(Article from Securities Law Alert, April 2015)
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In United States v. Newman, 773 F.3d 438 (2d Cir. 2014), a case brought under the “classical” theory of insider trading, the Second Circuit held that a tippee can only be liable for insider trading if “the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for a personal benefit.” On April 6, 2015, the Southern District of New York held that Newman’s “personal benefit” requirement also applies in cases brought under the “misappropriation” theory of insider trading. Sec. & Exch. Comm’n v. Payton, 2015 WL 1538454 (S.D.N.Y. 2015) (Rakoff, J.). The court also held that a tippee “may be civilly liable” for trading on material nonpublic information if the tippee either “knew or recklessly disregarded” the tipper’s receipt of a personal benefit in exchange for the disclosure of that information (emphasis added).
Background
At issue were allegations that Michael Dallas, a law firm associate, had disclosed information concerning IBM’s pending acquisition of SPSS to his roommate, Trent Martin, who was a registered broker-dealer at the time. The SEC alleged that Martin had “tipped inside information about the SPSS acquisition” to his roommate, Thomas Conradt, a lawyer affiliated with a New York broker. According to the SEC, Martin and Conradt “shared a close, mutually-dependent financial relationship, and had a history of personal favors.” For example, “Conradt took the lead in organizing and paying shared expenses for the apartment,” and assisted Martin when he ran into legal trouble in connection with a street altercation. Several days after the street altercation incident, Conradt purchased SPSS securities.
Conradt allegedly disclosed information concerning the SPSS acquisition to two of his colleagues. The SEC claimed that Conradt informed his two colleagues that he had obtained the information from his roommate. The two colleagues then purchased SPSS securities. The SEC subsequently brought civil insider trading claims against Conradt’s two colleagues (“defendants”), on the grounds that defendants knew that Martin had misappropriated the information concerning the SPSS acquisition and had inappropriately disclosed this information to Conradt.
Court Holds Newman’s “Personal Benefit” Requirement Applies Even in Misappropriation Cases Involving Remote Tippees
The SEC contended that Newman’ s “personal benefit” requirement should not apply in cases brought under the “misappropriation” theory of insider trading, in which “an outsider (i.e., not part of the company whose stock is to be traded) . . . embezzles material nonpublic information . . . and then either trades on it or, in return for a benefit, provides it for trading purposes to a tippee.” The SEC argued that “a remote tippee’s knowledge that the inside information emanated from an act of misappropriation should be sufficient to charge the remote tippee, for it is the equivalent of knowledge that the tippee is the knowing recipient of stolen property.”
The Southern District of New York rejected the SEC’s contention. The court explained that in Newman, the Second Circuit expressly stated that “[t]he elements of tipping liability are the same, regardless of whether the tipper’s duty arises under the ‘classical’ or the ‘misappropriation’ theory” of insider trading (quoting Newman, 773 F.3d 438). While the Second Circuit’s statements “were not technically necessary to the resolution of the case,” the Southern District of New York found that “these statements seem so clearly intended to give guidance to the lower courts of this Circuit that” the court “[took] them as binding.”
Court Finds the SEC Sufficiently Alleged the Tipper’s Receipt of a Personal Benefit for Disclosure of the Material Nonpublic Information
The court next considered whether the SEC had “sufficiently alleged that Martin, the tipper, [had] received a personal benefit for disclosing material nonpublic information about the SPSS acquisition to Conradt.” The court explained that in Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court stated that a “personal benefit” could be found if there is “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 Dirks Court further stated that a personal benefit may “also exist when an insider makes a gift of confidential information to a trading relative or friend.” In Newman, however, “the Second Circuit held that, to the extent Dirks suggests that a benefit may be inferred from a personal relationship, ‘such an inference is impermissible in the absence of proof of a meaningfully close relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature’” (quoting Newman, 773 F.3d 438).
While the court recognized that it may be difficult “to reconcile the two” decisions, the court found that the SEC’s allegations satisfied “any definition of ‘benefit’ set forth in either Dirks or Newman.” Here, the SEC contended that Martin and Conradt were roommates whose “expenses were ‘intertwined.’” The SEC also alleged that Martin had thanked Conradt for his legal assistance, and “told Conradt he was happy that Conradt [had] profited from the SPSS trading because Conradt had helped him.” The court found these allegations “indicative [of] Martin’s intent to benefit Conradt at the time of the disclosure of the information, as well as evidence of a quid pro quo relationship.”
Court Determines the SEC Adequately Alleged Defendants Recklessly Disregarded Whether the Tipper Had Received a Personal Benefit for Disclosing the Material Nonpublic Information
The court next considered the SEC’s allegations as to whether Conradt’s colleagues (the defendants in this action) knew that Martin had personally benefited by disclosing information concerning the SPSS acquisition to Conradt. The court explained that a defendant may be “guilty of criminal insider trading only if that person committed the offense ‘willfully,’ i.e., knowingly and purposely.” However, the court found that a defendant “may be civilly liable if that person committed the offense recklessly, that is, in heedless disregard of the probable consequences.” The court stated that in civil cases, it is “inclined to define unlawful insider trading broadly, so as to effectuate the remedial purposes behind the prohibition of such trading.”
Turning to the case before it, the court held that the complaint “more than sufficiently allege[d] that defendants knew or recklessly disregarded that Martin [had] received a personal benefit in disclosing information to Conradt, and that Martin in doing so [had] breached a duty of trust and confidence to the owner of the information.” The court noted that defendants allegedly “knew that Martin was the source of the tip to Conradt,” and “that Conradt and Martin were friends and roommates.” One of the two defendants also allegedly knew of “Martin’s assault arrest.” Moreover, defendants allegedly “took multiple steps to conceal their own trading in SPSS securities.” The court determined that these allegations were “enough to raise the reasonable inference that [ ] defendants knew that Martin’s relationship with Conradt involved reciprocal benefits.”