Courts will define boundaries in insider trading
Insider trading law is heating up again, with a trial involving high-profile gambler Billy Walters scheduled to start next week.
Just days ago, the 2nd U.S. Circuit Court of Appeals ordered another round of arguments about the conviction of Mathew Martoma, the former analyst at SAC Capital Advisors involved in the largest trading case ever, while a U.S. District Court on Friday rejected another effort by former hedge fund manager Raj Rajaratnam to overturn some of his convictions.
The issue in the cases revolves around how to interpret the Supreme Court’s decision in December in Salman vs. United States, which found that the government did not have to prove that any tangible benefit was given when one brother tipped another about impending deals.
As often happens, the opinion did not settle how far it should be applied, and now the lower courts will need to figure out what it means.
The source of the controversy was the decision in 2014 by the 2nd Circuit in Manhattan in U.S. vs. Newman, which added a wrinkle to the analysis of when tipping involved a gift that was sufficient to show the tipper received a benefit, a prerequisite to violating the law.
The appeals court held that the government must prove “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.” In overturning the convictions of two hedge fund managers, the Newman decision found that the original tippers and tippees were little more than casual acquaintances, so there was insufficient evidence to prove the information was given as a gift.
The two brothers in the Salman case had a much closer relationship, speaking almost daily, with one giving out information to help the other. The question was whether their personal relationship was sufficient without further proof that something tangible passed between them beyond the warm feeling one gets for being beneficent.
The Supreme Court’s unanimous answer was succinct: “A tipper breaches a fiduciary duty by making a gift of confi-
dential information to ‘a trading relative,’ and that rule is sufficient to resolve the case at hand.”
Justice Samuel Alito’s opinion rejected the benefit analysis in Newman, stating that the 2nd Circuit’s holding “that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family and friends” was inconsistent with the Supreme Court’s interpretation of insider trading law.
What was left unaddressed was how close a friendship needs to be to show a gift of inside information. Although the 2nd Circuit said there had to be a “meaningfully close personal relationship,” that language was not used by the Supreme Court.
Insider trading defendants want to preserve Newman’s description of the requisite personal relationship by limiting the Salman opinion as much as possible to cases involving close family members. The Justice Department, on the other hand, wants the Supreme Court’s decision construed as a clear rejection of the “meaningfully close” requirement so that most friendships — even a fairly casual one — can suffice to show a gift.
Did the Supreme Court reject only Newman’s tangible benefit requirement, or did it also mean to negate the reference to a meaningful relationship?
The 2nd Circuit will consider that question when it hears arguments in May about whether to uphold the conviction of Martoma. The case was first argued in October 2015, but the decision was held until after the Salman decision.
Martoma argues that the government did not introduce enough evidence that he had a sufficiently close relationship with Dr. Sidney Gilman, who leaked confidential information about a clinical trial of an Alzheimer’s drug that led SAC Capital to sell out its position in two pharmaceutical companies, resulting in gains and losses avoided of over $250 million.
The Justice Department’s position is that the two men developed a lucrative relationship through an expert networking firm for which SAC Capital paid Gilman thousands of dollars to speak with Martoma. The government also argues that the Salman decision made it “clear that a gift of confidential information to a trading friend or relative is enough to satisfy the personal benefit requirement” — with no mention of the “meaningfully close” language of Newman.
The Salman case was easy because the two brothers readily admitted to their close relationship, so the Supreme Court did not need to address what other types of relationships might be sufficient. The 2nd Circuit will have to decide how much of Newman’s analysis survives when it moves into a murkier area that mixed together business dealings and some measure of personal friendship.
It will be difficult for courts to fashion a clear test for when a friendship is close enough to show that a gift of confidential information is the benefit needed to violate the insider trading laws. Martoma’s case will be an opportunity for the 2nd Circuit to flesh out the meaning of the Salman gift analysis, perhaps preserving a portion of the Newman decision that the Supreme Court seemed to have unceremoniously rejected.
The trial of Walters, scheduled to begin next Monday, has generated headlines because of the involvement of professional golfer Phil Mickelson and questions about whether leaks by an FBI agent improperly influenced the investigation.
Last week, Judge P. Kevin Castel of U.S. District Court in Manhattan rejected a defense request to dismiss the charges because of the agent’s disclosures to the New York Times and the Wall Street Journal in 2014. He found that there was no prejudice to Walters, and that dismissal of the charges was not an appropriate way to punish the government for the misconduct of an investigator.
An issue in the trial will be whether the relationship between Walters and his source, Thomas Davis, a former chairman of the board of Dean Foods and a consultant in an activist campaign involving Darden Restaurants, was sufficiently close to find that tips about the two companies were a gift in violation of the insider trading laws.
The indictment says the two men “maintained a personal relationship and friendship founded on a shared interest in sports, golf, gambling and business.” In addition, Walters was involved in loans to Davis that were not repaid.
The defense wants the jury to be instructed that the government must prove a “meaningfully close personal relationship” between the two, arguing that there must be a line drawn “between a friend (where a gift of confidential information can satisfy the benefit requirement) and a casual acquaintance (where it may not).”
Prosecutors did not include that language in their proposed jury instructions, and will likely point to the intertwined personal and business relationship as sufficient to show there was either a payoff for the information or a gift from Davis, much like in Martoma’s case.
Whether the government can show the friendship was close enough so that the tips constituted a gift could be a crucial issue. Much of the evidence about the relationship will come from Davis, who has cut a deal and admitted that he had initially lied to investigators about passing confidential information, which could undermine his credibility. Castel’s decision whether to instruct the jury that the relationship must be “meaningfully close” might tip the scales.
In Rajaratnam’s effort to overturn his conviction, Judge Loretta A. Preska of U.S. District Court in Manhattan rejected the argument that he was not guilty because the government had not shown at his trial in 2011 that any benefit was passed to the tippers. Applying the Salman decision, she stated that “because all the information was transferred between trading relatives or friends, the mere transfer of information is sufficient to constitute a benefit.”
This approach is much closer to how prosecutors approached the benefit issue before Newman, when showing almost any connection between a tipper and tippee that could arguably be called a friendship sufficed to show a gift as the benefit for inside information. There was no reference to the closeness of the relationship in Preska’s opinion, perhaps indicating that any type of friendship is sufficient.
There is always a measure of uncertainty after a Supreme Court opinion as lower courts have to apply it to new cases. Much like Solomon, judges can be expected to fall somewhere in the middle, requiring more than a passing acquaintance but less than “BFF” to establish the relationship when there is a gift of inside information. How they explain that requirement will be the real test as insider trading law moves forward.