On June 25, 2018, the Second Circuit amended its decision affirming the insider trading conviction of hedge fund portfolio manager Matthew Martoma. As in the initial decision, Judge Rosemary Pooler dissented. The panel in its amended opinion again sought to clarify the standard for the “personal benefit” a tipper must receive to establish insider trading liability.

In its first opinion (Martoma I), the panel held that an insider tipper personally benefits from the disclosure of inside information when that information is disclosed with the expectation that the recipient will trade and the disclosure resembles the trading by the insider, who thereafter makes a gift of the profits. The Martoma I majority opinion found that Newman's additional requirement—that the government prove in gift cases that the tipper and tippee had a “meaningfully close relationship”—was inconsistent with the Supreme Court's decision in Salman. The panel's amended decision (Martoma II) clarified that the personal benefit element may be established by proving either that: (1) the tipper “intended to benefit” the tippee—regardless of whether the tipper and the tippee had a pre-existing relationship; or (2) the relationship between the insider and the recipient suggests a quid pro quo.

Given the government's apparent view that “a tipper personally benefits whenever the tipper discloses confidential trading information for a non-corporate purpose,” we expect that courts will continue to wrestle with factual questions about the personal benefit requirement, and whether particular disclosures constitute a breach of a fiduciary duty. The evolving and uncertain case law in this area leave insider-trading defendants plenty of room to challenge the sufficiency of the government's evidence that the insider's disclosure was fraudulent and that the tippee knew it, especially in cases involving “remote tippees” (persons who are removed from the initial communication of confidential information).

Background

The 1983 U.S. Supreme Court decision in Dirks v. SEC established the framework for tipping liability under the so-called classical theory of insider trading. The court held that a recipient of inside information cannot be liable for insider trading unless the insider who disclosed the information breached a fiduciary duty. And “the test [for breach of a fiduciary duty by an insider] is whether the insider personally will benefit, directly or indirectly, from his disclosure.” The court provided several examples of the circumstances that would support an inference of personal benefit: “pecuniary gain,” “reputational benefit that will translate into future earning,” “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,” or “a gift of confidential information to a trading relative or friend” where “the tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.”

In 2014, the Second Circuit in U.S. v. Newman overturned the convictions of two portfolio managers, who were remote tippees. The Second Circuit seemed troubled by the absence of “evidence that either [appellant] was aware of the source of the inside information.” And, recognizing that not every breach of a confidentiality obligation is fraudulent, the Second Circuit held that it is impermissible to infer personal benefit in gift cases absent proof of “a meaningfully close relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” (emphasis added). The outcome in Newman may also be explained, in part, by the Second Circuit's concerns regarding prosecutorial overreach in a line of cases featuring increasingly remote tippees.

The Supreme Court addressed the personal-benefit requirement for the first time in decades in its 2016 decision, Salman v. U.S. The court reaffirmed Dirks's holding that one of the ways in which a tipper receives a personal benefit, and thus breaches a fiduciary duty, is “by making a gift of confidential information to a 'trading relative or friend.'” The evidence established that Salman—unlike the appellants in Newman—knew that the insider had made a gift of trading information to the insider's brother. Because Dirks specifically identified making a gift of confidential information to a trading friend or relative as one example of when an insider breaches a fiduciary duty, the court found that principle sufficient to decide the issue. To address any perceived tension with Newman, the court observed, “[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 … this requirement is inconsistent with Dirks.”

It was against this backdrop that the Second Circuit heard Matthew Martoma's appeal of his conviction.

Martoma I and II

Matthew Martoma is a former portfolio manager at SAC Capital Advisors, a hedge fund. Evidence at his 2014 trial showed that Mr. Martoma, who mainly covered the health care sector, consulted with two doctors involved in confidential clinical trials for an experimental Alzheimer's medication. One of the doctors testified that he informed Mr. Martoma of negative efficacy findings approximately one week before the doctor publicly presented those findings. After receiving that information, Mr. Martoma and a colleague reduced SAC Capital's long positions and established short positions that ultimately resulted in approximately $275 million in gains and losses-avoided for SAC Capital. Mr. Martoma personally received a $9 million year-end bonus in large part due to those trades. Mr. Martoma was convicted of insider trading in the Southern District of New York, shortly before the decision in Newman was issued. He argued on appeal that the jury was not properly instructed in light of Newman and that he and the alleged tipper did not have a “meaningfully close personal relationship.”

In Martoma I, issued after the Supreme Court's Salman decision, a divided panel of the Second Circuit upheld Martoma's conviction, finding that Salman had abrogated Newman's “meaningfully close personal relationship” requirement. According to the Martoma I majority opinion, an “insider or tipper personally benefits from a disclosure of inside information whenever the information was disclosed 'with the expectation that [the recipient] would trade on it,'… and the disclosure 'resemble[s] trading by the insider followed by a gift of the profits to the recipient,' … whether or not there was a 'meaningfully close personal relationship' between the tipper and tippee.” Judge Pooler, dissenting, disagreed that Salman had fully abrogated Newman's “meaningfully close personal relationship” requirement. She concluded that both Dirks and Salman permitted an inference of personal benefit when an insider made a gift of information to a trading relative or friend, but neither Dirks nor Salman directly addressed information gifts made in other circumstances.

The majority's June 25, 2018 amended opinion (Martoma II) softened its rejection of Newman: “because there are many ways to establish a personal benefit, we conclude that we need not decide whether Newman's gloss on the gift theory is inconsistent with Salman.” Instead, the majority found that the trial evidence was sufficient to prove that the tipper received a personal benefit from his receipt of consulting payments and from disclosing information with the intention of benefitting Mr. Martoma.

The core dispute between the majority and dissent in Martoma II centers on how to interpret a single sentence among the “personal benefit” examples listed in Dirks. The sentence reads, “[f]or 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 Martoma II majority read the inclusion of a comma as creating two separate bases upon which a personal benefit could be found: either (1) a relationship between the insider and recipient or (2) an intention to benefit the tippee regardless of the existence of that relationship. The majority noted that “[o]ur cases applying Dirks demonstrate that the government can prove a personal benefit in several ways that do not require proof of any sort of personal relationship.” The examples the majority cited all involved either a tangible benefit to the tipper (e.g., pecuniary gain) or an intangible benefit that was inferred from the relationship with the tippee (e.g., currying favor with a boss).

Judge Pooler, in dissent, criticized the majority's reading of Dirks as “semantics over substance.” She argued that the majority was attempting to redefine Newman's “meaningfully close personal relationship” test in “subjective rather than objective terms.” In her view, the majority was subtly but improperly abrogating the decision in Newman by adding to Second Circuit jurisprudence a new “freestanding 'intention to benefit'” absent a “meaningfully close personal relationship.” Judge Pooler observed that such a change may only be effected by the Second Circuit sitting en banc or the Supreme Court.

On Aug. 27, 2018, the Second Circuit denied Mr. Martoma's petition for a rehearing en banc and noted that “no active member called for an en banc poll.”

Implications

Prosecutors in tipping cases will likely continue pressing for an expansive view of personal benefit. But while the court in Salman described the government's position as being “a tipper personally benefits whenever the tipper discloses confidential trading information for a non-corporate purpose,” the court did not adopt that position. As reflected in the split decisions in Martoma I and Martoma II, there will continue to be litigation post-Salman about what constitutes a personal benefit. Defendants in prosecutions of tippees, particularly remote tippees, should aggressively challenge the sufficiency of the evidence that the tipper breached a fiduciary duty and that the tippee knew the insider had disclosed confidential information in exchange for personal benefit.

Nicole M. Argentieri and Andrew J. Geist are partners, and Robert Ennis is a counsel, in the white collar defense and corporate investigations group at O'Melveny & Myers.