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E-MailDonald C. Langevoort is the Thomas Aquinas Reynolds Professor of Law at Georgetown Law School. This post is based on his recent paper. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation by Jesse Fried (discussed on the Forum here).
The accretive process by which insider trading law evolves—for all the benefits of incrementalism—has many critics. When insider trading law wobbles visibly on some matter, there are enhanced concerns about notice, predictability and due process as well as the substantive merit of the specific principles being applied. Judge Jed Rakoff recently said in an opinion that “the crime of insider trading is a straightforward concept that some courts have somehow managed to complicate.”
No subject in insider trading law has wobbled more recently than the standards for tipper-tippee liability. In 1983, the Supreme Court ruled in Dirks v. SEC that tipper-tippee liability requires proof that the tipper be breaching a fiduciary-like duty in passing on the information to the tippee for the tipper’s own personal benefit, and that the tippee knows or should know of that breach. For two decades after Dirks, the law steadily evolved in a way that made the personal benefit aspect easy for enforcers to satisfy. Two kinds became standard: quid pro quos with some pecuniary pay-offs (e.g., kickbacks to the tipper), and “gifts” of information to family members and friends. That increasingly relaxed approach emboldened both criminal prosecutors and the SEC. In a 2012 civil case, SEC v. Obus, the Second Circuit offered a sweeping restatement of all the elements of tipper-tippee liability, some never previously so characterized. Among other things, the Obus framework allowed tippees to be held liable without awareness of the tipper’s alleged benefit.
Soon thereafter, in United States v Newman, a panel of the Second Circuit addressed personal benefit more strictly, seemingly—but without directly saying so—rewriting Obus at least in the criminal context as to the standards for both tipper and tippee complicity. It sought to connect gift-giving and real benefit by demanding a higher level of proof of close relationship between tipper and tippee, and that the tippee have actual knowledge of both the breach and benefit. Newman was a god-send to the defense side, destabilizing the doctrine on which many prior and on-going cases were founded. But then, on review of a Ninth Circuit decision (United States v. Salman) that rejected the most demanding aspects of the Newman approach as to the meaning of gift in family settings, the Supreme Court agreed that Newman went too far in its retrenchment. Precisely how much too far was unclear, however, so the wobbling was far from over.
Then came two Martomas. The main legal question presented on appeal in a highly publicized prosecution, though not necessarily crucial to the ultimate outcome of the case, was whether the gift benefit prong under Dirks and Salman requires a close pre-existing relationship of family or friendship. Or is there a personal gift benefit in any intentional conveyance given with the purpose or expectation that the tippee will trade? In Martoma I, a divided Second Circuit panel said that the expectation is enough, regardless of to whom, and abrogated Newman to the extent that it indicated otherwise by its reference to a meaningfully close relationship. There was a petition for rehearing en banc claiming that (among other things) the panel had no authority to overturn that holding in Newman absent direct Supreme Court direction. Nearly a year later, in June 2018, the panel substituted a completely new opinion (Martoma II) reinterpreting Newman rather than abrogating it, but once again making the tipper’s specific purpose to confer a benefit on the tippee sufficient and dispositive. Part of Newman’s own precious gift to Wall Street and the defense side was thus taken back.
None of this is news. Newman and Salman have been the subjects of extensive academic and professional commentary for the last five years, and the Martoma cases have now joined the on-going contestation. Nearly everyone who writes much about insider trading (and a few interlopers as well) has had something to say about the wobble, with wildly mixed opinions. As to the panel’s authority to abrogate Newman, for example, a case comment in the Harvard Law Review treats Martoma II as a “stealth overruling” of Newman, but then concedes that Newman was a stealth overruling of Obus (and so on), so that what Martoma II did should not cause great angst.
My essay is about the kind of gratuitous tipping addressed in Martoma, which might not seem to be practically important but instead more of a legal brain teaser. In this academic spirit, Martoma I posed a hypothetical about an apartment dweller giving a Christmas gift to his doorman in the form of a stock tip in place of the usual cash. But this hypo isn’t particularly well-crafted insofar as valuable tips to doormen can be seen as an effort to buy superior service for the forthcoming year, which would be a form of pecuniary gain, not a pure gift. Thus Martoma II strips this down a gift of a stock tip to someone simply with the statement that he (the tippee) can make money by trading on the information. These are fun to a degree, but the fact that some version of the question presented itself in both Newman and Martoma, each a big-time hedge fund-related prosecution, shows how closely it lies to the subject of what constitutes a legitimate trading edge for securities professionals, and where the line is they cannot safely cross. Big money turns on the answer. The decision in Martoma arguably gives enforcers a tool against selective disclosure to market professionals they might not have realized was in the toolkit.
I think Martoma’s holding is well-grounded. Explaining why takes us into the weeds of insider trading theory and doctrine, the overgrowth of which is widely acknowledged. In taking this journey we have the opportunity to dissect Dirks in light of contemporaneous evidence about why it says what it does, examine the history of the clash between the classical and misappropriation theories of liability, and take note of the creeping criminalization of insider trading doctrine.
All this unnecessary complication is incurable without statutory codification, but even then would probably fall short of the clarity many say they want. Insider trading enforcement has become a recognizable brand symbol for American-style securities regulation, touching on some deep-seated public fascination, envy and distaste for the arrogance of economic elites and others who exploit some undeserved edge in the stock markets. It is not about creating a level playing field, which as Judge Rakoff has pointedly said is unrealistic, but rather when to take away the edge that comes from wrongfully being high on the privileged side. The campaign against abusive trading generates public support for the complex mission of investor protection more generally, which is consequential whether or not we have a coherent theory of how and why it constitutes securities fraud.
The complete paper is available for download here.
