US Supreme Court’s ‘Salman v. US’ Decision Answers One Insider-Trading Question, Leaves Others Unresolved

The federal prohibition of insider trading is principally a judicial creation fleshing out the bare bones of Securities Exchange Act of 1934 Rule 10b-5, which broadly prohibits fraud in connection with the purchase or sale of a security.¹ A trio of Supreme Court decisions—Chiarella, Dirks, and O’Hagan—established two distinct but complementary theories under which insider trading violates Rule 10b-5.² The classic disclose or abstain theory is violated when a corporate insider trades in her own company’s stock on the basis of material nonpublic information.³ The misappropriation theory is violated when someone in a fiduciary relationship with another uses material nonpublic information entrusted to him by the other without disclosing his intent to do so.⁴

Under both theories, liability arises both when the insider herself trades on the basis of material nonpublic information or discloses—i.e., tips—such information to a third party (the “tippee”).⁵ In Dirks, the Supreme Court held that a tippee’s liability is derivative of that of the tipper, “arising from [the tippee’s] role as a participant after the fact in the insider’s breach of a fiduciary duty.”⁶ A tippee therefore can be held liable only when the tipper breached a fiduciary duty by disclosing information to the tippee, and the tippee knows or has reason to know of the breach of duty.

The mere fact that an insider tips nonpublic information is not enough under Dirks. What Dirks effectively proscribes is not merely a breach of confidentiality by the insider, but rather the breach of a fiduciary duty of loyalty to refrain from profiting on information entrusted to the tipper.⁷ Looking at objective criteria, Dirks held, courts must determine whether the insider-tipper personally benefited, directly or indirectly, from his disclosure.⁸ In addition to pecuniary or reputational benefits, the Dirks court also held that a gift could constitute the requisite benefit:

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.⁹

Despite that fairly clear instruction, the Second Circuit in Newman held that tipping liability required proof of something more than “the mere fact of a friendship, particularly of a casual or social nature.”¹⁰ As the court pointed out, if the “Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity.”¹¹ While that holding could be squared with Dirks, the Newman court went on to also require proof of “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”¹²

In addition to arguably rewriting Dirks, the Newman court dealt with the problem of remote tippees. Suppose, for example, that Tipper tells Tippee #1 who tells Tippee #2 who trades. Can Tippee #2 be held liable? Such tipping chains were at issue in both Newman and Salman. In the former, the Second Circuit held that remote tippees can only be held liable if they know “that the insider disclosed confidential information in exchange for personal benefit.”¹³

In Salman, the Supreme Court overturned Newman “[t]o 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 ….” It thus reaffirmed the Dirks rule that a gift of information between friends and family constitutes the requisite benefit.

It is often said that hard cases make bad law, but so do easy cases. Under the well-established understanding of Dirks, a gift of information from one brother to another presented no real analytical difficulties.

Having disposed of that low-hanging fruit, however, the Supreme Court left any number of more difficult questions to be resolved in the future:

1. The Court assumed but did not resolve the question of whether the Dirks personal-benefit requirement applied to both the classic and misappropriation theories.
2. The Court noted the government’s argument “that a gift of confidential information to anyone, not just a ‘trading relative or friend,’ is enough to prove securities fraud,” but neither expressly accepted or rejected it.
3. The Court shed no light on whether all disclosures by a friend or family member constitute the requisite gift.
4. The Court failed to define the outer boundaries of the family or friends to whom a gift constitutes the requisite personal benefit. Do all of one’s Facebook friends count, for example?
5. While Newman’s redefinition of what constitutes the required personal benefit clearly does not survive Salman, does its holding that “the mere fact of a friendship, particularly of a casual or social nature” is not enough survive?
6. Likewise, does Newman’s requirement that remote tippees must know the original tip by the tipper to the initial tippee was made “in exchange for personal benefit” survive?

NOTES

1. See generally Stephen M. Bainbridge, Insider Trading Law and Policy (2014).
2. In addition, there is an ancillary prohibition of insider trading under Securities exchange Act Rule 14e-3, which prohibits insider trading in connection with tender offers. See generally id. at 123-40.
3. United States v. O’Hagan, 521 U.S. 642, 651-52 (“Under the ‘traditional’ or ‘classical theory’ of insider trading liability, § 10(b) and Rule 10b–5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. Trading on such information qualifies as a “deceptive device” under § 10(b), we have affirmed, because “a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation.”).
4. Id. at 652. (“The ‘misappropriation theory’ holds that a person … violates § 10(b) and Rule 10b–5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. … Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.”).
5. SEC v. Maio, 51 F.3d 623, 631 (7th Cir. 1995) (explaining that defendant faced tipping liability “under both [the] classical theory and misappropriation theory”).
6. Dirks, 463 U.S. 646, 659 (1983).
7. Technically, of course, Rule 10b–5 liability is grounded not on a breach of fiduciary duty but on violation of a disclosure obligation. Under Dirks, the tippee has a duty of disclosure to those with whom he trades where the tipper breaches a fiduciary duty by making the tip. Hence, the tippee does not succeed to any fiduciary duty. Instead, it is the tippee’s duty of disclosure that is said to be derivative of the tipper’s breach of duty
8. Id. at 663.
9. Id. at 664.
10. Newman, 773 F.3d 438, 452 (2d Cir. 2014).
11. Ibid.
12. Ibid.
13. Id. at 449.