Recently, courts in both the United States and Canada issued opinions in high-profile insider-trading cases. The two cases shed light on the nature of the benefit to a tipper necessary to sustain a conviction for insider trading, as well as the legal significance of both the relationship between the tipper and tippee, and the tippee’s knowledge of the tipper’s source of inside information.
United States: Salman v. United States
In its first insider-trading opinion in more than two decades, the Supreme Court unanimously held that a tipper need not receive anything of financial value in exchange for a tip to a trading relative or friend. Siding with the government and disavowing a recent Second Circuit opinion requiring the receipt of something of “a pecuniary or similarly valuable nature,” the Court upheld the conviction of a man who traded on tips gifted to him by a relative. The case, Salman v. United States, No. 15–628 (U.S. Dec. 6, 2016), clarifies the government’s burden in prosecuting insider-trading charges where the tipper and tippee are friends or family members.
The petitioner, Bassam Salman, traded on inside information he received from his brother-in-law, Michael Kara. Salman, slip op. at 2.The tips originated with Michael’s brother, Maher Kara, an investment banker who was privy to confidential information about mergers and acquisitions involving the bank’s clients. Id. at 2–3. Salman, Michael, and Maher were indicted for securities fraud, but only Salman proceeded to trial; Michael and Maher pleaded guilty and testified against Salman. Id. at 3.
The evidence at Salman’s trial established that Maher and Michael had a “very close relationship,” and that Maher “shared inside information with his brother to benefit him and with the expectation that his brother would trade on it.” Id. at 3–4. In one particularly pointed episode, Michael called Maher to ask “a favor”; Maher offered money, but Michael instead requested information regarding an upcoming acquisition. Id. at 4. Without Maher’s knowledge, Michael then fed the information to others, id. at 3, including Salman, whom he befriended when Maher began courting Salman’s sister, id. at 4. Importantly, Michael testified that he told Salman that Maher was the source of his information. Id. By the time of his arrest, Salman had made over $1.5 million in profits from trading on Maher’s tips. Id. at 3. After a jury trial, Salman was convicted on all counts and sentenced to 36 months of imprisonment, three years of supervised release, and over $730,000 in restitution. Id. at 4.
Salman unsuccessfully moved for a new trial and appealed his conviction to the Ninth Circuit. Id. While the appeal was pending, the Second Circuit issued its opinion in United States v. Newman, 773 F.3d 438 (2d Cir. 2014). Salman, slip op. at 5. There, the Second Circuit heldthat the inference of a personal benefit to a tipper from a gift of confidential information to “a trading relative or friend,” which the Supreme Court endorsed in Dirks v. SEC, 463 U.S. 646 (1983),1 “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 pecuniary or similarly valuable nature.” Newman, 773 F.3d at 452. Citing Newman, Salman argued that his conviction could not stand because the prosecution had failed to adduce evidence that Maher “received anything of ‘a pecuniary or similarly valuable nature’ in exchange” for the tips, “or that Salman knew of any such benefit.” Salman, slip op. at 5. The Ninth Circuit disagreed, holding that Salman’s appeal was squarely governed by Dirks, and “[t]o the extent Newman went further and required additional gain to the tipper,” the court expressly declined to follow its sister circuit. Id. at 5–6 (citing United States v. Salman, 792 F.3d 1087, 1093 (9th Cir. 2015)). The Supreme Court granted certiorari “to resolve the tension” between Salman and Newman. Salman, slip op. at 6.
In a twelve-page opinion issued only two months after oral argument, the Court unanimously affirmed the Ninth Circuit. See id. at 1–2. Writing for the Court, Justice Alito reasoned that Dirks “easily resolves the narrow issue presented here.” Id. at 8. Under Dirks, “a tippee is exposed to liability for trading on inside information only if the tippee participates in a breach of the tipper’s fiduciary duty.” Id. Whether the tipper breached that duty turns largely on the purpose of his or her disclosure—an inquiry focused on whether the insider “personally will benefit, directly or indirectly,” from that disclosure. Id. (quoting Dirks, 463 U.S. at 662). The requisite personal benefit “can ‘often’ be inferred ‘from objective facts and circumstances,’ . . . such as ‘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.’” Id. at 9 (quoting Dirks, 463 U.S. at 664). “In particular,” Justice Alito observed, “[Dirks]held that ‘[t]he elements of fiduciary duty and exploitation of nonpublic information also exists when an insider makes a gift of confidential information to a trading relative or friend,’” as “‘[t]he tip and trade resemble trading by the insider followed by a gift of the profits to the recipient.’” Id. (quoting Dirks, 463 U.S. at 664, 667).
These gift-giving principles, the Court held, “resolve this case”: “Maher would have breached his duty had he personally traded on the information here himself then given the proceeds as a gift to his brother,” and he “effectively achieved the same result by disclosing the information to Michael, and allowing him to trade on it.” Id. In turn, Salman acquired, and then breached, Maher’s fiduciary duty to the bank and its clients “by trading on the information with full knowledge that it had been improperly disclosed.” Id. at 10. The Court therefore agreed with the Ninth Circuit that Newman’s call for the tipper to “receive something of ‘a pecuniary or similarly valuable nature’ in exchange for a gift to family or friends” was “inconsistent with Dirks.” Id. (quoting Newman, 773 F.3d at 452).
The Court rejected Salman’s remaining contentions on similar grounds. Salman’s assertion that the Court’s precedents on criminal fraud, including insider trading, demand evidence of personal profit “does not undermine the test Dirks articulated and applied.” Id. at 10–11. Similarly, Dirks’s gift-giving standard was not unconstitutionally vague as applied to Salman’s case, as Dirks “created a simple and clear ‘guiding principle’ for determining tippee liability,” and Salman had not shown that either § 10(b) of the Securities Exchange Act of 1934 or the Dirks standard was plagued with the requisite uncertainty or indeterminacy. Id. at 11. “At most,” the Court held, “Salman shows that in some factual circumstances assessing liability for gift-giving will be difficult.” Id. Finally, the Court rejected Salman’s appeal to the rule of lenity, explaining that “Salman’s conduct is in the heartland of Dirks’s rule concerning gifts.” Id.
Salman demonstrates the Court’s commitment to flexible—albeit expansive—enforcement of the insider-trading laws. By rejecting the Second Circuit’s novel pecuniary gain requirement,2 the Court reaffirmed Dirks’s substance-over-form approach to insider trading—and relieved prosecutors of the burden of establishing a tangible benefit to tippers in exchange for gifts of inside information to family and friends. However, Salman is also notable for what the Court declined to decide. The Court resolved the case on Dirks’s narrow family-and-friends standard, explicitly rebuffing the Government’s invitation to hold that “a gift of confidential information to anyone, not just a ‘trading relative or friend,’ is enough to prove securities fraud.” Id. at 7 (emphasis added). In addition, the Court assumed without deciding that “Dirks’s personal-benefit analysis applies in both classical and misappropriation [insider-trading] cases.” Id. at 6 n.2. And, while denying Salman resort to the rule of lenity, the Court acknowledged that it will be “difficult” in some cases to identify a personal benefit to an insider from a particular disclosure. Id. at 11–12.
While Salman is a clear win for the government, the case does not resolve the scope of the personal-benefit test in several important respects. Cases involving classical insider trading as well as more attenuated relationships between the tipper and tippee may elude the Court’s central holding and present difficult and novel questions for the lower courts. Indeed, the types of relationships appropriately classified as a “trading relative or friend” seem to present the most vexing challenge. Do all remote relatives fall within this standard? Casual acquaintances? Co-workers? Social media connections (e.g., Facebook or LinkedIn)? Litigation can be expected as prosecutors test the bounds of their authority—and the reach of Salman.
Canada: Finkelstein v. Ontario (Securities Commission)
The Ontario Divisional Court’s opinion in Finkelstein resolves important issues about successive tippee liability under Canadian securities law and the utility of circumstantial evidence to prove insider trading and tipping.
The appeal is from a decision of the Ontario Securities Commission which determined that a lawyer (Finkelstein) and four investment advisers (Azeff, Bobrow, Miller, and Cheng) had violated the Ontario Securities Act by engaging in unlawful tipping. Finkelstein v. Ontario (Sec. Comm’n), 2016 ONSC 7508, paras. 1–5 (Can. Ont. Div. Ct.). All but Finkelstein were also found to have engaged in insider trading. Id. para.1
Broadly stated, Finkelstein was found to have been privy to confidential information concerning various corporate transactions being handled by his firm, and he shared that information with Azeff, a close friend of his. Id. paras. 2, 49–50, 63–64, 74–75. Azeff, in turn, passed that information on to others, including Bobrow and Miller. Id. paras. 56, 77, 79, 101. Cheng learned of the tips only through Miller. Id. para. 124. In one instance, Miller was found to have unlawfully traded and to have tipped others following his receipt of detailed and specific undisclosed information about a pending transaction from L.K., a partner in an accounting-and-auditing firm. Id. paras. 80, 106–08, 121. The Commission found that L.K. had received the information from Azeff, who had received it from Finkelstein. Id. para. 101. The court upheld all of the Commission’s findings and sanctions against Finkelstein, Azeff, Bobrow, and Miller, but vacated those against Cheng. Id. para. 192.
Under the Ontario Securities Act (and in most provincial securities legislation in Canada), a person in a special relationship with a public issuer who is in possession of material, non-public information about the issuer may be found liable for trading securities of the issuer or informing others of that information. The definition of “person in a special relationship” is broad and includes: (1) classic insiders such as officers and directors of the issuer; (2) persons or companies engaged in a business or professional relationship with or on behalf of the issuer, as well as their employees; and (3) under s. 76(5)(e), any person who learns of material, non-public information about the issuer from anyone else whom the person knows, or ought reasonably to have known, falls within the definition of “person in a special relationship.”
On appeal, the court first considered the use of circumstantial evidence, observing that “[t]his case, like almost all ‘tipping’ cases, is largely based on circumstantial evidence.” Finkelstein, 2016 ONSC 7508, para. 16. “Inferences must flow from established facts,” the court explained, but those inferences need not “be easily drawn”; the law requires only that an inference “be reasonably and logically drawn from established facts.” Id. para. 20.
Next, the court held that section 76(5)(e) of the Ontario Securities Act, which requires proof that a tippee “knows or ought reasonably to have known that” the tipper had a “special relationship” with the subject issuer, supplies both a subjective route and an objective route to liability. Id. paras. 109–111. Under either route, “[t]here is no requirement in the statute that one must trace the information back to the originator,” nor that all individuals “who may have transferred the non-public information” before its delivery to the defendant be identified. Id. para. 113. “Rather, all that the subsection requires is that the information must be a material fact or material change with respect to an issuer, and that the recipient knew or ought reasonably to have known that the person, who was providing the information to him/her, is him or herself caught by the section”—including another person falling within section 76(5)(e). Id. para. 114. Further, in assessing whether the tippee “ought reasonably to have known” that the tipper was in a “special relationship” with the issuer, courts may consider a host of factors, including: the relationship between the tipper and tippee; the “professional qualification and standing” of the tipper; the professional qualification of the tippee; the level of detail in the tip; the length of time between the tippee’s receipt of the tip and his trading activity; any efforts taken by the tippee to verify the information in the tip; the tippee’s previous ownership of the same stock; and the size of the trade relative to the size of the tippee’s portfolio. Id. para. 116.
Lastly, the court reiterated that “motive is not a requirement for a finding of tipping” under the statute. Id. para. 84. Nevertheless, “to the degree that the presence or absence of motive is relevant, motive can take many forms,” including gaining a client’s trust or building a professional reputation. Id. Echoing the Supreme Court’s ruling in Salman, the court declared, “There is no requirement that motive must involve a direct personal financial gain.” Id.
Applying these principles, the court upheld the Commission’s findings and sanctions, including significant administrative fines, against Finkelstein, Azeff, Bobrow, and Miller. Id. paras. 165–192. As for Cheng, the court faulted the Commission’s analysis for containing factual errors and failing to take relevant factors into account. Id. paras. 142, 145. Cumulatively, these errors rendered both “unsafe” and “unreasonable” the Commission’s finding that Cheng “ought reasonably to have known the information he received, and passed on, originated from an insider.” Id. para. 146.
Like Salman, Finkelstein provides an important and timely clarification of insider-trading law. Finkelstein sets forth much broader grounds for liability, however. The objective route, and the absence of any requirement to trace the full chain of tipping, lighten the government’s load considerably. Nevertheless, the fact-specific nature of the court’s inquiry leaves much room for debate on the adequacy of the government’s proof and the inferences to be drawn therefrom.
1 Specifically, the Court in Dirks held that insider-trading liability requires evidence that the insider has breached a fiduciary duty, a showing supportable by proof that the insider has received “a direct or indirect personal benefit from the disclosure.” 463 U.S. at 663. The Court further explained that “objective facts and circumstances,” such as the relationship between the insider and the recipient, “often justify” the inference that the necessary personal benefit has inured to the insider. Id. at 664.
2 Newman, it merits note, arose from the aggressive prosecution of remote tippees who were “several steps removed from the corporate insiders” and were evidently “[un]aware of the source of the inside information.” 773 F.3d at 443.