Supreme Court Denies Altruism In Insider Trading Cases
December 13, 2016 (Fault Lines) – The Duke Brothers were rich jerks, who got their comeuppance for trying to be richer jerks. Those who are easily triggered probably haven’t seen the comedy Trading Places. You may not recall; the movie commits the unforgivable sin of showing a white actor in black face, while wearing a wig with braids. Nowadays this movie would be destroyed on social media, if that scene could even make it into the final cut, while those same folks would be praising the smart and funny Ghostbusters remake. Comedy isn’t what it used to be.
The conflict in the film is when a successful trader’s career goes down in flames while a con man is deliberately elevated in his place. It makes sense in the movie’s internal logic. The resolution revolves around both men plotting to give the Duke Brothers their just desserts. They plan to make a killing in the frozen orange juice concentrate futures by getting the government’s weather report early. With that knowledge, they will know whether to go long or short in the market. The good guys trick the Duke Brothers into betting the wrong way, while they make a fortune on the information.
The legal term for this is insider trading. Although it was possible to make bundle on frozen orange juice concentrate through insider trading until 2010, it’s been illegal for securities trading since 1934. Apparently no one took Trading Places seriously for decades, but Congress took the Great Depression seriously. Now it’s too late to make your fortune on insider trading of commodities. Here’s what the rule says:
The “manipulative and deceptive devices” prohibited by Section 10(b) of the Act (15 U.S.C. 78j) and § 240.10b-5 thereunder include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.
So, if you are a corporate officer with nonpublic information, you cannot personally benefit from trading on it. But there is still criminal liability when that corporate insider does not trade personally but only passes on information. In those cases, insider trading occurs when someone, like an employee, with insider information (the tipper) gives that information to someone (the tippee), who then makes trades based on that special information.
Martha Stewart famously was convicted of insider trading lying to the Feds when she sold stocks ahead of bad news about the company being made public. She avoided $45,673 in losses, which is loose change in the couch for someone worth $700 million. Meanwhile, the CEO of the company, Sam Waksal, who was Stewart’s friend, got seven years in prison for insider trading, by trading on the same information.
What Waksal did is classic insider trading. During the course of his duties, he acquired nonpublic information about his company and traded on it. On the other hand, Stewart merely acted on a general tip from her stock broker, rather than on a specific tip from Waksal himself.
Under prior Supreme Court precedent, the tipper’s fiduciary responsibility not to trade on tips can pass to the tippee, who knows or should know that the information was conveyed in breach of the tipper’s fiduciary liability:
The conclusion that recipients of inside information do not invariably acquire a duty to disclose or abstain does not mean that such tippees always are free to trade on the information. The need for a ban on some tippee trading is clear.
Not only are insiders forbidden by their fiduciary relationship from personally using undisclosed corporate information to their advantage, but they also may not give such information to an outsider for the same improper purpose of exploiting the information for their personal gain. Similarly, the transactions of those who knowingly participate with the fiduciary in such a breach are “as forbidden” as transactions “on behalf of the trustee himself.
Thus, some tippees must assume an insider’s duty to the shareholders not because they receive inside information, but rather because it has been made available to themimproperly.
And Court described the test as follows:
Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach. * * * 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.
So, if the tipper gives the information to a family member or friend, who in turn trades on it, then that person is guilty of insider trading.
A strong argument can be made that allowing corporate officers to benefit from insider trading can potentially put them at odds with the corporation. It gets murkier when the rule is extended to tippees who receive the information as a gift. When the tippee acts on this information, it is usually to no one’s determent. Like Martha, they might have sold stocks above their objective value, but there was a willing buyer at that price. ‘Buyer beware’ is the motto of the marketplace.
The idea that tips to family members and close friends is a sort of gift is also a defensible idea. It could be a cheap way to enrich your family; or perhaps the tipper could hope to receive reciprocity in the future. While the rule may not stop Michael Milken type of people, it theoretically discourages collusive rigging of trading against the public. At a bare minimum, the rule keeps the system from potentially breaking down into a Byzantine system of patronage. That’s at least something; no one likes a rigged system in 2016.
But the further the information travels from the source, by way of one tipper to the next, the less the purpose of the original rule carries the day. That’s exactly what Todd Newman, a portfolio manager, argued in the Second Circuit. A cohort of analysts obtained and shared nonpublic information between themselves and then passed the information along to portfolio managers at their respective firms. Newman, and others, would make trades based on this information.
The original source of the information had no intention to benefit Newman or other portfolio managers and perhaps not themselves. And they were three to four links removed on the chain of tippers-to-tippees. Plus, it was not entirely clear that Newman knew that the tip he received was from a corporate insider, though if the jurors followed the jury instructions, it would be a fair inference that they believed it was the case. But who on the jury really carefully considers jury instructions?
Anyhow, the Second Circuit concluded that the tippee must have knowledge that the insider was personally benefiting from the tipping and concluded as follows:
In sum, we hold that to sustain an insider trading conviction against a tippee, the Government must prove each of the following elements beyond a reasonable doubt: that (1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade in a security or tip another individual for personal benefit.
The Ninth Circuit disagreed in U.S. v. Salman. Maher Kara was an investment banker at Citigroup, who started sharing information with his brother, Michael. Being an excellent brother, he started sharing the ill-gotten information with others, such as Salman. After being convicted, Salman argued that allowing the Government to treat tips to the tippees as gifts resulted in an automatic win on a critical element. It would be sort of like allowing an inference of complicity merely because the one person gave some instrument of the crime to another. Neat trick, if you can pull it off.
Salman then went to the Supreme Court, which swatted him away:
We adhere to Dirks, which easily resolves the narrow issue presented here.
Oh, okay. Sorry to bother you.
As Salman’s counsel acknowledged at oral argument, Maher would have breached his duty had he personally traded on the information here himself then given the proceeds as a gift to his brother. Tr. of Oral Arg. 3–4. It is obvious that Maher would personally benefit in that situation.
Obvious? Maybe money works differently in Washington. When I give my money away, I don’t have it anymore. And as much as I may like my brother, he’s not getting a $1.5 million dollar gift because I think he’s just swell.
Here, by disclosing confidential information as a gift to his brother with the expectation that he would trade on it, Maher breached his duty of trust and confidence to Citigroup and its clients—a duty Salman acquired, and breached himself, by trading on the information with full knowledge that it had been improperly disclosed.
This is a little shorthand, but the Court appears to be saying because Salman knew of Maher’s breach in favor of Michael, Salman is placed in Michael’s shoes. In other words, Salman doesn’t get a pass merely because he’s the second down line tippee. It meets all the aspects of the Second Circuit’s test, except the personal benefit was inferred from the relationship of the men.
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. * * * We reject Salman’s argument that Dirks’s gift-giving standard is unconstitutionally vague as applied to this case. Dirks created a simple and clear “guiding principle”for determining tippee liability….
Shots fired. Maher didn’t personally benefit from the tip, unlike Waksal did. Only by imputing a gift-giving motive does this conviction work. Presumably, it would be difficult to get the inference of gift giving in a situation like Newman. This doesn’t damage the Second Circuit decision generally, but it should make corporate insiders wary of open bars at family functions. Loose lips sink careers.