month when a three-judge panel heard Matthew Martoma’s appeal and ruled that a personal relationship was not necessary, and thus overruled Newman. ((United States v. Martoma, 869 F.3d 58, 69 (2nd Cir. 2017); Alexandra Stevenson, Matthew Martoma’s Insider Trading Conviction is Upheld, N.Y. Times: Deal Book (Aug. 23, 2017), https://www.nytimes.com/2017/08/23/business/dealbook/mathew-martoma-insider-trading-conviction-upheld.html.)) The defendant in this case, Matthew Martoma, managed Steve Cohen’s portfolio at a hedge fund. ((869 F.3d 58 at 61.)) Martoma planned to invest in two pharmaceutical companies’ stocks because these companies were developing drugs for Alzheimer’s and he thought that these stocks would fare well in the market ((Id. at 62.)) He then purchased the stocks for Cohen. ((Id.)) Martoma consulted with a knowledgeable doctor right after he purchased the stocks for Cohen. ((Id. at 61.)) Dr. Gilman charged him $1,000 per hour, and Martoma consulted him on forty-three different occasions. ((Id. at 62.)) Gilman provided Martoma with confidential information about the drug. ((Id.)) In July 2008, the two met to discuss data on the drug. ((Id.)) After this meeting, Martoma no longer believed that the stocks were profitable. ((See id.)) He quickly contacted Cohen and convinced him to sell his position in these companies because he knew that Cohen would save money if he did this. ((See Stevenson, supra note 19.)) He was right. Cohen avoided a $144.6 million loss, followed by an $80.3 million gain after he short-sold the stocks. ((869 F.3d 58 at 62.)) But Cohen was not the only one who benefitted: Martoma gained a $9 million bonus for his trading activity. ((Id. at 62.))
On appeal, the Second Circuit opined that the Salman court already overruled Newman’s requirement of a close personal relationship. ((Martoma, F.3d 58, at 69.)) This was no longer good law and, therefore, this was no longer necessary. ((Id.)) According to the majority opinion, a tipper personally benefits from disclosing insider information so long as he expects that the tippee will trade on the information. ((Id.at 71.)) His disclosure must also result in a “gift of profits to the recipient.” ((Id.))
Defendants in the Second Circuit are now likely to have a more difficult time prevailing in insider trading cases because the Martoma holding is overly broad and vague. ((See Walter Pavlo, Prosecuting Insider Trading Cases Just Got Easier: The Martoma Decision, Forbes (Sep. 6, 2017), https://www.forbes.com/sites/walterpavlo/2017/09/06/prosecuting-insider-trading-cases-just-got-easier-the-martoma-decision/#7c587a321bf0.)) How will this affect pending and future cases? These defendants will likely either plead immediately, or receive a guilty verdict upon trial.
One pending case in the Second Circuit involves a former Bank of America employee named Daniel Rivas. ((Peter J. Henning, Insider Trading Case to be a Test of the Role of Friendship, N.Y. Times: Deal Book (Aug. 21, 2017), https://www.nytimes.com/2017/08/21/business/dealbook/insider-trading-case-will-test-the-role-of-friendship.html.)) While Rivas worked in the bank’s Capital Markets group, he had access to confidential information regarding ongoing and future deals. ((Id.)) But he did not keep this information confidential. ((Id.)) He instead leaked information to several people, who traded on this information. ((Id.)) Defendants obtained over five million dollars in profits as a result of these trades. ((Id.)) Rivas had no choice and quickly pled guilty to tipping three different sets of people. ((See id.)) He is now trying to cooperate with the government. ((Id.))
Now that the Second Circuit no longer requires there be a “close relationship” between the tipper and the tippee to trigger liability, other defendants involved in the Rivas’ case will likely obtain negative outcomes in court. ((See Peter J. Henning, Insider Trading Case to be a Test of the Role of Friendship, N.Y. Times: Deal Book (Aug. 21, 2017), https://www.nytimes.com/2017/08/21/business/dealbook/insider-trading-case-will-test-the-role-of-friendship.html.)) One of the people that Rivas tipped was James Moodhe, his girlfriend’s father. ((Id.)) Moodhe also pled guilty to insider trading. ((Id.)) While Moodhe has pleaded guilty, one of the people he tipped, Michael Siva, has not. ((See Erik Larson, Ex-Morgan Stanley Broker Pleads Not Guilty to Insider Trades, Bloomberg (Sept. 5, 2017), https://www.bloomberg.com/news/articles/2017-09-05/ex-morgan-stanley-broker-pleads-not-guilty-to-insider-trading.)) Moodhe took the information that he learned from Rivas and tipped his old stock broker, Michael Siva. He either tipped him through code phrases over the telephone, or by reading the information aloud at secret meetings. ((Id.)) Either way, Siva obtained valuable information and used this information to execute profitable trades for both himself and his clients. ((Id.)) Very little information is currently available about his prosecution, however, the court just set his bail last month. ((Id.))
Given the recent Second Circuit holding, Siva will be unlikely to prevail in his case. Moodhe’s disclosure of this confidential information was no accident. ((See id.)) A person can easily assume that Moodhe expected Siva to trade on the information that he tipped him. Not to mention, Siva traded on the information and made a hefty profit. ((Id.)) Under the Martoma standard, in this case, Siva’s conduct therefore meets both conditions. ((See id.)). If the information that the prosecutors provided is true then he is liable for insider trading violations. And he is therefore likely to see a guilty verdict in court unless he willingly pleads sooner. Although the court could rule in his favor, the chances of this are increasingly slim.
Providing a gift to a recipient in a commercial relationship is now sufficient to trigger liability for insider trading. ((Matt Levine, Everything is Insider Trading Again, Bloomberg (Aug. 24, 12:14 PM), https://www.bloomberg.com/view/articles/2017-08-24/martoma-ruling-shows-that-everything-is-insider-trading-again.)) This holding is problematic for defendants because the test is completely fact-based. ((See 869 F.3d 58 71)). It therefore gives prosecutors the ability to charge many people with insider trading violations. ((See Walter Pavlo, Prosecuting Insider Trading Cases Just Got Easier: The Martoma Decision, Forbes (Sept. 6, 2017, https://www.forbes.com/sites/walterpavlo/2017/09/06/prosecuting-insider-trading-cases-just-got-easier-the-martoma-decision/#7c587a321bf0.)) “With this decision, prosecutors now have more leeway than they did after Newman.” ((Id.)) But this holding is even more problematic for defendants because it means that people should be very careful in the way they communicate with others about any kind of confidential information.
Can people “legally” trade on information? Unless the Supreme Court has a chance to rule otherwise, many people who work in the commercial world, their friends, and anyone who might receive information from them are walking on thin ice. This decision leaves the business world with a lot of uncertainty, and hopefully with more caution in disclosing valuable business information.
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