“It’s Complicated:” The Evolving Case Law on How Relationships Impact Insider Trading Liability

Last Wednesday, former SAC Capital Advisors manager Mathew Martoma lost a bid to overturn his 2014 insider trading conviction in the Second Circuit.  United States v. Martoma, No. 14-3599, 2017 WL 3611518 (2d Cir. Aug. 23, 2017).  Martoma, the latest in a string of important insider trading decisions, is significant because the Second Circuit departed from the “relationship test” that had been central to Second Circuit insider trading cases in recent years.  See United States v. Newman, 773 F.3d 438 (2d Cir. 2014).  The departure was based on a 2016 Supreme Court decision, Salman v. U.S., in which the Court rejected the “relationship test” as set forth in Newman, and reaffirmed the standard set in Dirks v. SEC, 463 U.S. 646, 103 S. Ct. 3255, 77 L. Ed. 2d 911 (1983), holding that where a close relationship exists between the tipper and tippee, the government is not required to show that the insider received a benefit of a “pecuniary or similarly valuable nature.”  Martoma had appealed his conviction before Salman was issued, and relied heavily on the Second Circuit’s relationship test outlined in Newman.

In Newman, the Second Circuit overturned the insider trading convictions of two portfolio managers who were “remote tippees,” individuals who traded on inside information but with one or more layers of individuals between them and the insider who originally provided the information.  The insiders in Newman were friends with the tippees but did not gain any personal benefit in exchange for the information provided.  The government argued in that case that it only needed to show that the tippees traded on “material, nonpublic information they knew insiders had disclosed in breach of a duty of confidentiality.”  However, the Second Circuit rejected that argument, explaining that the government was required to show that the insider shared confidential information in exchange for a personal benefit, and that the remote tippees were aware of that fact.  The Second Circuit also held that where there is no quid pro quo exchange for confidential information given by a tipper to a tippee, such information only amounts to a “personal benefit” when the tipper has a “meaningfully close personal relationship” with the tippee.  To meet the test, that relationship must “generat[e] an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”  (Emphasis added.)  Essentially, if there was no potential for financial gain resulting from the gift of information, no personal benefit existed under Newman.  In the immediate aftermath of Newman, many insider trading prosecutions within the Second Circuit became untenable and were dropped.

Martoma’s appeal relied heavily on Newman, which was decided after his original conviction.  He claimed that he and the tipper, a doctor, did not have a “meaningfully close personal relationship,” and that the doctor had not received any personal benefit in exchange for the confidential information he provided Martoma.  Martoma also argued that even if the evidence was sufficient to uphold his conviction, the district court’s jury instructions were insufficient because they did not instruct the jury regarding the “personal benefit” requirement under Newman.  However, while Martoma’s appeal was pending, the Supreme Court issued its decision in Salman v. United States, 137 S. Ct. 420, 196 L. Ed. 2d 351 (2016).  Salman explicitly rejected Newman’s requirement that the tipper must receive something of a “pecuniary or similarly valuable nature” in exchange for a gift to family or friends.  The Court held that providing information to a relative or friend who later trades on it is sufficient to satisfy the personal benefit requirement, although it did not specify how close the relationship must be.  After Salman was decided, Martoma offered supplemental briefing in the Second Circuit, arguing that his conviction still should be reversed because Salman did not overrule Newman’s “meaningfully close personal relationship” requirement.

The Second Circuit rejected Martoma’s argument and held that Salman overruled Newman to the extent Newman required a “meaningfully close personal relationship” between the tipper and tippee.  The court further held that there was no clear error in the jury instructions, and that any alleged error would not have changed the outcome of the trial because the government presented “overwhelming evidence that at least one tipper had received a financial benefit from providing confidential information to Martoma.”

While on its face Martoma appears to have opened the door to a broader range of insider trading prosecutions than were possible under preexisting Second Circuit case law, Judge Pooler’s 44-page dissent calls into question what the effect of the decision will be.  Her dissent argues that the Second Circuit panel went far beyond the limitation previous Supreme Court precedent set, which she said had not been disturbed by Salman.  That limitation was that an insider only receives a personal benefit from gifting information when it is gifted to family or friends—as these people are very unlikely to use the information for valid commercial reasons.  Furthermore, in the dissent’s view, the majority opinion “radically alters insider-trading law for the worse.”  Judge Pooler’s scathing dissent could indicate that the Second Circuit will convene an en banc panel to review the decision.  If en banc review is denied or if the panel affirms the decision, it is expected that Martoma will appeal to the Supreme Court.  In any event, the Martoma opinion may not be the final word on this topic.