Beyond the Personal Benefit Test: The Economics of Tipping by Insiders

Jonathan R. Macey is the Sam Harris Professor of Corporate Law, Corporate Finance & Securities Law at Yale Law School. This post is based on his recent article, forthcoming in the Journal of Law and Public Affairs.

In Dirks v. SEC, the U.S. Supreme Court ruled against the Securities and Exchange Commission and exonerated securities analyst Raymond Dirks from charges that he illegally passed along insider information garnered from a tipper, Ronald Secrist. Secrist’s tip concerned the existence of a massive, ongoing fraud at his former employer, the giant insurance company Equity Funding. The fraud, which was revealed largely as a direct result of Dirks’ efforts ultimately brought the insurance giant to its knees.

The Supreme Court decision ushered in the “personal benefit” test which requires the government to show as an element of any cause of action for insider trading under SEC Rule 10b-5 that the tipper who provides material insider information to downstream tippees received a personal benefit in exchange for the information. Because Mr. Secrist, who was Mr. Dirks’ tippee, received no personal benefit in exchange for his tip, Mr. Dirks could not be guilty of insider trading.

This outcome seems strange because the social value of Secrist’s tip, which came in the form of revealing a large, ongoing fraud, was not enhanced by the fact that Mr. Secrist received no personal benefit in exchange for the tip. Suppose, for example, the Dirks had paid Secrist $50,000 for the information. This payment would not have diminished the social gains that came from the revelation of the ongoing fraud at Equity Funding. In other words, where it is in the interests of society for information to be revealed, as is the case when the information pertains to a large ongoing fraud at a company, the personal benefit test appears to impede the operation of a robust market for information about corporate malfeasance.

The personal benefit test, therefore, appears to be over-inclusive in that it causes less information to be revealed than would be revealed in its absence. Specifically, where the information being tipped reveals to socially undesirable activities like fraud, the fact that the tipper receives a personal benefit should not render illegal the act of tipping.

On the other hand, the personal benefit test is under-inclusive in certain other contexts. For example, where an insider recklessly or negligently reveals valuable, proprietary information about legal corporate activities, the insider should be subject to civil charges, as should downstream tippees who trade on the information knowing that it is confidential and proprietary.

Expanding on this point, my article provides a complete taxonomy of tipping and trading from a societal perspective, and explains what the legal consequences of all of the various forms of tipping and trading should be.

The full article is available for download here.

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