Federal Securities Law: Insider Trading
Michael V. Seitzinger
Legislative Attorney
October 5, 2015February 2, 2016
Congressional Research Service
7-5700
www.crs.gov
RS21127
Federal Securities Law: Insider Trading
Summary
Insider trading in securities may occur when a person in possession of material nonpublic
information about a company trades in the company’s securities and makes a profit or avoids a
loss. Certain federal statutes have provisions which have been used to prosecute insider trading
violations. For example, Section 16 of the Securities Exchange Act of 1934 requires the
disgorgement of short-swing profits by named insiders—directors, officers, and 10%
shareholders. The 1934 Act’s general antifraud provision, Section 10(b), is frequently used in the
prosecution of insider traders. Although the statute does not specifically mention insider trading
but, instead, forbids the use of “manipulative or deceptive” means in buying or selling securities,
case law has made clear that insider trading is the type of fraud that is prohibited by Section
10(b). Securities and Exchange Commission rules issued to implement Section 10(b), particularly
Rule 10b-5, have also been frequently invoked in insider trading prosecutions. In the Insider
Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of
1988, Congress enacted legislation imposing up to treble damages (and in some cases the greater
of $1 million or up to treble damages) on a person found guilty of insider trading. More recently,
the Stop Trading on Congressional Knowledge (STOCK) Act of 2012 explicitly stated that there
is no exemption from the insider trading prohibitions for Members of Congress, congressional
employees, or any federal officials. As stated above, SEC Rule 10b-5 is the most frequently used
SEC rule in lawsuits that charge violations of insider trading prohibitions. However, other SEC
rules, some of which specifically target insider trading, are also important. There are numerous
cases that have used Section 10(b) and Rule 10b-5 to prosecute insider trading violations.
The decision by the U.S. Court of Appeals for the Second Circuit (Second Circuit) in United
States v. Newman has brought increased attention to the issue of insider trading. In its December
10, 2014, decision, the Second Circuit overturned two high-profile convictions for insider trading.
The court did not simply vacate the convictions; it remanded for the district court to “dismiss the
indictment with prejudice,” thereby forbidding the government from refiling the case. The Second
Circuit held that the evidence against two stock fund analysts could not sustain a guilty verdict
because the government did not adequately show that the alleged insiders received personal
benefits for providing information to the stock fund analysts and that the government did not
present evidence that the defendants knew that they were trading on inside information obtained
from insiders who were violating their fiduciary duties. The U.S. Attorney for the Southern
District of New York asked the Second Circuit to reconsider the ruling, but on April 3, 2015, the
Second Circuit denied the U.S. Attorney’s request. On July 30, 2015, the U.S. Department of
Justice asked the Supreme Court to review the Second Circuit decision. On October 5, 2015, the
U.S. Supreme Court declined to hear the Newman insider trading appeal.
On July 6, 2015, a case decided by the U.S. Court of Appeals for the Ninth Circuit may have
further complicated insider trading law. The case, Salman v. United States, affirmed a lower court
decision finding a breach
of fiduciary duty and creation of a personal benefit in a family insider
trading situation, holding
that the “gift” of inside information was sufficient to create liability for insider trading.
insider trading. On January 19, 2016, the U.S. Supreme Court granted certiorari in the Salman
case.
Several bills, including H.R. 1173, H.R. 1625, and S. 702, have been introduced in the 114th
Congress to attempt to prevent the type of securities trading allowed by the Newman decision.
This report will be updated as warranted.
Congressional Research Service
Federal Securities Law: Insider Trading
Contents
Overview of Federal Statutes Related to Insider Trading................................................................ 1
Securities Exchange Act of 1934 .............................................................................................. 1
Insider Trading Sanctions Act of 1984 ...................................................................................... 2
Insider Trading and Securities Fraud Enforcement Act of 1988 ............................................... 2
Stop Trading on Congressional Knowledge (STOCK) Act of 2012 ......................................... 3
Examples of Penalties for Insider Trading ................................................................................ 3
Selected Regulations ....................................................................................................................... 3
Selected Decisions That Have Used Section 10(b) and Rule 10b-5 to Prosecute Insider
Trading Violations ........................................................................................................................ 4
United States v. Newman ................................................................................................................. 8
Post-Newman Decision.United States v. Salman .................................................................................................................. 11
Congressional Interest in the Newman Decision ........................................................................... 13
Contacts
Author Contact Information .......................................................................................................... 13
Congressional Research Service
Federal Securities Law: Insider Trading
Overview of Federal Statutes Related to
Insider Trading
Insider trading in securities may occur when a person in possession of material nonpublic
information about a company trades in the company’s securities and makes a profit or avoids a
loss. Federal statutes have provisions which either specifically forbid insider trading or have been
interpreted by courts to prohibit insider trading.
Securities Exchange Act of 1934
One provision in the Securities Exchange Act of 19341 is specifically designed to discourage
insiders in the corporation from taking advantage of their inside information in the trading of the
corporation’s securities. Section 16 of the 1934 Act2 places sanctions on insiders who use inside
information in making short-swing profits. For purposes of this provision, an insider is defined as
any “person who is directly or indirectly the beneficial owner of more than 10 percent of any
class of any equity security ... which is registered ... or who is a director or an officer of the
issuer....” Every person meeting the insider definition must file a report with the Securities and
Exchange Commission (SEC) at the time of the registration of the security on a national securities
exchange or by the effective date of a filed registration statement or within 10 days after he
becomes a beneficial owner, director, or officer. If there has been a change in the ownership of the
security or if there has been a purchase or sale of a security-based swap agreement involving the
equity security, the insider must file the report before the end of the second business day
following the day on which the transaction has been executed.3
To prevent the unfair use of inside information, Section 16(b) permits the company or any
security holder suing on behalf of the company to recover any profit which the person realizes
from any purchase and sale or sale and purchase of any equity security of the company within a
period of less than six months.
Section 10(b)4 of the 1934 Act and SEC Rule 10b-55 are used in most cases of insider trading
violations, as well as in other kinds of alleged securities fraud. Section 10(b) is the 1934 Act’s
general antifraud provision. Although it does not refer to specific types of fraud or to specific
types of insiders, one of its most frequent applications over the years has been to insider trading.
The statute states,
It shall be unlawful for any person, directly or indirectly by the use of any means or
instrumentality of interstate commerce or of the mails, or of any facility of any national
securities exchange:
(a)...
(b) To use or employ, in connection with the purchase or sale of any security registered
on a national securities exchange or any security not so registered, or any securities-based
swap agreement any manipulative or deceptive device or contrivance in contravention of
1
15 U.S.C. §§78a et seq.
15 U.S.C. §78p.
3
15 U.S.C. §78p(a).
4
15 U.S.C. §78j(b).
5
17 C.F.R.§240.10b-5.
2
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such rules and regulations as the Commission may prescribe as necessary or appropriate
in the public interest or for the protection of investors.
(c)...
Rule 10b-5, mentioned later along with other SEC regulations which focus more specifically on
insider trading, is the general SEC rule which is used in all kinds of securities fraud cases. The
rule states,
It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of any national
securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the circumstances under
which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate
as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
Insider Trading Sanctions Act of 1984
The Insider Trading Sanctions Act of 19846 was enacted because of the belief that
[i]nsider trading threatens ... markets by undermining the public’s expectations of honest
and fair securities markets where all participants play by the same rules. This legislation
provides increased sanctions against insider trading in order to increase deterrence of
violations.
“Insider trading” is the term used to refer to trading in the securities markets while in
possession of “material” information (generally, information that would be important to
an investor in making a decision to buy or sell a security) that is not available to the
general public.7
The act provides that, if the commission believes that any person has bought or sold a security
while in possession of material nonpublic information, the commission may bring an action in
U.S. district court to seek a civil penalty. The penalty may be up to three times the profit gained
or loss avoided.8
Insider Trading and Securities Fraud Enforcement Act of 1988
After a number of hearings and considerable debate in the 100th Congress, the President signed
the Insider Trading and Securities Fraud Enforcement Act of 1988.9 This act expanded the scope
of civil penalties to control persons who fail to take adequate steps to prevent insider trading.10
6
P.L. 98-376, codified in a number of provisions of 15 U.S.C. §§78a et seq.
H.Rept. 98-355, at 2 (1984).
8
15 U.S.C. §78u-1(a)(2).
9
P.L. 100-704, codified in a number of provisions of the federal securities laws.
10
15 U.S.C. §78u-1(a)(3) imposed on a person controlling the violator a penalty of the greater of $1,000,000 or three
times the profit gained or loss avoided. Limitations on the liability of controlling persons may be found at 15 U.S.C.
§78u-1(b).
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The act, among other things, also established a private right of action for buyers or sellers of
securities against the inside trader if they traded contemporaneously with the insider.11
Stop Trading on Congressional Knowledge (STOCK) Act of 2012
The STOCK Act,12 signed into law on April 4, 2012, makes clear that insider trading prohibitions
apply to Members of Congress, congressional staff, and other federal officials. According to
Section 3 of the STOCK Act,
[A] Member of Congress and an employee of Congress may not use nonpublic
information derived from such person’s position as a Member of Congress or employee
of Congress or gained from the performance of such person’s official responsibilities as a
means for making a private profit.
Section 9 of the STOCK Act places this prohibition on other federal officials and also affirms the
non-exemption from insider trading prohibitions for these officials:
Executive branch employees, judicial officers, and judicial employees are not exempt
from the insider trading prohibitions arising under the securities laws, including section
10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.
The STOCK Act also has provisions concerning financial disclosure reporting requirements for
legislative and executive branch officials.13
Examples of Penalties for Insider Trading
There are both civil and criminal penalties14 for insider trading, and the penalties can vary
depending on what statutes a trader is found guilty of violating. For example, 15 U.S.C. Section
78u-1 sets out the civil penalties for securities transactions while in possession of material
nonpublic information. As mentioned above, the penalty can be up to three times the profit gained
or loss avoided. However, willful violations of other provisions, such as Section 10(b), the
general antifraud securities statute, may result in other significant penalties. These penalties for
each willful violation of a securities statute by an individual include fines up to $5 million and/or
imprisonment up to 20 years; a business may be fined up to $25 million.15
Selected Regulations
As stated above, SEC Rule 10b-5, which implements Section 10(b) of the Securities Exchange
Act, is the most frequently used SEC rule in lawsuits that charge violations of insider trading
prohibitions. However, other SEC rules, some of which specifically target insider trading, are also
important.
Rule 10b5-116 prohibits trading “on the basis of” material nonpublic information. This rule states
that one of the proscribed activities under Section 10(b) and Rule 10b-5 is securities trading “on
11
15 U.S.C. §78t-1.
P.L. 112-105, codified in provisions and notes of several titles of the U.S. Code, particularly in Titles 5 and 15.
13
For more information on the STOCK Act, see CRS Report R42495, The STOCK Act, Insider Trading, and Public
Financial Reporting by Federal Officials, by Jack Maskell.
14
The SEC typically seeks the civil penalties, and the Department of Justice typically seeks the criminal penalties.
15
15 U.S. C. §78ff.
16
17 C.F.R. §240.10b5-1.
12
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the basis of material nonpublic information about that security or issuer, in breach of a duty of
trust or confidence that is owed” to the issuer of the security, shareholders of the issuer, or another
who is the source of the inside information. The regulation defines “on the basis of” as having a
kind of knowledge requirement:
[A] purchase or sale of a security of an issuer is “on the basis of” material nonpublic
information about that security or issuer if the person making the purchase or sale was
aware of the material nonpublic information when the person made the purchase or sale.
Various affirmative defenses are allowed to avoid prosecution under the rule, such as the alleged
violator’s demonstrating that, before becoming aware of the material nonpublic information, he
had entered into a binding contract to buy or sell the security, had instructed another person to
buy or sell the security for his account, or had adopted a written plan for trading securities.
Rule 10b5-217 sets out duties of trust or confidence in misappropriation insider trading cases. The
misappropriation theory of insider trading is a fairly recent development in securities law. Under
the classical theory of insider trading, a corporate insider is prohibited from trading that
corporation’s securities if the trade is based on inside information and if the trader has a duty of
trust and confidence to the corporation’s shareholders. In contrast to classical insider trading, the
misappropriation theory finds liable a person not actually a corporate insider but who has instead
been provided inside information in confidence and who breaches a fiduciary duty to the source
of the information in order to gain profit or avoid loss in the securities market. Rule 10b5-2 sets
out examples of what is meant by “duties of trust or confidence.” They include a person’s
agreement to maintain the disclosed information in confidence; a person’s history with the
discloser of the inside information indicating an expectation that the recipient of the information
will keep the information in confidence; and a person’s receiving information from a spouse or
close relative, unless the recipient can show that he neither knew nor should have reasonably
known or agreed that he would keep the information confidential.
Regulation FD18 is another SEC rule which may concern a prohibition on insider trading.
Regulation FD addresses selective disclosure. It provides that, when an issuer or any person
acting on behalf of the issuer discloses material nonpublic information to certain enumerated
persons (typically securities market professionals and holders of the securities), it must disclose
that information to the public. The disclosure of the material nonpublic information to the public
must be made simultaneously with the intentional disclosure to the enumerated persons or as
promptly as possible to the public in the case of a non-intentional disclosure to the enumerated
persons.
Selected Decisions That Have Used Section 10(b)
and Rule 10b-5 to Prosecute Insider Trading
Violations
There are numerous cases that have used Section 10(b) and Rule 10b-5 to prosecute insider
trading violations. What follows is a brief discussion of a few of the most important of these
cases.
17
18
17 C.F.R. §240.10b5-2.
17 C.F.R. §243.100–243.103.
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Although it was decided 25 years before the enactment of the Securities Exchange Act, Strong v.
Repide19 illustrates that the common law rule of fiduciary duty, which is arguably the idea driving
the case law imposing penalties for insider trading, prohibits a company insider from profiting
from knowledge that he alone knows about the company. The Court stated,
A director upon whose action the value of the shares depends cannot avail of his
knowledge of what his own action will be to acquire shares from those whom he
intentionally keeps in ignorance of his expected action and the resulting value of the
shares.
This is a rule of common law....
Even though a director may not be under the obligation of a fiduciary nature to disclose to a
shareholder his knowledge affecting the value of the shares, that duty may exist in special cases,
and did exist upon the facts in this case.
In an administrative broker-dealer disciplinary proceeding, In re Cady Roberts & Co.,20 the SEC
held that Section 10(b) and Rule 10b-5 prohibited insider trading by a person, in this case a
broker-dealer, who may not actually be within the corporation whose stock has been traded but
who has received privileged information about the corporation from someone within the
corporation.
The case concerned a partner in a brokerage firm who, after receiving a message from a director
of Curtiss-Wright that the board of directors had voted to cut the dividend, placed orders to sell
some of the stock before news of the dividend cut was disseminated to the public. The broker was
not a corporate insider (i.e., he was not an officer, director, or significant shareholder). However,
the SEC found that the broker’s conduct violated at least clause (3) of the above-quoted SEC Rule
10b-5 in that it operated as a fraud or deceit on the purchasers and that there was no need to
decide the scope of clauses (1) and (2). In determining that there was a violation of clause (3), the
SEC appears to have found fraud committed on both the company and on persons on the other
side of the market:
Analytically, the obligation [not to trade on inside information] rests on two principal
elements: first, the existence of a relationship giving access, directly or indirectly, to
information intended to be available only for a corporate purpose and not for the personal
benefit of anyone, and second, the inherent unfairness involved where a party takes
advantage of such information knowing it is unavailable to those with whom he is
dealing. In considering these elements under the broad language of the anti-fraud
provisions we are not to be circumscribed by fine distinctions and rigid classifications.
Thus, it is our task here to identify those persons who are in a special relationship with a
company and privy to its internal affairs, and thereby suffer correlative duties in trading
in its securities. Intimacy demands restraint lest the uninformed be exploited.
The SEC rejected the broker’s argument that the obligation to disclose material information exists
only in a situation involving face-to-face dealings:
It would be anomalous indeed if the protection afforded by the anti-fraud provisions were
withdrawn from transactions effected on exchanges, primary markets for securities
transactions. If purchasers on an exchange had available material information known by a
selling insider, we may assume that their investment judgment would be affected and
their decision whether to buy might accordingly be modified. Consequently, any sales by
the insider must await disclosure of the information.
19
20
213 U.S. 419 (1909).
40 SEC 907 (1961).
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Thus, it appears that this case established that Section 10(b) and Rule 10b-5 extend beyond
officers, directors, and major stockholders to others who receive information from a corporate
source.
Securities and Exchange Commission v. Texas Gulf Sulphur,21 a 1968 decision by the U.S. Court
of Appeals for the Second Circuit (Second Circuit), supported the SEC’s ruling in Cady Roberts
by suggesting that anyone in possession of inside information must either publicly disclose the
information or not trade the particular stock until the information becomes public.
The U.S. Supreme Court appears, however, in 1980 to have somewhat modified Texas Gulf
Sulphur by indicating that, for there to be a fraud actionable under Rule 10b-5, there must be a
duty to disclose arising from a relationship of trust and confidence between parties to the
transaction. Chiarella v. United States22 alleged a violation of Rule 10b-5 by an employee of a
financial printer. The employee, who was involved in printing materials related to corporate
takeover bids, deduced the names of the target companies from information contained in
documents delivered to the printer by the acquiring companies. Without disclosing his
knowledge, the employee purchased stock in the target companies and sold the shares
immediately after the information was made public, realizing a profit of $30,000. The lower
courts found a violation of Rule 10b-5 and convicted the employee of the print company for
willfully failing to inform the sellers of the target company securities that he knew of an
imminent takeover bid that would increase the value of their stock.
The Supreme Court reversed. According to the Court, the employee in this situation did not have
a duty to disclose the information. He was not a corporate insider and he received no confidential
information. In addition, no duty arose from the relationship between the printing company
employee and the sellers of the target companies’ securities. The Court held that a duty to disclose
under Section 10(b) and Rule 10b-5 does not arise from the mere possession of nonpublic market
information.23
Dirks v. Securities and Exchange Commission24 went perhaps a little further than Chiarella in the
direction of indicating that noncorporate persons with inside information are not always liable
when trading on inside information. This case involved an officer of a broker-dealer who
specialized in providing investment analysis of insurance company securities to institutional
investors. He received information that the assets of an insurance company were greatly
21
401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969).
445 U.S. 222 (1980).
23
Concurring and dissenting opinions in Chiarella suggest that, if the misappropriation theory of securities fraud had
been presented, Chiarella, a financial printer employee who deduced information from the printing materials related to
takeover bids and then traded based on the information, might have been found guilty under it. Chief Justice Burger
believed that the employee’s conviction should have been affirmed because the “evidence shows beyond all doubt that
Chiarella, working literally in the shadows of the warning signs [stating employer’s confidentiality policy] in the
printshop misappropriated—stole, to put it bluntly—nonpublic information entrusted to him in the utmost confidence.”
Chiarella, 445 U.S. at 245 (Burger, C.J., dissenting). Although Justice Brennan disagreed with the Chief Justice’s view
of the evidence, he agreed that a “person violates section 10(b) whenever he improperly obtains or converts to his own
benefit nonpublic information which he then uses in connection with the purchase or sale of securities.” Id. at 239
(Brennan, J., concurring). Justice Blackmun, with whom Justice Marshall joined, wrote that, even without resting
Chiarella’s conviction on a misappropriation theory, he should have been convicted because he had “purloined”
information (Blackmun, J., dissenting, id. at 246-252). Justice Stevens, who concurred in the opinion of the Court,
wrote separately, emphasizing the “fact that we have not necessarily placed any stamp of approval on what this
petitioner did, nor have we held that similar actions must be considered lawful in the future.” (Stevens, J., concurring,
id. at 238).
24
463 U.S. 646 (1983).
22
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overstated because of fraudulent corporate practices and that regulatory agencies had not acted on
these charges made by company employees. Although the officer of the broker-dealer did not
himself trade the stock, some of his customers did, based on information that they received from
him. The price of the stock fell, and the SEC began investigations, eventually finding that the
officer had violated Rule 10b-5 by repeating the allegations of fraud to investors who later sold
their stock in the insurance company. However, because of his role in uncovering the fraud, he
received only a censure from the SEC.
The Supreme Court found that no violation of Section 10(b) had occurred. In order to find a
violation of Section 10(b) by a corporate insider, two elements are necessary, according to the
Court: the existence of a relationship affording access to inside information intended to be
available only for a corporate purpose and the unfairness of allowing a corporate insider to take
advantage of that information by trading without disclosure. However, the duty arises from a
fiduciary relationship; in addition, there must be manipulation or deception to bring about a
breach of the fiduciary duty. Here, according to the Court, the insider did not trade on the inside
information, nor did he make secret profits. For the officer of the broker-dealer to have the duty
to disclose inside information or to abstain from trading, the officer must have breached his
fiduciary duty. Since he had no duty to abstain from using inside information, he had no preexisting fiduciary duty to the insurance company’s shareholders and, therefore, did not violate
Section 10(b) or rule 10b-5.
Seven years after Dirks, the Supreme Court decided another landmark securities case, Carpenter
v. United States.25 Although the case did not find the defendants guilty under the misappropriation
theory of securities fraud, it did discuss the issue. In the Carpenter case, R. Foster Winans, a
former writer for the Wall Street Journal’s “Heard on the Street” column, and others were charged
with violations of Section 10(b) and Rule 10b-5. They were also charged with violating the
federal mail and wire fraud statutes26 and with conspiracy.27 In researching information to be used
in his column, Winans interviewed corporate executives, but none of the information that he
obtained contained corporate inside information. Because of its perceived quality and integrity,
the column had the potential for affecting the prices of the stocks that it discussed.
The Wall Street Journal’s official policy was that, before publication, the contents of the column
were its confidential information. Despite being familiar with the rule, Winans agreed to give
Peter Brant and Kenneth Felis, both employees of Kidder Peabody, advance information about
the columns. Brant, Felis, and another conspirator, David Clark, bought and sold stocks based on
the probable impact of the information that would later appear in Winans’s columns. The profits
from these trades over a four-month period amounted to $690,000. Kidder Peabody’s compliance
department eventually noticed correlations between the Winans columns and the Clark and Felis
accounts. The SEC began an investigation; Winans and his roommate, David Carpenter, revealed
the scheme; and the indictments followed.
The lower courts found that Winans had knowingly breached a duty of confidentiality by
misappropriating prepublication information. They found that this misappropriation had violated
Section 10(b) and Rule 10b-5 because the deliberate breach by Winans of his duty of
confidentiality was a fraud and deceit on the newspaper. The lower courts also held that Winans
had fraudulently misappropriated property within the meaning of the mail and wire fraud statutes.
The parties found guilty filed for certiorari to challenge the lower courts’ conclusions.
25
484 U.S. 19 (1987).
18 U.S.C. §§1341 and 1343.
27
18 U.S.C. §371.
26
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The Supreme Court was evenly divided28 concerning the convictions under the securities laws
and therefore affirmed the lower courts’ judgment. The Court did not elaborate on the issue of
whether Winans’s activities violated the securities laws. The Court affirmed the lower courts’
judgment with respect to the mail and wire fraud convictions.
Ten years later, in United States v. O’Hagan, the Supreme Court legitimated the misappropriation
theory of securities fraud by finding O’Hagan guilty of Section 10(b) and Rule 10b-5 violations.
O’Hagan was a partner in a Minneapolis law firm, which represented Grand Met, a large
diversified law firm based in London. Grand Met was interested in acquiring Pillsbury. O’Hagan
purchased call options for and stock in Pillsbury after he learned of Grand Met’s interest. After
the tender offer was publicly announced, Pillsbury stock immediately rose. O’Hagan exercised
his options and liquidated his stock, realizing a profit of over $4 million.
The SEC indicted O’Hagan on 57 counts, including securities fraud under Section 10(b) and Rule
10b-5. A jury convicted him on all of the counts, but the U.S. Court of Appeals for the Eighth
Circuit (Eighth Circuit) reversed,29 holding, among other things, that the misappropriation theory
is inconsistent with Section 10(b). The Supreme Court reversed the Eighth Circuit.30
In its decision with respect to the misappropriation theory, the Court found that O’Hagan’s
fiduciary status and his willful intent to violate that status were sufficient to find him guilty of
misappropriating confidential information.
[T]he fiduciary’s fraud is consummated, not when the fiduciary gains the confidential
information, but when, without disclosure to his principal, he uses the information to
purchase or sell securities. The securities transaction and the breach of duty thus
coincide. This is so even though the person or entity defrauded is not the other party to
the trade, but is, instead, the source of the nonpublic information.... A misappropriator
who trades on the basis of material, nonpublic information, in short, gains his
advantageous market position through deception; he derives the source of the information
and simultaneously harms members of the investing public.... 31
United States v. Newman
A decision late in 2014 by the U.S. Court of Appeals for the Second Circuit has brought increased
attention to the issue of insider trading. Some commenters have gone so far as to indicate that the
decision has “upended the government’s campaign” against insider trading, referring to successes
that the U.S. Attorney for the Southern District of New York has had in prosecutions over the past
few years.32
In its decision, United States v. Newman,33 the Second Circuit overturned two high-profile
convictions for insider trading. The court did not simply vacate the convictions; it remanded for
the district court to “dismiss the indictment with prejudice,” thereby forbidding the government
from refiling the case. In March 2015 the U.S. Attorney for the Southern District of New York
28
Because of Justice Powell’s retirement, there were only eight members of the Court at the time of the decision.
92 F.3d 612 (8th Cir. 1996).
30
521 U.S. 642 (1997).
31
Id. at 656.
32
http://dealbook.nytimes.com/2014/12/10/appeals-court-overturns-2-insider-trading-convictions/?_r=0.
33
773 F.3d 438 (2d Cir. 2014).
29
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asked the Second Circuit to reconsider its ruling, but in April 2015 the Second Circuit denied the
U.S. Attorney’s request.34
The Office of the U.S. Attorney for the Southern District of New York brought charges against
various hedge fund and investment fund analysts, including Newman and Chiasson, charging
them with insider trading for allegedly obtaining material nonpublic information from employees
of publicly traded technology companies and then passing that information to the portfolio
managers at their companies. Defendants-appellants Newman and Chiasson appealed their May
2013 convictions from the lower court (U.S. District Court for the Southern District of New York)
on two general bases—insufficiency of evidence and failure to instruct the jury that to convict the
defendants it had to find that a tippee (one who receives inside information) knew that the insider
disclosed financial information in exchange for a personal benefit.
The Second Circuit held that the evidence could not sustain a guilty verdict because the
government did not adequately show that the alleged insiders received personal benefits for
providing information to Newman and Chiasson. In addition, according to the court, the
government did not present evidence that the defendants knew that they were trading on inside
information obtained from insiders who were violating their fiduciary duties.
The Second Circuit’s decision in the Newman case turned on a close examination of the Supreme
Court’s Dirks decision. As mentioned above, Dirks held that, in order to find a tipper (one who
provides inside information to others) liable for violating federal securities laws, the insider must
have a fiduciary duty to the company whose information he discloses and he must have received a
personal benefit from the disclosure. The tippee’s duty to abstain from trading derives from the
insider’s fiduciary duty and benefit. If the insider did not commit a breach of fiduciary duty
resulting in a personal benefit from the disclosure, then the tippee, according to the Supreme
Court, cannot be found liable because liability occurs only when the insider has breached a
fiduciary duty and the tippee knows or should know that there has been a breach of a fiduciary
duty.
In its analysis of the law concerning insider trading, the Second Circuit found that the lower
court’s instructions to the jury were erroneous. According to the Second Circuit, to sustain an
insider trading conviction against a tippee, the government must prove the following elements
beyond a reasonable doubt: (1) the corporate insider was entrusted with a fiduciary duty; (2) the
corporate insider breached his fiduciary duty by disclosing confidential information to a tippee in
exchange for a personal benefit; (3) the tippee knew that the information was confidential and
that it was disclosed for personal benefit; and (4) the tippee nevertheless used that information to
trade in a security or to tip another for personal benefit. In contrast, the lower court instructed the
jury that the government had to prove (1) the insiders had a fiduciary or other relationship of trust
and confidence with their corporations; (2) the insiders breached that duty by disclosing material
nonpublic information; (3) the insiders personally benefited from the disclosure; (4) the defendant
knew that the information he had received had been disclosed in violation of a duty; and (5) the
defendant used the information to buy a security.
The Second Circuit found that, in adhering to the lower court’s jury instructions, a reasonable
juror might conclude that a defendant could be found guilty of insider trading just because the
defendant knew that the insider had disclosed information that was required to be confidential.
This is not an accurate reading of the decision in Dirks, the Second Circuit indicated.
34
No. 13-1837 (L) (2d Cir. April 3, 2015).
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But a breach of the duty of confidentiality is not fraudulent unless the tipper acts for
personal benefit, that is to say, there is no breach unless the tipper “is in effect selling the
information to its recipient for cash, reciprocal information, or other thing of value for
himself.... ” Dirks, 463 U.S. at 664 (quotation omitted). Thus, the district court was
required to instruct the jury that the Government had to prove beyond a reasonable doubt
[emphasis added] that Newman and Chiasson knew that the tippers received a personal
benefit for their disclosure. 35
In addition to its conclusion that the district court provided inaccurate instructions to the jury, the
Second Circuit found that the government, though it was entitled to prove its case through
circumstantial evidence, could not “demonstrate” each element of the charged offense beyond a
reasonable doubt. The Second Circuit’s language concerning the government’s not meeting this
mark is somewhat strong.
[I]f the evidence [presented] “is nonexistent or so meager,” ... such that it “gives equal or
nearly equal circumstantial support to a theory of guilt and a theory of innocence, then a
reasonable jury must necessarily entertain a reasonable doubt.... ” Because few events in
the life of an individual are more important than a criminal conviction, we continue to
consider the “beyond a reasonable doubt” requirement with utmost seriousness.... Here,
we find that the Government’s evidence failed to reach that threshold, even when viewed
in the light most favorable to it.36
The circumstantial evidence in this case was simply too thin to warrant the inference that the
corporate insiders received any personal benefit in exchange for their tips.
Based on its analysis of the Dirks decision, the Second Circuit’s reasoning in Newman may not be
especially surprising. However, the decision has resulted in a great deal of discussion. On the one
hand, there appears to be concern that the decision is a blow to prosecutors and will make it more
difficult for the government to obtain convictions against persons charged with insider trading.
On the other hand, there is praise that needless government prosecutions may have been curtailed.
One article states:
Two camps [have] formed: Prosecutors who complained that the ruling will tie their
hands in pursuing Wall Street crime, and defense lawyers who expressed delight after
years of lamenting what they saw as government overreach. From both sides, a consensus
emerged that the ruling would have a chilling effect on insider trading prosecutions. 37
On July 30, 2015, the U.S. Department of Justice asked the Supreme Court to review the Second
Circuit decision.38 On October 5, 2015, the U.S. Supreme Court declined to hear the Newman
insider trading appeal.39
35
773 F.3d at 450.
773 F.3d at 451.
37
B. Protess and M. Goldstein, Appeals Court Deals Setback to Crackdown on Insider Trading, NEW YORK TIMES
(December 10, 2014), located at http://dealbook.nytimes.com/2014/12/10/appeals-court-overturns-2-insider-tradingconvictions/?_r=1.
It is possible that the Newman decision may affect only criminal insider trading cases brought by the government and
may not have the same kind of impact on the proof needed to convict a person for civil violations related to insider
trading. On April 6, 2015, a judge in the U.S. District Court for the Southern District of New York allowed the SEC to
pursue a civil enforcement action in Securities and Exchange Commission v. Payton after the SEC had dropped the
criminal insider trading charges in the wake of the Newman decision. See Kleinberg Kaplan, Civil Insider Trading Case
Survives Newman, located at http://kkwc.com/publications/civil-insider-trading-case-survives-newman/.
38
http://www.nytimes.com/2015/07/31/business/dealbook/us-asks-supreme-court-to-review-insider-tradingruling.html?_r=0.
39
http://www.law360.com/articles/708238/breaking-supreme-court-rejects-newman-insider-trading-appeal.
36
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Post-Newman DecisionUnited States v. Salman
On July 6, 2015, the U.S. Court of Appeals for the Ninth Circuit (Ninth Circuit) decided a case
that may further complicate the law of insider trading. In United States v. Salman (Salman),40
defendant Bassam Yacoub Salman appealed his conviction by jury trial for conspiracy and insider
trading. He argued that the evidence against him was insufficient to sustain his conviction
according to the Second Circuit’s standard set out in Newman, and he urged the Ninth Circuit to
adopt the Newman standard.
The case involved insider trading in Salman’s extended family. In 2002, Salman’s future brotherin-law Maher Kara began working with Citigroup’s investment banking group focused on health
care. Maher discussed his work with his older brother Michael, who traded on information that
Maher provided him. Maher continued to provide inside information to Michael, including
information about upcoming mergers. Salman became close to Michael and traded on inside
information that Michael provided him. Salman also shared the information with other family
members, and they split the profits. The government presented evidence showing that Salman
knew that he was receiving inside information. Maher testified that he gave his brother Michael
inside information to benefit him. The government also showed that Salman knew how close
Michael and Maher were. Salman, charged with securities fraud and conspiracy to commit
securities fraud, defended on appeal that the government’s evidence was insufficient under the
standard announce in Newman; that is, that there was insufficient evidence to find that Maher
disclosed information to Michael in exchange for a personal benefit or that, if he did, Salman
knew of the benefit.
The Ninth Circuit in its analysis41 looked to the Dirks case, particularly the Dirks discussion of
the “personal benefit” requirement for tippee liability. In examining what the Dirks case had to
say about what “personal benefit” means, the Ninth Circuit focused on the Court’s statement 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.”42 The Ninth
Circuit went on to state concerning the Dirks quote:
The last-quoted holding of Dirks governs this case. Maher’s disclosure of confidential
information to Michael, knowing that he intended to trade on it, was precisely the “gift of
confidential information to a trading relative” that Dirks envisioned. Indeed, Maher
himself testified that, by providing Michael with inside information, he intended to
‘benefit” his brother and to “fulfill [] whatever needs he had.”
Salman argued that the Second Circuit in Newman interpreted Dirks to require that more than
mere evidence of a friendship or family relationship between tipper and tippee is sufficient to find
that a personal benefit was received in exchange for inside information. Salman particularly
focused on the Newman language indicating that, for there to be liability for the exchange of
inside information, there must be “at least a potential gain of a pecuniary or similarly valuable
nature.” The Ninth Circuit disagreed and stated some possible opposition to the Newman
decision:
40
792 F.3d 1087 (9th Cir. 2015).
Judge Jed S. Rakoff, who is Senior Judge of the U.S. District Court for the Southern District Court of New York,
wrote this Ninth Circuit decision. Judge Rakoff sits on a few Ninth Circuit panels each year and was assigned by lot to
the Salman appeal.
42
792 F.3d at 1092, quoting from Dirks, 463 U.S. at 664.
41
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To the extent Newman can be read to go so far, we decline to follow it. Doing so would
require us to depart from the clear holding of Dirks that the element of breach of
fiduciary duty is met where an “insider makes a gift of confidential information to a
trading relative or friend.” Dirks, 463 U.S. at 664. Indeed, Newman itself recognized that
the “’personal benefit is broadly defined to include not only pecuniary gain, but also,
inter alia,...the benefit one would obtain from simply making a gift of confidential
information to a trading relative or friend.’” 43
The Ninth Circuit found that the evidence presented by the government was more than enough for
a “jury to find both that the inside information was disclosed in breach of a fiduciary duty, and
that Salman knew of that breach at the time he traded on it”44 and affirmed the lower court’s
decision convicting Salman of securities fraud and conspiracy to commit securities fraud.
The Ninth Circuit Salman decision and the Second Circuit Newman decision appear to have
different views of what is necessary for finding insider trading violations. Some commenters have
wondered whether the Newman decision is compatible with the Supreme Court’s treatment of
tippee liability in Dirks. Judge Rakoff, the author of the Salman decision, appears to be one of
these questioners. For example, in an April 2015 U.S. District Court for the Southern District of
New York decision, Securities and Exchange Commission v. Payton,45 Judge Rakoff discussed a
possible incompatibility between the two cases, keeping in mind that Dirks is a civil case and
Newman is a criminal case:
In Dirks, a civil case, the Supreme Court defined a personal benefit as
“a pecuniary gain or a reputational benefit that will translate into future earnings.... For
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
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.”
Dirks, 463 U.S. at 663-64 (emphasis supplied). It is arguably unclear whether the
italicized sentence modifies the prior reference to “pecuniary gain or...future earnings,”
or is an independent stand-alone possibility. However, in Newman, a criminal case, the
Second Circuit held that, to the extent Dirks suggests that a benefit may be inferred from
a personal relationship, “such an inference is impermissible in the absence of proof of a
meaningfully close personal relationship that generates an exchange that is objective,
consequential, and represents at least a potential gain of a pecuniary or similarly viable
nature.” 773 F.3d at 452. Whether this is the required reading of Dirks may not be
obvious, [footnote omitted] and it may not be so easy for a lower court, which is bound to
follow both decisions, to reconcile the two [emphasis added].46
The possible incompatibility between Newman and Salman, coupled with the Supreme Court’s
rejection of the Newman appeal, arguably creates something of a split in the federal circuit
courts.47 This may lead to some confusion in prosecuting insider trading cases.
On January 19,
2016, the U.S. Supreme Court granted certiorari48 in the Salman case. A decision may clarify
what is required to find a person guilty of insider trading.
43
Id. at 1093-94.
Id. at 1094.
45
No. 14 Civ. 4644 (S.D.N.Y. April 6, 2015).
46
Id., slip op. at 10-11.
47
For more information on the possible federal circuit split, see CRS Legal Sidebar WSLG1353, Circuit Split on
Insider Trading Law, by Michael V. Seitzinger.
48
United States v. Salman, cert. granted, 577 U.S. ___ (Jan. 19, 2016) (No. 15-628).
44
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Congressional Interest in the Newman Decision
At least three bills have been introduced in the 114th Congress in an attempt to prevent the type of
securities trading allowed by the Newman decision. Two of the bills would amend Section 10, the
general antifraud provision of the Securities Exchange Act, and one of the bills would add a new
provision, Section 16A, to the Securities Exchange Act.
H.R. 1173, referred to the House Committee on Financial Services, would add subsection (d) to
Section 10. It would hold a person liable for violating the insider trading prohibition laid out in
Section 2(a) of the bill if the person intentionally discloses “without a legitimate business
purpose” information that he knows or should know is material information and inside
information. The bill lists factors defining “should know” as including the person’s financial
sophistication, knowledge of and experience in financial matters, position in the company, and
assets under management.
H.R. 1625, referred to the House Committee on Financial Services, would add new Section 16A
to the Securities Exchange Act. The section would prohibit the trading of securities if a person
has material nonpublic information about the securities or knows or recklessly disregards that the
information has been wrongfully obtained or that the securities transaction would be a wrongful
use of the information. The section would also prohibit a person from communicating material
nonpublic information about securities to others if others engage in securities transactions based
on the communication and the securities transactions were reasonably foreseeable. The standard
for wrongfulness of a communication is based on information that has been obtained by such
activities as theft, violation of a federal law protecting computer data, or breach of a fiduciary
duty. Specific knowledge of how the information was obtained is not necessary for a violation so
long as the person trading was aware that or recklessly disregarded that the information was
wrongfully obtained or communicated. The SEC may by rule provide for exemptions from the
prohibitions if the exemptions are not inconsistent with the purposes of the section.
S. 702, referred to the Senate Committee on Banking, Housing, and Urban Affairs, would add
subsection (d) to Section 10 of the Securities Exchange Act. It would prohibit securities
transactions on the basis of material information that a person knows or has reason to know is not
publicly available. It would also prohibit knowingly or recklessly communicating information
that is not publicly available if it is reasonably foreseeable that the communication is likely to
result in a securities transaction. “Not publicly available” does not include information that a
person has independently developed from publicly available sources. The SEC may provide for
exemptions if it determines that they are necessary or appropriate in the public interest and
consistent with the protection of investors.
Author Contact Information
Michael V. Seitzinger
Legislative Attorney
mseitzinger@crs.loc.gov, 7-7895
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