In United States vs. Martoma, issued on August 23, the Second Circuit reexamined its standard for evaluating liability for insider trading under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. In particular, the Second Circuit clarified the personal benefit requirement for a finding of tippee liability. A tippee violates Section 10(b) and Rule 10b-5 when he or she makes a purchase or sale based on material, nonpublic information received from a tipper, such as a corporate insider, where the tippee knew or should have known that the tipper breached a fiduciary duty, and where the tipper received a personal benefit from the disclosure.

In Martoma, defendant-appellant Mathew Martoma challenged his convictions for conspiracy to commit securities fraud and securities fraud on the basis of insufficient evidence, showing a personal benefit to the tipper as required under the “pecuniary quid pro quo” theory of insider trading liability, and by challenging the jury instruction on what it means to receive a personal benefit. Martoma was a portfolio manager for the hedge fund S.A.C. Capital Advisors, LLC (SAC) who managed an investment portfolio focused on pharmaceutical and health care companies. During the relevant time period, two pharmaceutical companies were developing an experimental drug for the treatment of Alzheimer’s disease. According to evidence presented at trial, Martoma met with two doctors involved in the clinical trial several times to discuss information about the clinical trial, despite the doctors’ obligations to keep that information confidential. Both doctors were paid consultants. Ultimately, SAC reduced its position in the securities of both pharmaceutical companies, based on information gained by Martoma. When the final results of the trial were announced, the share price of both companies began to decline. As a result of the trades made in advance of the announcement, SAC gained $80.3 million and averted losses of $194.6 million.

Following Martoma’s four-week jury trial, and during the pendency of his appeal, the Second Circuit decided United States vs. Newman. In Newman, the Second Circuit clarified the “personal benefit” requirement. 773 F.3d 438, 452 (2d Cir. 2014) abrogated by Salman vs. United States, 137 S. Ct. 420 (2016). The Second Circuit held that an inference of a “personal benefit” to the tipper was only permissible where there was “proof of 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.” Id. The Ninth Circuit subsequently declined to adopt the Second Circuit’s reasoning regarding a personal benefit, creating a circuit split on the issue.

The Supreme Court resolved that circuit split in Salman vs. United States. The Court held that a “personal benefit” includes “the benefit one would obtain from simply making a gift of confidential information to a trading relative.” Salman, 137 S. Ct. at 429. Additionally, the Supreme Court expressly rejected the Second Circuit’s requirement that the tipper “also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for gift to family or friends.” Id. at 428. The Court stated that “the tipper benefits personally because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.” Id.

On appeal, Martoma argued that it was not proven that he and the tipper had a “meaningfully close personal relationship” as required by the Second Circuit for a finding of insider trading liability. However, applying Salman and Dirks vs. SEC, 463 U.S. 646 (1983), which Salman reaffirmed, the Second Circuit held that “an insider or tipper personally benefits from a disclosure of inside information whenever the information was disclosed ‘with the expectation that [the recipient] would trade on it,’ . . . and the disclosure ‘resemble[s] trading by the insider followed by a gift of the profits to the recipient,’ . . . whether or not there was a ‘meaningfully close personal relationship’ between the tipper and tippee.” United States vs. Martoma, No. 14-3599, 2017 WL 3611518, at *8 (2d Cir. Aug. 23, 2017) (internal citations omitted). The Second Circuit was careful to note that its holding “does not eliminate or vitiate the personal benefit rule; it merely acknowledges that it is possible to personally benefit from a disclosure of inside information as a gift to someone with whom one does not share a ‘meaningfully close personal relationship.’” Id. at *9. In light of Salman, the court explicitly rejected “the categorical rule that an insider can never personally benefit from disclosing inside information as a gift without a ‘meaningfully close personal relationship.’” Id. Accordingly, the Second Circuit affirmed Martoma’s conviction.

This post was also written by Carrie M. Stickel and Alexandra McNicholas.