The Latest Chapter in Insider Trading Law: Major Circuit Decision Expands Scope of Liability for Trading on a “Tip”

The Latest Chapter in Insider Trading Law: Major Circuit Decision Expands Scope of Liability for Trading on a “Tip”

Legal Sidebari

The Latest Chapter in Insider Trading Law:
Major Circuit Decision Expands Scope of
Liability for Trading on a “Tip”
November 14, 2017
In late August, a split panel of the U.S. Court of Appeals for the Second Circuit (Second Circuit) affirmed
the insider trading conviction of Mathew Martoma, a former portfolio manager at the hedge fund SAC
Capital Advisors. Martoma’s conviction, resulting from trades that netted the defendant and his firm
millions of dollars, was part of a broader investigation in which SAC Capital itself was forced to pay $1.8
billion in the largest insider trading penalty in history. Martoma not only involved high dollar figures, but
the Second Circuit’s decision may have significant implications for insider trading law. The case is the
first from the Second Circuit—an appeals court based in Manhattan and known for its securities law
expertise—interpreting last year’s Supreme Court decision in Salman v. United States. As commentators
have noted, Martoma has raised important questions as Congress, courts, law enforcement and market
participants consider what type of information sharing—and specifically, to whom—can form the basis
for insider trading liability based on a “tip.”
Insider Trading Liability and “Tipping”
As background, insider trading is a violation of Section 10(b) of the Securities Exchange Act and the
Securities and Exchange Commission’s (SEC’s) Rule 10b-5, which prohibit, respectively, the “use [of] . .
. any manipulative or deceptive device or contrivance” and “any act, practice, or course of business which
. . . operates as a fraud or deceit” in connection with the purchase or sale of a security. In its classic form,
insider trading involves corporate insiders trading securities on the basis of material, non-public
information in violation of a fiduciary duty (i.e., a duty of trust and confidence owed under the law) to the
corporation’s shareholders. Others, such as a company’s lawyers, for example, can also be found guilty of
insider trading if they trade on material, non-public information that they have “misappropriated” in
breach of a fiduciary duty to their principal. Otherwise, market participants are generally free to trade on
the basis of inside information without running afoul of Section 10(b) and Rule 10b-5, with an important
exception: “tipping liability.”
Tipping liability arises in a situation where the insider, instead of trading on inside information himself,
acts as a “tipper” and provides inside information to a “tippee,” who then, in turn, trades on that
information. If the tippee knew (or should have known) that the insider or tipper breached a fiduciary duty
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in disclosing the information, the tippee may be liable for insider trading along with the tipper. Martoma’s
case, like a number of other significant insider trading convictions in recent years, involves trading based
on a “tip.”
Personal Benefit Requirement and “Gifting”
In order to conclude that a tipper breached a fiduciary duty, courts require a finding that “[the tipper]
personally will benefit, directly or indirectly, from [making the] disclosure,” an inquiry that is largely fact
dependent. For instance, a personal benefit is most obviously found where a tipper receives monetary
payment from the tippee in exchange for information. The Supreme Court in Dirks v. SEC, however, has
also explained that a “personal benefit” can be inferred when a tipper “makes a gift of confidential
information to a trading relative or friend.” While perhaps not perfectly intuitive that the giver of a gift
would be seen as receiving a benefit, Dirks viewed a “tip” of information to a relative or friend as not
meaningfully different from the tipper trading on the information himself for cash and then gifting the
proceeds to the tippee. However, Dirks also found it important to protect from liability those who may
regularly receive material, non-public information, such as market analysts and reporters, from sources
encountered in the course of their employment.
In recent years, courts have struggled to balance these considerations from Dirks in defining the limits of
when the “gifting” inference should apply:
 In 2014, in United States v. Newman, the Second Circuit expressed concern that casual
acquaintances could become encompassed within “gifting theory,” resulting in the
personal benefit requirement having little “consequence.” Accordingly, Newman
articulated a relatively strict test, holding that a “gift” of inside information could not
serve as the basis for an insider trading conviction absent “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 valuable nature” for the
tipper.
 Two years later, in Salman v. United States, the Supreme Court upheld a defendant’s
conviction for insider trading based on inside information obtained from his brother-in-
law. Salman addressed—and rejected—certain language from Newman. Specifically, the
Supreme Court made clear that a potential gain of a “pecuniary or similarly valuable
nature” to the tipper is not necessary for the “gifting theory” to apply, reaffirming Dirks’
statement that a tip that is provided to a “friend or relative” can form the requisite
inference of a personal benefit. The Court, however, perhaps because the relationship at
issue in Salman fell squarely within Dirks’ “friend or relative” language, did not
explicitly address the “meaningfully close relationship” requirement from Newman.
Martoma and Its Implications for Insider Trading Law
Martoma focused his argument on appeal on Newman’s “meaningfully close relationship” requirement.
Martoma contended that he did not have such a relationship with his tippers, two doctors working on the
clinical trial for a drug being developed by two pharmaceutical companies. In his role as a portfolio
manager covering healthcare and pharmaceutical stocks for SAC Capital, Martoma regularly met with the
doctors, who divulged confidential information regarding the drug. Martoma, in turn, used the
information to profit in subsequent transactions involving those pharmaceutical companies’ stock.
The Second Circuit rejected Martoma’s argument, concluding that the “meaningfully close relationship”
requirement was untenable in light of the Supreme Court’s fundamental changes to the Newman analysis
in Salman, including its reaffirmation of the logic in Dirks. Adding another wrinkle to this already
complicated area of law, the majority articulated a new test for finding a personal benefit in the case of
gifting a tip—one which dispenses with any “friend or relative” requirement altogether. In a clear

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departure from Newman, Martoma held that a personal benefit could be inferred if the tip is made to
anyone “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.”
The majority reasoned as such because of Dirks’ conclusion that a tip to a friend or relative was not
meaningfully distinguishable from a cash gift for purposes of insider trading liability. Building on this
rationale, the court explained that, for example, a tenant’s “gift” of information to his doorman in lieu of a
year-end gratuity should be a basis for liability as well. As raised in dissent in Martoma, the standard set
forth by the majority has the potential to vastly expand the gifting theory’s use—and insider trading
liability—based on an insider or tipper’s sharing of information with a range of tippees, such as
acquaintances, colleagues, or even strangers. The court’s expansive view has since been called a “boon to
prosecutors” by some reporters, and comports with one of the government’s arguments in Martoma that
the depth of a friendship should not matter where one has disclosed information to another without
legitimate corporate purpose in violation of a fiduciary duty.
Going forward, Martoma has asked to have his case reheard by the entire Second Circuit, arguing that the
August decision inappropriately overruled the “meaningfully close relationship” requirement from
Newman and misconstrued the Supreme Court’s decision in Salman. In particular, Martoma contends that
the panel’s expansion of the gifting theory essentially nullifies the personal benefit requirement, because
all information sharing (with the expectation that the recipient will trade on that information) could now
potentially be seen as a “gift.” Two outside groups have argued in support of Martoma’s motion,
contending that the Martoma standard for when a tip will be considered a “gift” is vague and subjective,
leaving juries with the difficult and confusing task of “divining” the mental states of both the tipper and
tippee. The Second Circuit’s decision as to whether it will rehear the case is pending. If the Second
Circuit declines to rehear the case, Martoma may still choose to file a petition for a writ of certiorari to the
Supreme Court.
In the meantime, Martoma could be of interest to those in Congress with concerns about clarifying the
scope of insider trading liability, which has developed over the years solely through the courts. For
example, after the Second Circuit’s Newman decision, several insider trading bills were introduced in the
114th Congress (H.R. 1173, H.R. 1625, and S. 702). While some, including several federal judges, have
periodically called upon Congress to legislate in this area, SEC Chairman Jay Clayton recently remarked
that he does not believe there is a need for such a statute, satisfied with the SEC’s ability to punish
wrongdoers under current law.

Author Information

Nicole Vanatko

Legislative Attorney

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