Wednesday, December 7, 2016

US Supreme Court Clarifies Tippee Liability in Insider Trading

The law on insider trading has received considerable attention in the United States (US) in recent years. At the same time, the law in the US is quite narrow compared to most other jurisdictions because liability for insider trading arises only if the person trading owes a fiduciary duty to the company and its shareholders, which has subsequently been extended to a duty owed to the source of the information. This becomes especially important in the case of persons who receive information, known as “tippees”, who then trade while in possession of that information. A tippee who receives such information with the knowledge that its disclosure breached the tipper’s duty acquires that duty and may be liable for securities fraud for any undisclosed trading on that information.

Tippee liability was enunciated by the US Supreme Court in 1983 in Dirks v. SEC, 463 US 646, wherein the Court held that “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. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.”

In the present case, Salman was indicted for trading on inside information he received from a friend and relative-by-marriage, Michael Kara, who in turn received information from his brother Maher Kara, who was a former investment banker with Citigroup. Salman was convicted, and the Ninth Circuit held that Dirks allowed the jury to infer that the tipper breached a duty because he made “a gift of confidential information to a trading relative.” On the other hand, the Second Circuit held in United States v. Newman, 773 F. 3d 438, that a mere gift of confidential information to friend or relative is insufficient and that there must be “proof of a meaningfully close personal relationship” between the tipper and the tippee “that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature”. It was these different approaches adopted by the Second and Ninth Circuits that the Supreme Court was called upon to resolve.

In a unanimous judgment delivered yesterday by Justice Alito in Salman v. United States, the US Supreme Court affirmed the Ninth Circuit’s decision that was on appeal before it, and rejected the position adopted by the Second Circuit in Newman. In doing so, it simply adhered very closely to its earlier decision in Dirks, “which easily resolves the narrow issue presented here”. The decision noted: “Dirks makes clear that a tipper breaches a fiduciary duty by making a gift of confidential information to “a trading relative,” and that rule is sufficient to resolve the case at hand”. Accordingly, when a tipper provides information to a relative or friend, there is a consequential inference that the tipper meant to provide the equivalent of a cash gift. To the extent that the Second Circuit in Newman required something of a “pecuniary or similarly valuable nature” in exchange, the Supreme Court disagreed with that requirement.

In sum, this decision keeps alive a comparatively expanded scope of liability for trading by tippees. The Newman decision had caused some controversy by arguably limiting the scope of liability, but the situation appears to have been corrected by the Supreme Court by staying true to the spirit of its earlier decision in Dirks. To that extent, it emboldens prosecutorial efforts in insider trading cases.

At the same time, it may be noted that the jurisprudence developed in the US, while quite often cited by the Indian regulator and appellate authorities, must be adopted with caution because the regulatory approach towards insider trading in the US (based on fiduciary duties) is vastly different from the rule-based approach in India (based on parity of information).


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