Beyond Dirks: Gratuitous Tipping and Insider Trading

Donna M. Nagy is the C. Ben Dutton Professor of Law and Executive Associate Dean at Indiana University Maurer School of Law–Bloomington. This post is based on Professor Nagy’s forthcoming article, to be published at 42 Journal of Corporation Law 1 (2016). Nagy also has written an introductory essay for the Stanford Law Review Online Symposium on Salman v. United States, which will be published a few days in advance of the October 5 Supreme Court argument.

Is an investment banker who gratuitously shared confidential merger-and-acquisition information with his brother—with no expectation of receiving any tangible benefit in return—guilty of securities fraud? And is the investment banker’s brother-in-law jointly liable for trading securities on the basis of what he knew to be gratuitous tips? The Supreme Court is poised to consider these questions on October 5, when it hears argument in Salman v. United States. It has been thirty-three years since the Court decided Dirks v. Securities and Exchange Commission (1983), the precedent that established a “personal benefit” test for joint tipper-tippee liability under the federal securities laws.

In 2015, a circuit split arose as to whether gratuitous tipping, and securities trading on the basis of such tips, constitute violations of Exchange Act Section 10(b) and Rule 10b-5, which prohibit fraud “in connection with the purchase or sale of any security.” The petitioner-tippee in Salman is arguing that his securities fraud conviction and three-year prison sentence should be vacated because, as he reads Dirks’s personal benefit test, an insider’s pursuit of his own personal enrichment is the only purpose that can transform the disclosure of confidential information into a fraudulent tip. The Supreme Court should reject emphatically that argument and affirm the Ninth Circuit’s decision, which correctly construed Dirks to recognize that a tipper benefits indirectly from making “a gift of confidential information to a trading relative or friend.” [1] The Salman Court also should disavow United States v. Newman’s heightened personal benefit standard, which the Second Circuit constructed in a decision that overturned the securities fraud convictions of two portfolio managers at hedge funds. The managers traded securities on the basis of tips conveyed by securities analysts, who received confidential earnings information from sources who were casual friends with insiders at two technology companies. Salman’s petitioner is defending his own insider trading by invoking Newman’s ruling that Dirks conditioned joint tipper-tippee liability on an “exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” [2]

But while the Salman Court could affirm the Ninth Circuit simply by reiterating Dirks’s clear statement that informational gifts can trigger joint tipper-tippee liability, the Court should seize this opportunity to re-conceptualize insider trading law more generally. The Court should do so by drawing from four key developments since its iconic decision in Dirks.

One important development concerns the “misappropriation theory” of insider trading, which the Court endorsed in United States v. O’Hagan (1997) as a complement to the “classical theory” it entrenched in Chiarella v. United States (1980) and Dirks. Whether a tipper stands as a securities issuer’s classical insider (such as the technology companies’ employees in Newman) or a misappropriating outsider (such as the investment banker in Salman), tippers deceive sources of entrusted information when they secretly make third-party disclosures that deprive sources of the exclusive use of their entrusted information. O’Hagan supports joint tipper-tippee liability whenever a fiduciary secretly breaches a duty of loyalty by sharing information to facilitate a tippee’s securities trading, whether or not the tipper is seeking a personal benefit. However, insider trading liability should not be limited entirely to instances involving a fiduciary’s deceptive disloyalty. Instead, the Salman Court should adopt the broader approach first espoused by Chief Justice Warren Burger in his Chiarella dissent, which interpreted Section 10(b) and Rule 10b-5 to prohibit securities trading based on informational advantages obtained through misappropriation or other wrongful means. A “fraud on contemporaneous traders” approach to insider trading would not only support the guilty verdict in Salman, it would also provide a theory of liability when information thieves (such as computer hackers) trade securities based on market-moving information stolen from its rightful owner.

A second post-Dirks development involves Congress’s amendments to the Exchange Act that clearly ratify, and build on, Chiarella, Dirks, and O’Hagan’s holdings that Section 10(b) and Rule 10b-5 prohibit insider trading and tipping. The statutory text and legislative history of the Insider Trading Sanctions Act of 1984, the Insider Trading Securities Fraud and Enforcement Act of 1988, and the Stop Trading on Congressional Knowledge (STOCK) Act of 2012 evidence concerted congressional judgments that fraud-based insider trading and tipping prohibitions—and the judicial determinations that are inherent in such proscriptions—put traders on appropriate notice that securities transactions based on misappropriated information will be subject to stiff civil sanctions and harsh criminal penalties.

The Salman Court also should evaluate gratuitous tipping in light of Regulation FD, which the SEC adopted in 2000 to effectively ban corporate insiders from selectively sharing material nonpublic information with securities analysts and their privileged clients. Newman heightened Dirks’s personal benefit standard to facilitate efforts by analysts and other market professionals to gather and use selective disclosure in their securities trading, which the Second Circuit viewed as an overall positive force in securities markets because it contributes to pricing efficiency. But the SEC rejected that view when it adopted Regulation FD after notice and comment. Newman’s notion that courts should be interpreting Rule 10b-5 narrowly to facilitate the very types of insider-analyst communications that are illegal under Regulation FD is both strange and unsettling.

Finally, along with the misappropriation theory, the Exchange Act’s insider trading amendments, and Regulation FD, the Salman Court should consider recent state fiduciary law decisions that construe breaches of the duty of loyalty to encompass other actions evidencing a fiduciary’s lack of good faith, in addition to self-dealing. Although Section 10(b) and Rule 10b-5’s prohibitions against insider trading and tipping implicate federal common law, federal courts often look to state law in determining whether a person has acted deceptively by tipping or trading securities on the basis of entrusted information. These decisions, particularly the Delaware Supreme Court’s 2006 rulings in Stone v. Ritter and The Walt Disney Company Derivative Litigation, provide another justification for disavowing Newman’s restrictive view that tipping constitutes securities fraud only when confidential information is exchanged for the tipper’s pecuniary gain.

In short, when the Salman Court considers the scope of joint tipper-tippee liability under Section 10(b) and Rule 10b-5, it should do so in light of the jurisprudential changes brought about by Congress, the SEC, state courts, and the Court itself in the three decades since its decision in Dirks. Looking beyond Dirks should prompt the Court not only to affirm the Ninth Circuit’s decision but also to establish a more coherent doctrine of insider trading and tipping that consolidates the classical and misappropriation theories into a unified and expanded framework.

The full article is available for download here.


[1] United States v. Salman, 792 F. 3d 1087, 1092 (9th Cir. 2015) (quoting Dirks v. SEC, 463 U.S. 646, 664 (1983)).
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[2] United States v. Newman, 773 F.3d 438, 452 (2nd Cir. 2014).
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