The Second Circuit has spoken…again. For what seems like the umpteenth time in three years, twice on the same case US v. Martoma, the Circuit put pen to paper to address the controversial personal benefit issue. To understand how we got here…here is a, sort of, brief recap.
Newman shook up the legal world. In US v. Newman, the Second Circuit held that personal benefit (and remember we are talking about it only in relation to a tipper making an improper gift of confidential information to a trading relative or friend) existed where there was 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.” This raised all kinds of hullabaloo (yes, I just used the word hullabaloo). Some of us thought Newman was brilliant, some thought it was a disaster.
It is fair to say that Newman tried to stand for the rule of reason, plain and simple. That rule is that no one would gift a tip worth potentially millions of dollars (and risk his job and prison) to some dude they went to college with, or with whom they attended church. But lawyers being what we are, had to try to dissect every word, to twist and turn the language into something it was not. Rather than simply accept the premise that people give expensive gifts only to their close friends and relatives, defendants tried to apply the language in ways that did not make sense and in ways which the Second Circuit did not intend.
Enter Salman. US v. Salman took issue with Newman…but sort of did so for no good reason. Salman (which went to the Supreme Court) was a case where one brother tipped another allowing the latter to trade and make large illicit profits. Had the Salman court applied Newman to the facts of that case, no conflict would have existed between the two. This is because the Salman facts are on the opposite end of the spectrum from Newman. There was an obviously close personal relationship between the brothers whereby one would, and did, gift to the other information worth hundreds of thousands of dollars. If you view Newman as suggested above, for the point that casual relationships don’t necessarily equate to gifting MNPI, Salman, in essence, proves the point in Newman and demonstrates that there is a distinction between what most people would do for casual acquaintances as opposed to family.
The Supremes weighed in on Salman. The Supreme Court saw the distinction between Newman and Salman (i.e., the difference between a gift to a distant college friend and a gift to a close relative) and found that the closeness of the tipper and tippee allowed for the inference of personal benefit. What it did not see, and what Newman did not intend, was that all insider trading must be accompanied by a pecuniary gain to the tipper. In deciding Salman, the Supreme Court addressed this controversial sentence in Newman. The High Court slapped down any attempt to rewrite the law to require money in exchange for information. In so doing it questioned the offending sentence, and only that sentence, in Newman. “To the extent the Second Circuit held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends, Newman, 773 F. 3d, at 452, we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.” The Supreme Court did not accuse the Second Circuit of saying money must change hands, it said “to the extent” Newman intended that Newman’s language is inconsistent with Dirks. In the Salman opinion, “to the extent” means “if”
Martoma took center stage after Salman. The first Martoma decision gutted Newman’s personal benefit standard. The Martoma court read Salman to “abrogate” Newman’s meaningfully close personal relationship test. Instead of simply stating that the Second Circuit had never intended to suggest that tippers and tippees must exchange money for information, one Second Circuit panel tried to strike down another’s interpretation of the personal benefit standard. In so doing, the dissent argued, the majority went further than the Supreme Court did and overruled a previous panel, which it could not do.
This caused Martoma to petition for a rehearing en banc in the Second Circuit. This is a rarity and such petitions do not take long for the Second Circuit to deny. It is said to be a very collegial court. This one, however, lasted approximately 10 months with no word from the circuit. This fueled speculation that there must be infighting within the court over the law. The silence continued until last week. Finally, the Second Circuit spoke. It issued a new Martoma opinion that backed off on its criticism of Newman.
I’m sure you are (un)grateful for the history lesson but want to know “what’s the punch line?” Fine the punchline is that Martoma, says the court, could have been decided based on the intent to benefit theory and did not need to get into gift to a friend. Newman, as stated before, tried to tie intent to benefit to its practical application of the law (no one would give millions to a veritable stranger), Martoma says “no” intent to benefit is a stand-alone theory of liability. The Martoma Court is apparently deeply moved by the possibility that a tipper might approach a total stranger and offer illegal information for nothing more than the notion that the tipper felt like benefitting someone she didn’t know. With all due respect to the Court – that is silly. In the history of insider trading I am aware of no case where a stranger committed this crime to benefit a perfect stranger. Could it happen? Obviously, it is within the realm of all things that are possible. So too is the notion that the New York Yankees will call me out of the stands one night to be the starting shortstop at the age of 51. We should not, however, waste our time on such flights of fancy and stick to what is far more likely to happen.
The sad part about the Martoma majority opinion is that it does seem to be in keeping with Dirks. Dirks does not tie intent to benefit to gift to a trading relative or friend the way Newman did. Dirks reads: “there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient. 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 tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.” (emphasis added). Intent to benefit comes before Dirks discusses gift to a friend or relative and in discussing possible theories Dirks uses the word “also”. This clearly means that intent to benefit is not the same thing as gift to a trading relative. Newman structured it the other way around, in an effort to make intent to benefit mean something reasonable. Newman stated: “To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades ‘resemble trading by the insider himself followed by a gift of the profits to the recipient,’…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. In other words,…this requires evidence of ‘a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the [latter].’ Jiau, 734 F. 3d at 153.” (internal quotations omitted). Newman, trying to inject common sense into Dirks notion of intent to benefit, linked intent to benefit to the only situation it would plausibly come up in, where there was a preexisting actually close relationship between the tipper and tippee.
The Martoma majority has, by reading Dirks literally, essentially ensured that unless there is a money for information quid pro quo, all insider trading cases will be tried under the most expansive theory of insider trading ever – the tipper’s subjective intention to improperly benefit the tippee. Why would any prosecutor use a different theory when this one is liable to swallow all of the insider trading theories that have been used to date?
So here is the punch-line to the punch-line. It is easy to blame the Martoma court or the Salman decision out of the Ninth circuit for undercutting Newman’s effort to inject a rule of reason and common sense into insider trading law. But the blame would be misplaced. The blame is rightfully placed on Dirks. It is time that we simply acknowledge what has been whispered around the courthouse for years now, that Dirks, though we think of it as the holy grail of insider trading, is a flawed decision that has led us to the messy state of insider trading that we have suffered through these past few years.
Gregory Morvillo is a partner at Orrick, Herrington and Sutcliffe LLP.
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