It is by now old news that the United States Supreme Court recently upheld a tipping conviction in Salman v. United States. The case turned on the issue of personal benefit, introduced in the seminal 1983 Supreme Court case of Dirks v. SEC, 463 U.S. 646 (1983). In a widely discussed forerunner to Salman handed down in 2014, U.S. v. Newman, 773 F. 3d 438 (2d Cir. 2014), the Second Circuit overturned the conviction of remote tippees, in part on the basis that the government had not demonstrated that the initial tippers received a personal benefit. In addition to finding no personal benefit, however, the Second Circuit in Newman also reversed "because the Government introduced no evidence that the defendants knew that the information they traded on came from insiders or that the insiders received a personal benefit in exchange for the tips." The Supreme Court in Salman expressly left this ruling from Newman – which has significant consequences for professional market participants – undisturbed. Salman offers an opportunity to review Newman and more recent case law on remote traders from a prophylactic perspective.
U.S. v. Newman
In Newman, the evidence at trial showed that defendants Todd Newman and Anthony Chiasson (and others) indirectly obtained information from company insiders at Dell and NVIDIA. Newman and Chiasson were several degrees of separation away from the source of the information, and there was no evidence that either was aware of the source.
In reversing the conviction, the Second Circuit reasoned that even if the first-stage exchange of information involved a personal benefit conferred upon the tipper, there was no evidence that the downstream tippees knew of this benefit, or even of identities of the initial tipper and tippee. As the court said, "It is largely uncontroverted that Chiasson and Newman and even their analysts, who testified as cooperating witnesses for the government, knew next to nothing about the insiders and nothing about what, if any, personal benefit had been provided to them." The court thus rejected the invitation of the government to conclude that the "specificity, timing and frequency of the updates provided to Newman and Chiasson about Dell and NVIDIA were so 'overwhelmingly suspicious' that they warranted material inferences that could support a guilty verdict." According to the appellate court, even if "detail and specificity could support an inference of the nature of the source of information, it cannot, without more, permit an inference as to that source's improper motive for disclosure." Thus, even assuming such an improper motive, the defendants could not be convicted unless they knew, or deliberately avoided knowing, that the information they received originated from corporate insiders whose relationship with their tippees was such that they received the personal benefit required by Dirks. This holding of the Second Circuit was not disturbed by Salman.
SEC v. Payton
Newman was a criminal case. Last year, a federal trial court addressed the teachings of Newman in a civil case, SEC v. Payton, 97 F. Supp. 3d 558 (SDNY 2015). The court observed that there was an important distinction between criminal and civil insider trading cases. "[S]ometimes [insider trading] cases are criminal prosecutions, in which circumstance a court is obliged to define unlawful insider trading narrowly ... Other times those cases are civil proceedings, most often brought by the [SEC], in which circumstance a court is inclined to define unlawful insider trading broadly ..." With the lower standards of proof in the civil case, the court allowed the SEC to proceed to trial with its case in Payton, even though the Department of Justice had declined to bring a criminal action.
In brief, the facts of Payton were as follows. Michael Dallas was a law firm associate assigned to work on the acquisition of SPSS, Inc. by IBM. Trent Martin, who was employed at a registered broker-dealer, was a close friend of Dallas. Martin roomed with Thomas Conradt, a lawyer who also worked at a broker-dealer. Defendants Daryl Payton and Benjamin Durant worked at the same broker-dealer as Conradt. Dallas told Martin about the SPSS acquisition in confidence, after which Martin tipped the information to Conradt. Conradt then informed Payton and Durant about the pending acquisition. According to the SEC complaint, Payton and Durant knew that Conradt was Martin's roommate and the source of the information "but did not ask why Martin told Conradt, and they did not ask how Martin learned the information."
In their motion to dismiss, the defendants asserted that the complaint did not adequately allege that the original tipper (Martin) received a personal benefit or that the defendants had knowledge of the personal benefit, as required by Newman. The court disagreed, saying there were facts (not recited here) on the basis of which a jury could make a finding of personal benefit. The court also held that under the facts of the case, a jury could find that the remote tippees, Payton and Durant, had enough knowledge of the personal benefit to satisfy a lower standard of knowledge than would be required in a criminal case. As the court said in a later pretrial ruling in the case (155 F. Supp. 3d 428 (SDNY 2015)), "the SEC need only prove 'that the defendants knew or had reason to know of the benefit to the tipper' in the general sense that they knew that a benefit had been provided." The court distinguished Newman, where the tippees "knew next to nothing about the tippers," from Payton, "where the defendants knew the basic circumstances surrounding the tip."
In February of this year, a jury returned a verdict in favor of the SEC in the Payton case, and in November, the court denied a motion to set aside the judgment as a matter of law. On the knowledge issue, the court said, "There was ... plentiful evidence from which the jury could have concluded that defendants deliberately chose not to ask Conradt questions about the circumstances in which Martin told him about the confidential SPSS information, because they understood that there was a high probability that they would have learned of Martin's personal benefit."
A Spectrum of Situations
At one end of the situational spectrum is information that likely came from an insider but is now widely known in the market. While the widespread knowledge does not vitiate possible fraud of an initial tipster, it is difficult to envision an enforcement action, since the market price should have largely assimilated the information. At the other end is a circumstance in which the information has not been disseminated, the trader does not actually know the source of the information, but the trader consciously avoids learning the source's identity. Newman, in the criminal context, and Payton, in the civil context with its lower standard of proof, counsel that a trader cannot intentionally turn a blind eye to available information on the identity and motivation of the source.
In the middle ground, the information is not yet out in the market, but the trader, while possibly suspicious, lacks credible knowledge of the source. Newman seemingly protects the trader from liability, but caution and consultation with legal counsel are nonetheless advisable even when the source of the information is remote and unknown. While the holding of Newman stands undisturbed, recent case law, and possible after-the-fact accusations of conscious avoidance, argue in favor of a cautious approach.
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