The personal benefit element of insider trading tipping liability post-Newman

« Active fund management doesn't work | Main | Recent citations to my work »

12/15/2014

The personal benefit element of insider trading tipping liability post-Newman

Michael Perino has a Dealbook post about the state of insider trading law after US v. Newman. It's an lengthy and thoughtful argument, but here's the gist:

In order to show a violation, prosecutors must now prove “a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or valuable nature.” The government cannot prove the existence of this kind of benefit from “the mere fact of a friendship, particularly of a casual or social nature.” A tip to a golfing buddy, a college roommate, or a neighbor, without more, is apparently no longer improper.

I disagree with Perino's claim that this represents "a much narrower view than previous courts." To be sure, the US Supreme Court's decision in Dirks v. SEC held that:

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.

But does this mean that all gifts give rise to liability under Dirks? I don't think so. As I wrote in my book Insider Trading Law and Policy:

The question of what constitutes the requisite personal benefit was posed by well-known economics blogger Megan McArdle in connection with the insider trading case against prominent Wall Street executive Rajat Gupta:

Rajat Gupta, formerly a director at Proctor and Gamble and Goldman Sachs, has been indicted on multiple counts of passing insider information about the companies he was supposed to be helping to oversee. He is alleged to have delivered this information to Raj Rajaratnam, the hedge-fund manager who just got 11 years for insider trading.

… This is a very interesting case, because Gupta is not accused of having directly profited from the tips. He’s accused merely of having used them to build his relationship with Rajaratnam.

… [I]nsider trading cases usually require proving that the insider who delivered the information did so for some gain. That gain doesn’t have to be immediate, or in cash, but it does have to be something that you can point to and say “That’s what he got out of it”.

“Rajaratnam’s goodwill” is slightly more nebulous than I believe usually goes to trial. And that’s not just because you have to spend hours in court arguing about whether this is actually valuable. It’s also because without a gain, there’s less in the way of a paper trail. ...[1]

McArdle was not the only commentator who raised this issue in connection with the Gupta case. University of Chicago law professor Randal Picker opined that:

According to Wayne State University Law School professor Peter J. Henning in a recent New York Times article, there are complications to each aspect of this case. ...

Proving Gupta received a personal benefit from his alleged tips to Rajaratnam is likely the hardest aspect of the case for the Department of Justice. In Dirks vs. SEC, the Supreme Court said that to prove insider trading by a tipper, “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.” The indictment itself is surprisingly muted on this aspect, merely stating that Gupta “provided the inside information to Rajaratnam because of Gupta’s friendship and business relationships with Rajaratnam. Gupta benefitted and hoped to benefit from his friendship and business relationships with Rajaratnam in various ways, some of which were financial”. Gupta’s lawyer, in contrast, stated that during the time in question his client lost his entire investment in the Galleon Fund. It will be interesting to see what evidence prosecutors have to demonstrate how exactly Gupta benefitted (especially since the financial relationships between Gupta and Rajaratnam cited in the indictment occurred mostly from 2003 through 2006, well before 2008).[2]

Any analysis of this issue must start by recognizing that Gupta was not charged with insider trading as such. Instead, he was charged with the related offense of tipping information to an outsider who then used it to trade. As a tipper, Gupta could be held liable if the government showed—as it succeeded in doing—that he (a) disclosed material nonpublic information to Rajaratnam (b) in return for a personal benefit (c) expecting Rajaratnam to trade. The question raised by McArdle goes to the second prong; namely, whether Gupta making tips “to build his relationship with Rajaratnam” rises to the requisite personal benefit. In short, it does.

Dirks itself held that the tipper can be held liable when he ““receive[s] a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.”[3] The court further explained that “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] As the Second Circuit later explained, by this formulation “the Supreme Court has made plain that to prove a § 10(b) violation, the SEC need not show that the tipper expected or received a specific or tangible benefit in exchange for the tip.”[5] In that case, the court held that “The close friendship between [tipper] Downe and [tippee] Warde suggests that Downe’s tip was ‘inten[ded] to benefit’ Warde, and therefore allows a jury finding that Downe’s tip breached a duty under § 10(b).”[6] If a “close friendship” is not too nebulous, getting on the good side of a major player in the hedge fund industry is a very easy case. The Gupta case thus can be instructively contrasted with SEC v. Maxwell,[7] which rejected tipper liability on grounds that the alleged tipper was unlikely to receive any future pecuniary or reputational benefit from giving tips to his barber. As a major hedge fund manager, Rajaratnam was no mere barber.

As Thomson Reuters’ Accelus blog explained:

In S.E.C. v. Sekhri, the court both distinguished and refined the concept of personal benefit as an element of insider trading:

The first part of Sehgal’s argument fails because it is based on an overly narrow interpretation of the rule stated in Dirks. While Sehgal is correct in arguing that the evidence must show that Sekhri sought some personal benefit from disclosing the nonpublic information to Sehgal in order to have breached his fiduciary duty, he ignores the remainder of the Court’s statement.... While noting that the insider must seek to benefit from disclosing inside information, the Supreme Court noted that “[t]here are objective facts and circumstances that often justify [the] inference” that the insider benefitted from the disclosure.... For example, “[t]he 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.” .... (emphasis added (by Court)). Thus, when Sekhri disclosed insider information to his father-in-law, Sehgal, it may be inferred that Sekhri received some personal benefit from the gift of information. Likewise, the burden of proof shifts from the SEC to Sehgal, and Sehgal must prove that his son-in-law derived no benefit from the disclosure in order to negate the inference that Sekhri benefitted from the transaction.

In the case of Gupta and Rajaratnam, the two men, in addition to years-long friendship, had a number of investments together.[8]

Not surprisingly, the jury apparently had no difficulty finding the requisite personal benefit, as it convicted Gupta of multiple counts of illegal tipping.

Nothing in Newman overturns any of these precedents. To the contrary, Newman is entirely consistent with SEC v. Maxwell. Being friends is not a personal benefit. Being friends with benefits, however, is the requisite personal benefit. Put another way, to rephrase Perino, a tip to a golfing buddy, a college roommate, or a neighbor, remains improper if the tipper may receive any future pecuniary or reputational benefit from the tippee. At most Newman clarified the law in this regard. But Newman did not make new law.

[1] Megan McArdle, Can You Be Guilty of Insider Trading Without Personal Gain?, The Atlantic (Oct. 27, 2011), http://www.theatlantic.com/business/archive/2011/10/can-you-be-guilty-of-insider-trading-without-personal-gain/247489.

[2] Stephen M. Bainbridge, “Can You Be Guilty of Insider Trading Without Personal Gain?” Yes, ProfessorBainbridge.com (Nov. 6, 2011) (quoting a no longer available internet blog post by Picker), http://www.professorbainbridge.com/professorbainbridgecom/2011/11/can-you-be-guilty-of-insider-trading-without-personal-gain-yes.html.

[3] Dirks, 463 US at 663.

[4] Id. at 664.

[5] SEC v. Warde, 151 F.3d 42, 48 (2d Cir. 1998).

[6] Id. at 49.

[7] 341 F. Supp. 2d 941 (S.D. Ohio 2004).

[8] Thomson Reuters Accelus Staff, Gupta Under Fire: Feds Come at Former Goldman Director with Both Barrels, Business Law Currents (Oct. 27, 2011), http://currents.westlawbusiness.com/Article.aspx?id=3330bda0-eb82-4185-ab83-90d99bb8a52e&cid=&src=&sp=.

So even if the Second Circuit's decision in Newman was intended to impose a quid pro quo requirement, it can't overturn Dirks.

Posted at 04:25 PM in Insider Trading | Permalink

Comments

Michael Perino has a Dealbook post about the state of insider trading law after US v. Newman. It's an lengthy and thoughtful argument, but here's the gist:

In order to show a violation, prosecutors must now prove “a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or valuable nature.” The government cannot prove the existence of this kind of benefit from “the mere fact of a friendship, particularly of a casual or social nature.” A tip to a golfing buddy, a college roommate, or a neighbor, without more, is apparently no longer improper.

I disagree with Perino's claim that this represents "a much narrower view than previous courts." To be sure, the US Supreme Court's decision in Dirks v. SEC held that:

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.

But does this mean that all gifts give rise to liability under Dirks? I don't think so. As I wrote in my book Insider Trading Law and Policy:

The question of what constitutes the requisite personal benefit was posed by well-known economics blogger Megan McArdle in connection with the insider trading case against prominent Wall Street executive Rajat Gupta:

Rajat Gupta, formerly a director at Proctor and Gamble and Goldman Sachs, has been indicted on multiple counts of passing insider information about the companies he was supposed to be helping to oversee. He is alleged to have delivered this information to Raj Rajaratnam, the hedge-fund manager who just got 11 years for insider trading.

… This is a very interesting case, because Gupta is not accused of having directly profited from the tips. He’s accused merely of having used them to build his relationship with Rajaratnam.

… [I]nsider trading cases usually require proving that the insider who delivered the information did so for some gain. That gain doesn’t have to be immediate, or in cash, but it does have to be something that you can point to and say “That’s what he got out of it”.

“Rajaratnam’s goodwill” is slightly more nebulous than I believe usually goes to trial. And that’s not just because you have to spend hours in court arguing about whether this is actually valuable. It’s also because without a gain, there’s less in the way of a paper trail. ...[1]

McArdle was not the only commentator who raised this issue in connection with the Gupta case. University of Chicago law professor Randal Picker opined that:

According to Wayne State University Law School professor Peter J. Henning in a recent New York Times article, there are complications to each aspect of this case. ...

Proving Gupta received a personal benefit from his alleged tips to Rajaratnam is likely the hardest aspect of the case for the Department of Justice. In Dirks vs. SEC, the Supreme Court said that to prove insider trading by a tipper, “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.” The indictment itself is surprisingly muted on this aspect, merely stating that Gupta “provided the inside information to Rajaratnam because of Gupta’s friendship and business relationships with Rajaratnam. Gupta benefitted and hoped to benefit from his friendship and business relationships with Rajaratnam in various ways, some of which were financial”. Gupta’s lawyer, in contrast, stated that during the time in question his client lost his entire investment in the Galleon Fund. It will be interesting to see what evidence prosecutors have to demonstrate how exactly Gupta benefitted (especially since the financial relationships between Gupta and Rajaratnam cited in the indictment occurred mostly from 2003 through 2006, well before 2008).[2]

Any analysis of this issue must start by recognizing that Gupta was not charged with insider trading as such. Instead, he was charged with the related offense of tipping information to an outsider who then used it to trade. As a tipper, Gupta could be held liable if the government showed—as it succeeded in doing—that he (a) disclosed material nonpublic information to Rajaratnam (b) in return for a personal benefit (c) expecting Rajaratnam to trade. The question raised by McArdle goes to the second prong; namely, whether Gupta making tips “to build his relationship with Rajaratnam” rises to the requisite personal benefit. In short, it does.

Dirks itself held that the tipper can be held liable when he ““receive[s] a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.”[3] The court further explained that “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] As the Second Circuit later explained, by this formulation “the Supreme Court has made plain that to prove a § 10(b) violation, the SEC need not show that the tipper expected or received a specific or tangible benefit in exchange for the tip.”[5] In that case, the court held that “The close friendship between [tipper] Downe and [tippee] Warde suggests that Downe’s tip was ‘inten[ded] to benefit’ Warde, and therefore allows a jury finding that Downe’s tip breached a duty under § 10(b).”[6] If a “close friendship” is not too nebulous, getting on the good side of a major player in the hedge fund industry is a very easy case. The Gupta case thus can be instructively contrasted with SEC v. Maxwell,[7] which rejected tipper liability on grounds that the alleged tipper was unlikely to receive any future pecuniary or reputational benefit from giving tips to his barber. As a major hedge fund manager, Rajaratnam was no mere barber.

As Thomson Reuters’ Accelus blog explained:

In S.E.C. v. Sekhri, the court both distinguished and refined the concept of personal benefit as an element of insider trading:

The first part of Sehgal’s argument fails because it is based on an overly narrow interpretation of the rule stated in Dirks. While Sehgal is correct in arguing that the evidence must show that Sekhri sought some personal benefit from disclosing the nonpublic information to Sehgal in order to have breached his fiduciary duty, he ignores the remainder of the Court’s statement.... While noting that the insider must seek to benefit from disclosing inside information, the Supreme Court noted that “[t]here are objective facts and circumstances that often justify [the] inference” that the insider benefitted from the disclosure.... For example, “[t]he 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.” .... (emphasis added (by Court)). Thus, when Sekhri disclosed insider information to his father-in-law, Sehgal, it may be inferred that Sekhri received some personal benefit from the gift of information. Likewise, the burden of proof shifts from the SEC to Sehgal, and Sehgal must prove that his son-in-law derived no benefit from the disclosure in order to negate the inference that Sekhri benefitted from the transaction.

In the case of Gupta and Rajaratnam, the two men, in addition to years-long friendship, had a number of investments together.[8]

Not surprisingly, the jury apparently had no difficulty finding the requisite personal benefit, as it convicted Gupta of multiple counts of illegal tipping.