Past, Present, and Future: Insider Trading's Personal Benefit Test After Martoma, Gupta, and Other Recent Cases
Late last week, former SAC Capital Advisors portfolio manager Mathew Martoma petitioned the Supreme Court to review his 2014 conviction for insider trading. Martoma's conviction stems from activity in 2008 when he paid a doctor from the University of Michigan for tips about clinical trials of a potential Alzheimer's medication. Before the results of the clinical trial were announced, Martoma caused SAC Capital to enter into substantial short-sale and options trades that resulted in approximately $275 million in gains and losses avoided. Martoma's appeal is the latest in a series of insider trading cases, mostly in the Second Circuit, attempting to provide guidance on what type of "personal benefit" an insider or tipper must receive in order for there to have been a breach of duty.
The Personal Benefit Test
According to the SEC, illegal insider trading is "buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security."1 For decades, criminal insider trading charges have been brought pursuant to Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Any successful prosecution for insider trading requires proof of each of the elements above, including, in cases involving the sharing of material, non-public information with someone who subsequently trades, whether the insider/tipper breached a duty in disseminating the information to the tippee. The issue of what constitutes a breach, which was first established decades ago, has been the subject of significant litigation in recent years.
In Dirks v. SEC,2 the Supreme Court held that a breach of duty occurs when, based on objective criteria, "the insider personally will benefit, directly or indirectly, from his disclosure."3 The Court explained:
For example, 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.4
For decades, courts deemed the personal benefit requirement of Dirks to be satisfied if the government proved either tangible (e.g., money) or intangible (e.g., friendship) benefits to the tipper. Then, in 2014, the Second Circuit narrowed the definition of a personal benefit. In U.S. v. Newman,5 Todd Newman and Anthony Chiasson were charged with insider trading after material, nonpublic information had been shared with acquaintances, rather than good friends or relatives. These acquaintances later passed the tips along to others who ultimately told Newman and Chiasson. For Newman, the insider initially gave the information to a colleague and fellow alumnus of the same school while receiving casual career advice. In Chiasson's case, the initial tip was given from one acquaintance to another through a church relationship. Each tip eventually reached the defendants, who traded on it and were convicted in December 2012.
The Second Circuit reversed the convictions in 2014 on the bases that (1) the initial exchanges of information were not for a personal benefit, and (2) the government failed to prove the defendants knew of any such benefit. The court held that an inference of a personal benefit 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."6 The casual career advice given between colleagues and the conversation between church acquaintances at issue in Newman were insufficient to make that inference. Without such a benefit, the court reasoned, the insider-tippers had not breached a fiduciary duty, and tippees Newman and Chiasson could not be held liable.
The Supreme Court declined to review Newman directly but addressed it two years later in another case from the Ninth Circuit, Salman v. United States.7 The insider-tipper in Salman, Maher Kara, was an investment banker who gave information to his brother, Michael Kara. Maher testified at trial that he gave the information to his brother to "fulfill whatever needs he had," along with the knowledge that Michael would trade on it. Michael also passed the information along to Bassam Salman, whose sister was engaged to Maher. Salman used that information to trade and was convicted in the Northern District of California in 2013.
The Ninth Circuit affirmed the conviction in an opinion that rejected the Second Circuit's formulation of Newman. Notably, the opinion was written by Judge Jed S. Rakoff, who was sitting on the Ninth Circuit by designation from the Southern District of New York. The Supreme Court then decided to resolve the circuit split in favor of the Ninth Circuit, although narrowly, holding that the additional requirements of Newman's personal benefit were inconsistent with Dirks when information is shared with the intent to benefit a "trading relative or friend." Thus, the facts at issue in Salman—an insider giving information to his trading brother—clearly qualified as the type of gift giving that was prohibited by Dirks.
The Second Circuit's next opportunity to revisit Newman came in Martoma. As discussed, Martoma was convicted after being found to have caused SAC Capital to trade on information about confidential clinical trials that he received after paying at least one doctor as a consultant for a number of months. The Second Circuit upheld the conviction, holding that the personal benefit requirement was satisfied by Martoma's payments to the doctor. The court, however, issued two lengthy opinions in an effort to further clarify the personal benefit analysis. Ultimately, the court attempted to marry Salman and Newman with a slightly more nuanced version of the personal benefit test, which it said could be satisfied in one of two ways: (1) if the tipper and tippee share a quid pro quo relationship (akin to the "meaningfully close personal relationship" test of Newman), or (2) if the tipper simply intended to benefit the tippee.8
The Second Circuit's latest opportunity to wrestle with the personal benefit test came earlier this month, when the court affirmed the conviction of Rajat Gupta, a board member at Goldman Sachs who shared material, nonpublic information to a friend and business colleague Raj Rajaratnam, founder of the hedge fund family Galleon Group. Gupta's initial appeal, based on the admission and exclusion of certain pieces of evidence, was denied. The Newman decision sparked Gupta's second appeal in which he argued that the jury instructions were improper as to how personal benefit was defined and whether he had received such a benefit. The Second Circuit rejected Gupta's argument, reiterating its decision in Martoma that the personal benefit need not be pecuniary, and held that the "good relationship with a frequent business partner was consistent" with the personal benefit requirement in Dirks.9 Gupta is yet another case in which Newman's additional personal benefit requirements were confirmed as inconsistent with Dirks, this time in the context of business partners.
The Second Circuit's latest decision in Gupta appears to further distance personal benefit jurisprudence from the Newman decision almost five years ago. Although some questions linger after Martoma, the court took another step in Gupta to delineate the limits of Newman's heightened burden. First, Salman eliminated the need for a "meaningfully close personal relationship that generates an exchange that . . . represents at least a potential gain of a pecuniary or similarly valuable nature" test in the context of trading relatives and friends. Then, Martoma made clear that Newman is inapplicable when either a quid pro quo is involved or, more broadly, the tipper intends to benefit the tippee. And, finally, Gupta indicated that business relationships need nothing from Newman and can be assessed under Dirks alone.
One might argue that potential circumstances exist under which Newman's version of the personal benefits test could be validly applied. Perhaps the factual circumstances exist under which the Second Circuit could breathe new life into Newman, but that possibility appears to have grown smaller with every new decision on the topic. Furthermore, it is unlikely that the Supreme Court will see Martoma as an opportunity to weigh in. It did not feel the need to do so in Newman and only issued a succinct opinion in Salman to resolve a circuit split. Given the clear exchange of money for information in Martoma, it would seem that there is little reason for the Court to hear the appeal.
In the meantime, prosecutors may choose to avoid the challenges posed by the personal benefit test altogether. Later this year, the Second Circuit will review another set of high profile insider trading convictions in U.S. v. Blaszczak.10 In that case, David Blaszczak obtained inside information from a former colleague at the Centers for Medicaid & Medicare Services (CMS) and then provided it to several individuals, who traded on the information. Blaszczak and three others were convicted in the Southern District of New York last year. In addition to the typical charges under Section 10(b) and Rule 10b-5, prosecutors charged the Blaszczak defendants with violations of Title 18, United States Code, Section 1348 (Securities and Commodities Fraud). Section 1348 was enacted as part of the Sarbanes-Oxley Act of 2002, but it had seldom been used to charge insider trading prior to Blaszczak. Significantly, the defendants were convicted on the Section 1348 charges but acquitted on the more traditional insider trading charges under Section 10(b) and Rule 10b-5. Unlike the jury instructions for those traditional charges, the instructions for the Section 1348 charge included no discussion of any breach of duty or personal benefit as an element of the crime. The Second Circuit may choose to address this disparity between the two legal standards.
If the Blaszczak convictions stand up on appeal, prosecutors may have a simple path forward that enables them to obtain convictions while side-stepping the burdens imposed by the personal benefit test. Regardless of which path prosecutors choose, all eyes remain on the Second Circuit for the next development in insider trading law.
© Arnold & Porter Kaye Scholer LLP 2019 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.