United States: Insider Trading's Personal Benefit Test One Year After Martoma

Last Updated: June 20 2019
Article by Andrew Bauer and Ryan D. White

On Monday, June 3, 2019, the Supreme Court declined to review former SAC Capital Advisors portfolio manager Mathew Martoma's 2014 conviction for insider trading. The news comes as the one-year anniversary approaches of the Second Circuit's revised opinion in Martoma's case. Martoma's conviction was part of what many have called the biggest insider trading scheme in history—spawning TV shows such as Showtime's Billions, and best-selling books such as Black Edge, by Sheelah Kolhatkar—stemming from activity in 2008 when he paid a doctor from the University of Michigan for tips about clinical trials of a potential Alzheimer's medication. Before the results of the clinical trial were announced, Martoma caused SAC Capital to enter into substantial short-sale and options trades that resulted in approximately $275 million in gains and losses avoided. Martoma's appeal is one of several recent insider trading cases attempting to provide guidance on what type of "personal benefit" an insider or tipper must receive in order to trigger insider trading liability.

The Personal Benefit Test

According to the SEC, illegal insider trading is "buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, nonpublic information about the security."1 Therefore, any successful prosecution for insider trading requires, among other things, proof that an insider/tipper breached a duty in disseminating the information to the tippee. The issue of what constitutes a breach, which was first established decades ago, has been the subject of significant litigation in recent years.

According to the Supreme Court, a breach of duty occurs when, based on objective criteria, "the insider personally will benefit, directly or indirectly, from his disclosure."2 In other words, that the insider engaged in self-dealing by trading on the information or sharing it with others. For almost thirty years, courts deemed the personal benefit requirement to be satisfied if the government proved that the tipper received a benefit that was either tangible (e.g., money) or intangible (e.g., friendship).

Then, in 2014, a Court of Appeals sitting in New York sparked a new debate in U.S. v. Newman when it narrowed the definition of a personal benefit, making it harder for prosecutors to prove insider trading. The court added a requirement that there be 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."3 The two instances of tipping at issue in Newman—casual career advice between colleagues and a conversation between church acquaintances—did not meet that standard. Without such a benefit, the court reasoned, the insider-tippers had not breached a fiduciary duty, and the tippees could not be held liable.

Two years later, however, the Supreme Court at least partially rejected heightened burden,4holding that the additional requirements were inconsistent with Supreme Court precedent when information is shared with the intent to benefit a "trading relative or friend."

Then, in July 2018, the same New York Court of Appeals that shook things up in Newman upheld Martoma's conviction and, in the process, attempted to clarify the personal benefit test. The court provided a slightly more nuanced version of the test, which it said could be satisfied in one of two ways: (1) if the tipper and tippee share a quid pro quo relationship (akin to the "meaningfully close personal relationship" test in Newman), or (2) if the tipper simply intended to benefit the tippee.5 Regarding the latter test, the "intent to benefit" the tippee, the Martoma court likened the sharing of inside information to a tip you might give your doorman during the holidays. You and the doorman may not have a meaningful relationship (kudos if you do), but if you give him inside information for him to trade on, you clearly intended that he benefit from the information, just as you would if you had given him a cash tip. Critics, on the other hand, have argued that this new emphasis on the tipper's "intent" will all but eviscerate the personal benefit requirement entirely.

The Year Since Martoma

Earlier this year, the Second Circuit issued another decision that appears to further distance the personal benefit test from the heightened standard that was suggested in Newman almost five years ago. Rajat Gupta, a board member at Goldman Sachs who shared material, nonpublic information to a friend and business colleague Raj Rajaratnam, founder of the hedge fund family Galleon Group, appealed his conviction arguing that that the jury instructions were improper as to how personal benefit was defined and whether he had received such a benefit. The Second Circuit rejected Gupta's argument, reiterating its decision in Martoma that the personal benefit need not be pecuniary, and held that the "good relationship with a frequent business partner was consistent" within the personal benefit requirement established by the Supreme Court long ago.6

Prosecutors appear to have taken advantage of the relaxed requirements for satisfying the personal benefit burden. For instance, in a recent case in Florida, Brian Fettner gained access to material, non-public information regarding a potential acquisition of G&K Services by Cintas. Using that information, Fettner placed several trades on behalf of his ex-wife and a former girlfriend and persuaded his father and another friend to make trades. The SEC's complaint explicitly stated that "Fettner did not purchase G&K stock in any account of his own. He did not receive proceeds from any of the G&K trades he placed or from any of the G&K trades he persuaded others to place." While Fettner himself had no pecuniary gain from the trades, the intent to benefit the other four individuals was sufficient to satisfy the personal benefit test and establish liability.7

Other cases suggest that prosecutors may choose to avoid the challenges posed by the personal benefit test altogether. In March, the Court of Appeals in New York heard oral arguments in the appeal of another set of high-profile insider trading convictions in U.S. v. Blaszczak.8 Blaszczak and three others were convicted last year for trading on information leaked from the Center for Medicaid and Medicare Services (CMS) about how certain medical treatments would be reimbursed. In addition to those standard insider trading charges, prosecutors charged the Blaszczak defendants with Securities and Commodities Fraud, which had been enacted as part of the Sarbanes-Oxley Act of 2002 but had been seldom used to charge insider trading prior to Blaszczak. Significantly, the defendants were convicted under the new theory but acquitted on the more traditional insider trading charges. Unlike traditional insider trading, the new theory included no discussion of any breach of duty or personal benefit as an element of the crime. The Court of Appeals may choose to address this disparity between the two legal standards, so securities lawyers are staying tuned awaiting the court's decision.

Looking Forward

The 2014 decision in Newman may have created the impression that passing tips to friends and family would not create any risk of insider trading liability so long as there was no quid pro quo or financial gain. The past year has made clear, however, that is not the case. Last summer, Martoma brought some needed clarity to what triggers insider trading liability for a tipper. Since then, several court decisions have solidified (at least for the time being) that the "intent to benefit" standard will control moving forward. Thus, family and friends cannot hide behind the personal benefit test and insiders need to avoid even the appearance that they have shared material, nonpublic information with family, friends, or business associates.

In the meantime, if the Blaszczak convictions stand up on appeal, prosecutors may have an even simpler path forward that enables them to obtain convictions while side-stepping the burdens imposed by the personal benefit test. Regardless of which path prosecutors choose, all eyes remain on the that case for the next development in insider trading law.

  1. SEC, Fast Answers: Insider Trading.
  2. Dirks v. SEC,  463 U.S. 646, 662 (1983).
  3. United States v. Newman, 773 F.3d 438, 452 (2d Cir. 2014).
  4. Salman v. United States,  137 S. Ct. 420 (2016).
  5. United States v. Martoma, 894 F.3d 64 (2d Cir. 2017) (amended Jun. 25, 2018).
  6. Gupta v. United States, No. 15-2707, 2019 WL 165930, at *3 (2d Cir. Jan. 11, 2019).
  7. SEC v. Fettner, No. 9-19-CV-80613 (S.D. Fla. 2019).
  8. 308 F. Supp. 3d 736, 738 (S.D.N.Y. 2018).

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