The Supreme Court, Salman, and Insider Trading: Why Stock Tips Make Bad Stocking Stuffers

Almost exactly two years ago, this blog posed the following question in a post about insider trading:

Suppose your brother-in-law has too much eggnog at Christmas dinner and starts blabbing about confidential inside information concerning the company where he works. If you trade the company’s stock based on that information, do you risk finding a subpoena from the SEC in your stocking?

Last week, in Salman v. United States, the Supreme Court provided some answers to this holiday conundrum. The bottom line: insider stock tips still make lousy holiday gifts.

Image of the bull on Wall St., home of insider trading

The Standards for Tippee Liability: Dirks v. SEC

Salman involves a subspecies of insider trading called “tippee” liability. Insider trading is defined as buying or selling securities based on material, non-public information, in violation of a duty of trust and confidence. Corporate insiders and others who acquire company secrets may not use that information to enrich themselves in violation of a duty owed to the source of the information.

But the ban on insider trading would be easily evaded if a corporate insider, forbidden to trade herself, could simply tip off an outside friend or family member and encourage them to trade instead. Accordingly, in some circumstances such tippees may themselves be charged with insider trading.

The Supreme Court first addressed tippee liability in Dirks v. SEC in 1983. Dirks held that a tippee who does not owe a direct duty to shareholders may nevertheless be liable for insider trading, but only if: 1) the tipper was violating a duty by providing the information; and 2) the tippee knew or should have known about that violation.

Whether the tipper was violating a duty, the Court said, turns on the purpose of the tip: “[T]he test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach [by the tippee].”

The Court recognized that potential benefits to tippers are not limited to monetary gains and may include reputational benefits or other intangibles. In particular, a benefit could be inferred when an insider “makes a gift of confidential information to a trading relative or friend.”

An important aspect of the Dirks test, therefore, is determining whether the tipper received a personal benefit sufficient to find a breach of duty. The Court took the Salman case to shed some light on how courts should approach this question.

Teeing up Salman: The Second Circuit’s Newman Decision

To fully appreciate Salman one must first consider the U.S. Court of Appeals for the Second Circuit’s 2014 decision in United States v. Newman, the subject of my post two years ago. Corporate insiders in Newman had disclosed confidential information to several securities analysts who passed the information along to others, including the defendants.

After they were convicted for trading on that information, the defendants appealed and argued the government had failed to satisfy both prongs of the Dirks test: they claimed there was insufficient evidence the insiders had received a personal benefit in exchange for the tips and thus violated their duty, and even if they did, there was no evidence the defendants knew about that violation.

The Second Circuit agreed that the government’s evidence of personal benefit to the tippers was inadequate. The government had argued that one tipper received occasional career advice from an analyst to whom he leaked information, while the other tipper and another analyst were social friends who attended the same church.

The Court agreed that “personal benefit” could include intangible benefits, but this did not mean the government could simply establish that the tipper and tippee were friends. If that were sufficient this requirement would practically disappear, because at least a casual friendship between tipper and tippee probably exists in almost all such cases.

Accordingly, the court held, proof of a personal benefit requires evidence of a “meaningfully close relationship [between tipper and tippee] that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”   The evidence in Newman did not meet that standard, and so the court reversed the convictions.

The Supreme Court turned down the government’s request to review Newman, but then just three months later it granted certiorari in Salman, a Ninth Circuit case that also raised the “personal benefit” issue. (I wrote about Salman at the time, in a post you can find here.)

Image of street sign for Wall Street, the home of insider trading

Salman: What Qualifies as a Benefit to the Tipper?

Salman represents the Supreme Court’s first foray into tippee liability since Dirks. Maher Kara, a Citigroup investment banker, repeatedly passed confidential information about upcoming mergers and acquisitions to his brother Michael, knowing that Michael would use it to trade. Michael, in turn, shared the information with Bassam Salman, a close friend whose sister was married to Maher. Salman made more than $1.5 million by trading on these tips before the scheme was discovered. He was convicted of insider trading and sentenced to 36 months in prison.

On appeal to the U.S. Court of Appeals for the Ninth Circuit, Salman urged that court to apply Newman to overturn his conviction. Salman argued that Maher, the tipper, was simply helping his brother out and did not receive anything of a “pecuniary or similarly valuable nature” in exchange. Under the Newman test, he claimed, that meant no violation of a duty by Maher and thus no tippee liability for Salman.

The Ninth Circuit rejected Salman’s arguments, finding that his case involved a straightforward application of Dirks and disagreeing with the analysis in Newman. That created a circuit split that likely led the Supreme Court to take Salman’s case. But when it came to convincing the high court to adopt Newman, Salman was swimming upstream.

In a unanimous opinion by Justice Alito, the Court agreed with the Ninth Circuit and held that Dirks “easily resolves the narrow issue presented here.” Dirks, the Court observed, held that a personal benefit may be inferred when an insider “makes a gift of confidential information to a trading relative or friend.” Maher passed information to his brother knowing he would trade on it, which falls squarely within this language. Game, set, match.

The Court noted that if Maher had traded on the information himself and given the proceeds to his brother, there is no question that would be insider trading. By passing the information to his brother knowing he would trade himself, Maher achieved exactly the same goal. “In such situations, 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.” Because he obtained this personal benefit, sharing the information was a violation of Maher’s duty of trust and confidence to his clients – a duty that Salman inherited and then violated when he traded on the information with full knowledge of its improper origins.

The Supreme Court expressly rejected the more stringent benefit test adopted by Newman: “To the extent that the Second Circuit [in Newman] held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends . . .we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.”

The Court also rejected Salman’s claim that the benefit test was unconstitutionally vague. Although it agreed that determining whether a benefit occurred might be difficult in some cases, the Court said it did not need to confront that issue because “Salman’s conduct is in the heartland of Dirks’s rule concerning gifts.”

Image of Christmas Stockings - stock tips make bad holiday gifts

Issues Remaining after Salman: Moving Beyond Friends and Family

The most significant aspect of Salman is its rejection of Newman. Because the Second Circuit includes New York and Wall Street, Newman had caused quite a stir and was seen as a significant blow to the government. Prosecutors were forced to drop a number of insider trading cases in the wake of the decision. Salman thus should give a boost to both criminal and civil insider trading investigations.

The court of appeals in Newman had also considered what the government must prove concerning the tippee’s knowledge – the second part of the Dirks test. The government argued it had to prove the tippee knew the information was given in violation of the tipper’s duty but did not need to prove the tippee knew the tipper had received a benefit. The Second Circuit, however, held that the government must prove that the tippee knew both.

The knowledge issue was not before the Supreme Court in Salman, as the Court noted in a footnote. But the briefs, oral argument, and opinion all indicate the government now agrees it must prove the tippee knew both that the tipper violated a duty and that he received a benefit. Salman therefore provides some clarity on the knowledge prong of the Dirks test as well, and that portion of Newman appears to remain good law. And that means cases like Newman involving “remote tippees” – those several steps removed from the source of the information and thus less aware of the details of the tipper’s activities – may continue to be challenging for the government.

Some commentators have suggested Salman leaves unanswered how close a friendship must be before the tipper can be said to benefit from disclosure. Must there be a close, personal friendship, or would the standard apply to an occasional golfing buddy or even a casual Facebook friend? And who qualifies as a “relative”? In-laws? Second cousins twice removed?

I think future cases are unlikely to hinge on such questions. Basing criminal liability on determining, for example, whether a friendship was sufficiently “meaningfully close,” as the Second Circuit suggested in Newman, would likely be vague and unworkable.

The Court in Dirks listed a gift of information to a friend or relative merely as an example of an improper disclosure, not as the definition of one. It would be a mistake to believe that a court must now determine whether a tippee is truly a “friend” or “relative” and what exactly that means. The test should focus not on the nature of the relationship but on the purpose behind the tip.

Dirks held that whether disclosure is a breach of duty “depends in large part on the purpose of the disclosure,” and the Court in Salman reaffirmed this language. Much of the Salman oral argument also focused on the purpose of the gift, with the Justices (and the government) pointing out that Maher’s gift of inside information was done for a personal purpose and not a corporate one.

The government in Salman argued that the benefit requirement of Dirks is met any time an insider discloses information for a personal purpose rather than a corporate purpose. The Court did not need to go that far because Salman fell squarely within the language of Dirks about disclosure to a relative, and the Court simply took the narrowest path possible to decide the case at hand. But for future cases a test that hinges on the tipper’s purpose is the logical outgrowth of Dirks and Salman.

To borrow an analogy used during oral argument, suppose I see a sad person on the street and feel bad for them, so I give them inside information intending that they trade on it. If I traded on the information myself and give the stranger the money, that would be insider trading. That tip benefits me – it allows me to make the desired charitable gift without actually taking money out of my pocket. As the Court said in Dirks: “[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.”

A test based on the tipper’s purpose does not make criminal liability rest upon something as nebulous as the closeness of the relationship between tipper and tippee. Instead it focuses on intent, with which criminal law is accustomed to dealing. An insider who tips to a family member, occasional golfing buddy, or stranger on the street does not act for any proper corporate purpose. All such disclosures violate the insider’s duty to refrain from using corporate information for some personal end.

Tippee liability based on gifts of information is unlikely to be limited to close friends and family. Anyone who believes Salman leaves them free to act on improper tips from casual acquaintances will likely find that prosecutors and courts disagree. The Supreme Court’s reaffirmation of Dirks and rejection of Newman signify that it remains very comfortable with a robust theory of insider trading liability.

And as for that errant brother-in-law, tell him you’d rather have a nice sweater or something — and ask him to pass the eggnog.

Note: This post is adapted from a commentary I published in the George Washington Law Review’s “On the Docket.”  You can find that commentary here.

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The Ongoing Legal Saga of Martin Shkreli

When we last checked in on former pharmaceutical executive Martin Shkreli, he had just been indicted for securities fraud and related charges. Shkreli – a/k/a the “pharma bro” and “most hated man in America” – is best known for purchasing the rights to an anti-cancer drug called Daraprim and promptly raising the price by 5,000%. His defiant attitude in the face of the resulting outcry, along with his insult-laden Twitter feed, only heightened his notoriety.

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Pharma Bro Martin Shkreli

But Shkreli’s indictment last December had nothing to do with extortionate drug prices. The charges are based on Shkreli’s earlier conduct at two different hedge funds and at a company he founded called Retrophin. Shkreli allegedly defrauded his hedge fund investors by lying to them about their investments, and then defrauded Retrophin by wrongfully using company assets to settle claims from those hedge fund investors. An attorney who worked as Retrophin’s outside counsel, Evan Greebel, was charged with Shkreli in one count of conspiracy. (You can read a more detailed analysis of the indictment in my earlier post here.)

The criminal proceeding against Shkreli and Greebel is still in the early stages, but there have been a couple of interesting related developments in the past couple of weeks.

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Congressional Testimony – or Lack Thereof

Shkreli was subpoenaed to testify last Thursday, February 4, before the House Committee on Oversight and Government Reform. The committee was holding a hearing about skyrocketing drug prices, and the incident where Shkreli raised the price of Daraprim by 5,000% was Exhibit One.

Shkreli’s attorney made it clear in advance of the hearing that Shkreli would invoke his Fifth Amendment right against self-incrimination. That was no surprise. Even though the hearing was not specifically about Shkreli’s criminal case, there would be too much risk that something he said might end up facilitating his own prosecution. Almost any lawyer would likely give him the same advice.

Shkreli’s lawyer asked that his client be excused from attending the hearing, since he was not going to be able to answer questions. But Congress insisted that he appear, threatening him with additional criminal sanctions if he ignored the subpoena. And so, in a familiar Washington theater production, Shkreli sat before the committee, with his attorney in the “I am not a potted plant” seat directly behind him, and repeatedly invoked his right to remain silent in response to every question.

This type of scene unfortunately plays out quite regularly on Capitol Hill. In most legal proceedings, if a witness is going to take the Fifth it is relatively rare for him to be called to the stand. There may be a hearing before a judge to determine whether the assertion of privilege is valid, but if it is, the witness generally will not be forced to appear simply to assert the privilege over and over. For one thing, it’s a waste of everyone’s time if the witness is not going to answer. But more important, it is grossly unfair: repeatedly forcing a witness to assert his right to remain silent can’t help but lead to the impression he is hiding something and must have done something wrong. What should be a constitutional shield is turned into a bludgeon wielded to suggest the witness must be guilty of something – if not, why not answer the questions?

But Congress routinely compels witnesses to appear even when it is perfectly clear they are going to take the Fifth. Then they pepper the witness with speeches masquerading as questions, forcing the witness repeatedly to invoke his or her right to remain silent.

This is a tawdry business. Perhaps the reason it continues is that some Members of Congress are less concerned about actually getting answers and more concerned with trying to create a good video clip that will get replayed on cable news or social media. And indeed Shkreli’s brief appearance was a made-for-TV event, carried live on CNBC and elsewhere.

Shkreli didn’t do his image any good at the hearing. He smirked, rolled his eyes, and generally seemed annoyed that he had to be there. After he was finally excused, he sent out a Tweet calling the Members of Congress “imbeciles.”

But if Shkreli didn’t exactly cover himself in glory, neither did the Members of the committee. I’m no apologist for the pharma bro, but this practice of publicly pillorying a witness who is simply asserting his basic constitutional rights is pretty disgraceful.

Congress may be one of the few things in this country currently held in lower esteem than Shkreli. The spectacle before the House committee last week will do nothing to boost the approval ratings of either.

Attorney-Client Privilege – or Lack Thereof

In another development, we learned a couple of weeks ago that back in December U.S. District Judge Jack Weinstein ruled the grand jury investigating Shkreli could have access to emails that Shkreli and his former company had claimed were protected by attorney-client privilege.

One aspect of the fraud charged in Shkreli’s indictment relates to Retrophin, the pharmaceutical company he founded in 2011 and took public in 2012. The indictment charges that Shkreli defrauded Retrophin by using its assets to pay off debts that Shkreli incurred while running his hedge funds.

While acting as CEO of Retrophin and engaging in the alleged fraud, Shkreli had email exchanges with his outside counsel (and now co-defendant) Evan Greebel. Greebel, who is now a partner with Kaye Scholer LLP, was employed at the law firm of Katten Muchin Rosenman LLP at the time.

The grand jury subpoenaed documents from Retrophin, including copies of emails between Shkreli and Greebel. Retrophin produced the emails but redacted many of them, based on a claim by Shkreli’s attorney that the documents were protected by the attorney-client privilege.

Normally, of course, communications between attorney and client would be privileged and would not need to be produced. But the privilege is subject to something called the crime-fraud exception: if the client communicates with the attorney in furtherance of a crime or fraud, the law will not protect those communications.

The exception applies only if the communications are used to further an ongoing or future crime or fraud. If a client communicates with a lawyer about past criminal conduct, that of course is fully protected. Indeed, such communications are at the very heart of the privilege in the criminal context.

But a client will not be allowed to use an attorney’s services to help him commit a crime and then turn around and try to protect the very communications with counsel that made the crime possible. In other words, clients are not allowed to convert the shield of the attorney-client privilege into a sword that affirmatively helps them engage in criminal activity.

The crime-fraud exception can apply even when the attorney doesn’t know about the criminal conduct. I recall one case where I was arguing as a prosecutor that the crime-fraud exception applied to certain communications between a major corporation and its lawyers. Some of those communications were with a very distinguished former DOJ official who was now a partner at the firm. The firm brought him into the courtroom during the hearing to sit in the front row and glower at the judge, while the corporation’s lawyers expressed outrage at the suggestion that this gray-haired pillar of the bar might have been involved in any criminal activity.

It was all for show, of course — more theater —  because the attorney does not need to be involved. The client may be lying to his own counsel, just as he is to the victims of his fraud. If the attorney was deceived by the client and was assisting in the crime or fraud unwittingly, the privilege may still be overridden. The focus is on what the client intended, not on the intent or knowledge of the attorney.

In this case, of course, the government has done more than simply allege the attorney was involved – it has indicted the attorney, Greebel, as a co-defendant. Although it’s not legally required, that the attorney has been charged as a co-conspirator in committing the alleged fraud certainly bolsters the government’s argument for the crime-fraud exception.

The burden is on the government to establish that the exception applies. In support of its claim, the government submitted a 47-page affidavit from an FBI agent involved in the investigation. The affidavit alleges that the emails in question directly relate to fraudulent activities carried out by the co-defendants, including the backdating of documents to deceive the SEC and the creation of other phony documents used to defraud Retrophin.

In a December 3 order that was just recently unsealed, Judge Weinstein agreed with the government that the emails were not privileged. He noted first that to the extent the communications between Shkreli and Greebel related to Retrophin’s business, the privilege belonged to the company, not to Shkreli, and the company had already waived any privilege claims. But even if there were a personal attorney-client relationship, the judge ruled, “exchanges in redacted emails between the attorney [Greebel] and employee [Shkreli] were part of a scheme, conspiracy or fraudulent attempt to commit a securities fraud. The attorney-client relationship and privilege, if any, is voided by the criminal conduct.”

Accordingly, the unredacted emails were produced to the grand jury, were referenced in the indictment, and will undoubtedly play a major role at trial. There’s a reason prosecutors often say that “email” is short for “evidence mail” – it is frequently a rich source of incriminating information.

The fact that Shkreli was unable to shield his communications with his alleged co-conspirator attorney is not particularly surprising, but it nevertheless has to be considered a blow to the defense.

And in other news, Shkreli recently replaced his legal team with a celebrity lawyer who previously defended rappers Jay Z and Sean “Diddy” Combs. It appears this is only going to get weirder. Stay tuned.

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Supreme Court Agrees to Clarify the Law of Insider Trading

Update 12/6/16: As predicted below, today the Supreme Court unanimously upheld Salman’s conviction and rejected the Second Circuit’s standard in Newman.  I’ll have more on the case in a post next week.

Just three months after it refused to hear the government’s appeal in a landmark insider trading case from the Second Circuit, the Supreme Court announced last week that it will revisit the law of insider trading after all. The Court’s decision to grant review of the Ninth Circuit’s ruling in Salman v. United States may bode well for the government’s future prosecutions.

Both Salman and the Second Circuit case, United States v. Newman, involve the question of “tippee” liability for insider trading: when is a person who receives a tip of confidential information from a corporate insider prohibited from trading on that information? The two courts of appeal adopted apparently conflicting standards, and now the high court will weigh in.

The Supreme Court declined to take the appeal in Newman, where the government lost, and accepted the appeal in Salman, where the government won. At first glance that might suggest the Court’s decision to take Salman’s case is bad news for the government. But I think there’s a good chance the Court will use Salman’s case to clarify the law of tippee liability while affirming Salman’s conviction and rejecting the narrower legal standard adopted in Newman – an outcome that would favor the prosecution.

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The Law of “Tippee” Insider Trading 

Insider trading is buying or selling securities based on material, non-public information, in violation of a fiduciary duty or similar duty of trust and confidence. Trading on the basis of inside information alone is not a crime. In order to constitute securities fraud, there must be a breach of a legal duty in connection with the trading.

The most classic type of insider trading involves a corporate officer personally trading the company’s stock on the basis of corporate information not available to the shareholders. This violates the officer’s fiduciary duty to act in the best interests of the shareholders and to refrain from misappropriating corporate information for his or her own private benefit.

But the ban on insider trading would be pretty toothless if an insider could simply provide confidential information to a friend or family member who did not owe a duty to the shareholders and they were free to trade on that information. Thus the law has long recognized that, under certain circumstances, tippees who receive confidential information are prohibited from trading on it just as if they were corporate insiders.

The Supreme Court ruled on tippee liability in the 1983 case of Dirks v. SEC. Raymond Dirks was a broker who received inside information from Ronald Secrist, an officer with a life insurance company called Equity Funding. Secrist claimed there was massive fraud going on within Equity Funding and urged Dirks to investigate and make it public.

Dirks spent a couple of weeks investigating and trying to expose the fraud allegations. At the same time, he advised his clients and other investors about what he was finding, and some sold their shares. The stock price plummeted; ultimately the SEC began an investigation and Equity Funding collapsed.

The SEC thanked Dirks for his work in exposing the fraud by charging him with a civil insider trading violation. The SEC’s theory was that Dirks, as a tippee who received confidential inside information from Secrist, had an obligation to refrain from trading on that information or encouraging others to do so.

But the Supreme Court rejected the SEC’s position. The Court began by reaffirming the holding of its landmark insider trading case from three years earlier, Chiarella v. United States: insider trading is not established simply because someone traded on non-public information. To constitute securities fraud there must be a “manipulation or deception” involved, which means there must be a violation of a legal duty in connection with the use of the information.

The Court noted that not all disclosures of confidential information are done with a bad purpose.  For example, corporate officers frequently talk with stock analysts, whose job it is to ferret out corporate information and report it to investors. Even the SEC agreed such information flow is good for the markets. Such conversations may sometimes include matters not yet known to the public or to all shareholders, but that is not considered improper if done for the purpose of disseminating information about the company.

What matters is not the disclosure of inside information per se, but why it was disclosed: “[w]hether disclosure is a breach of duty . . . depends in large part on the purpose of the disclosure. . . . [T]he test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach [by the tippee].”

Accordingly, the Court held, a tippee is prohibited from acting on the inside information only if: 1) the tipper was violating a duty by providing the information; and 2) the tippee knew or should have know about that violation. Whether the tipper was violating a duty depends on the purpose of the tip and whether the tipper received any personal benefit in return.

The benefit to the tipper that will indicate a breach of duty is not limited to tangible monetary gains. The Court noted there also can be reputational or other intangible and indirect benefits to the tipper. In particular, the “elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.”

Secrist had been providing information not in order to reap some personal benefit but to help expose widespread fraud within the company. Because Secrist himself therefore did not breach a duty, the Court concluded that Dirks did not inherit any obligation to refrain from using the information and could not be liable for insider trading.

Newman and Salman

 In 2014, more than thirty years after Dirks, the Second Circuit in Newman dealt a blow to the SEC and prosecutors by adopting a very narrow view concerning the benefit to the insider that must be established for tippee liability. (The Second Circuit includes New York and Wall Street, the venue for most securities fraud cases, so its decisions on these issues are particularly important.)

Corporate insiders in Newman disclosed confidential information to several securities analysts who passed the information along to others, including the defendants. After they were convicted for trading on that information, the defendants appealed and argued the government had failed to satisfy both prongs of the Dirks test: they claimed there was insufficient evidence that the insiders had violated a duty by receiving a personal benefit in exchange for the tips, and even if they did, there was no evidence the defendants knew about that violation.

The government argued it had presented sufficient evidence of a personal benefit to the tippers. One had received occasional career advice from an analyst to whom he leaked information. The other insider was a family friend of one of the analysts; they went to the same church and occasionally socialized together.

The court found this evidence of “personal benefit” was insufficient. Although the court agreed a benefit could arise from a tip to a relative or very close friend, the mere existence of a casual friendship was not enough. Proof of a personal benefit, the court held, requires evidence 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.”   The evidence in Newman did not meet that standard, and the Second Circuit reversed the convictions.

Salman, the case that the Supreme Court took last week, also raises the issue of what kind of benefit to the insider is required. Maher Kara, a Citigroup banker, passed confidential information to his brother Michael while knowing that Michael was likely to trade based on that information. Michael, in turn, shared the information with Salman. There was evidence that Michael and Maher had a very close family relationship, that Salman knew of that relationship, and that Salman knew Maher was the source of the information.

Salman argued the Ninth Circuit should apply the Newman standard and require the government to show that any benefit to Maher was “objective, consequential, and represented at least a potential gain of a pecuniary or similarly valuable nature.” He claimed there was no evidence of such a benefit to Maher and so Salman could not be liable as a tippee.

But the Ninth Circuit rejected Salman’s claim. The court held the case was a straightforward application of the holding in Dirks that an insider personally benefits from disclosing confidential information when he “makes a gift of confidential information to a trading relative or friend.”   Maher passed the information to his brother, with whom he had a close relationship – and that, according to the court, is all that Dirks requires. To the extent Newman went further and would require proof of a “consequential” or “tangible” benefit to the tipper even when the tip was to a close family member, the Salman court disagreed.

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What to Expect from the Supreme Court’s Decision

When urging the Supreme Court to take his case, Salman argued that the Second Circuit’s holding in Newman directly conflicts with the Ninth Circuit’s decision in his case. He argued that if a close family relationship between the insider and the tippee is enough to establish a personal benefit to the insider, as the Ninth Circuit held in his case, then Salman loses. But if there must be “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature,” as the Second Circuit held in Newman, then Salman should win.

The fact the Court agreed to hear the case may suggest it agrees there is a conflict between the circuits that it wants to resolve; resolving a circuit split is one of the main reasons the Court grants certiorari. But that doesn’t necessarily translate into good news for Salman.

It’s true the Court could have granted review in Newman if it disagreed with that court’s holding about personal benefit, but Newman was not a great vehicle to address that standard. Although the question of benefit to the tipper was important in Newman, there was a second big issue looming in that case: the defendants had received the inside information second or third hand and were several steps removed from the corporate insiders who made the initial tips. The Second Circuit was deeply troubled by this aspect of the case, and scolded the government for bringing prosecutions the court said have been “increasingly targeted at remote tippees many levels removed from corporate insiders.”

In other words, even if the Supreme Court had reversed the Second Circuit on the benefit issue, the defendants in Newman likely would have gone free anyway. The government had failed meet the second requirement of Dirks: proving that the remote tippee knew about the benefit received by the tipper and the corresponding breach of duty.

Salman, on the other hand, squarely presents the benefit issue, with no issue about Salman’s knowledge of the possible violation. But although the Court granted Salman’s appeal, it would be surprising if it reversed his conviction. As the Ninth Circuit recognized, leaking information to one’s brother is exactly the kind of tip that Dirks held would qualify as a benefit: providing information to a “trading relative or friend.”

Reversing Salman’s conviction would not only require effectively overruling Dirks; it would gut the prohibition on insider trading. Corporate insiders would be free to leak confidential information to friends, relatives, neighbors, or anyone, as long as they did not receive a direct tangible benefit in return. That would overturn decades of insider trading law.

Although predicting what the Court will do is always a risky exercise in reading tea leaves, I think it is far more likely that the Court will affirm Salman’s conviction while taking the opportunity to affirm and clarify the holding of Dirks – and in the process disagreeing, directly or indirectly, with the narrower Newman rationale.

Such a ruling could focus on the statement in Dirks that whether disclosure is a breach of duty “depends in large part on the purpose of the disclosure.” The focus should be more on the insider’s purpose and less on the nature of any benefit received.

The Court in Dirks was primarily concerned about sweeping within the insider trading prohibition the activities of corporate officers who were acting in the interest of the corporation by, for example, speaking with securities analysts. Even if inside information was inadvertently disclosed, the officers were acting with the purpose of fulfilling their duties and aiding the corporation, not for some improper personal purpose.

Similarly Secrist, who tipped Dirks, was acting not for some personal purpose but for the purpose of exposing fraud and wrongdoing within the company. Once again, the purpose behind the disclosure did not suggest a corporate officer breaching a duty by using corporate information for his own benefit.

An insider who tips to a family member, close friend, or golfing buddy is not acting for any proper corporate purpose. Whether or not the insider personally receives some “consequential” or “pecuniary” benefit, he or she is not acting to further the best interests of the company. Even if the benefit received is nothing more than the intangible pleasure of seeing a friend profit from the information, the disclosure violates the insider’s duty to refrain from using corporate information for some personal end.

Focusing on the purpose of the disclosure, rather than on the precise nature of the benefit, will better serve the goals of the ban on insider trading. If a corporate insider is not acting with the purpose of fulfilling his or her corporate duties, then they are likely acting with the kind of personal purpose that will result in the required personal benefit, tangible or intangible.

Focusing on the purpose of the disclosure also avoids hinging potential criminal liability on murky questions such as whether a particular friendship was sufficiently “meaningfully close” to find that the tipper benefited from the disclosure. That’s the kind of issue invited by the Newman standard.

The Newman court’s approach of requiring a more tangible kind of benefit may have been born out of that court’s frustration with the government’s “remote tippee” cases, but it seems misplaced. The tippers in Newman had no apparent legitimate corporate purpose for sharing the inside information, and so the benefit they received from sharing that information with friends or colleagues should have been considered sufficient.

It’s been more than three decades since the Court last addressed tippee liability. The Court in Salman has the opportunity to reaffirm that a tippee can be liable for trading on inside information, even if the benefit received by the tipper is not necessarily consequential or tangible. Although the government was denied review in Newman, it may still get the clarification of insider trading law that it sought when it tried to appeal that decision.

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Analyzing the Indictment of Martin Shkreli

You might think that if your nickname already was “the most hated man in America,” things couldn’t get a whole lot worse for you. Turns out you’d be wrong.

Pharmaceutical executive and former hedge fund manager Martin Shkreli recently earned the “most hated” moniker when his company, Turing Pharmaceuticals, bought the rights to a drug called Daraprim and promptly raised the price of a single tablet by more than 5,000%, from about $13.50 to $750. Daraprim is primarily used to treat or prevent toxoplasmosis, a serious parasitic infection often suffered by HIV and cancer patients and others with compromised immune systems.

The public and political outcry over the dramatic price hike threatened to break the Internet. Shkreli was defiant and unrepentant, saying his job was to make money for his shareholders. He remarked at one point that his only regret was he didn’t raise the price even higher. But although the incident may have qualified him for a starring role in American Greed, it didn’t appear to be illegal.

Then yesterday, in an unrelated case, the 32-year-old man who social media loves to hate was arrested.  Shkreli stands charged with securities fraud and conspiracy in a seven count federal indictment in Brooklyn. A lawyer who worked as his outside counsel, Evan Greebel, is charged as a co-defendant in one of the conspiracy counts.

The charges against Shkreli have nothing to do with Daraprim or jacking up drug prices; they are based on his earlier activities as a hedge fund manager and CEO of a different company. But the near-universal reaction to his arrest seems to be, “Couldn’t happen to a nicer guy.” A new hashtag quickly popped up on Twitter to describe the satisfaction that people felt upon seeing Shkreli being “perp walked” in handcuffs: #Shkrelifreude.

Ponzi

Charles Ponzi: The Classics Never Get Old

The Alleged Schemes

The indictment lays out three different fraudulent schemes allegedly carried out by Shkreli. As U.S. Attorney Robert Capers noted during the press conference announcing the indictment, the frauds were basically a Ponzi scheme, but with a twist. (You can find the press release and a link to the indictment here.)

In a typical investment Ponzi scheme (a la Bernie Madoff), the defendant lies to investors about the spectacular returns they are allegedly earning, when in fact the defendant is simply stealing their money. As word of the supposedly stellar results spreads, more money and investors pour in. If anyone wants to take their money out, the defendant uses money from new investors to pay for the withdrawal, further adding to the illusion that the supposed returns are real. Typically the scheme collapses at some point when the defendant is no longer able to meet the demands of investors who are seeking to cash out.

In classic Ponzi fashion, Shkreli allegedly lied to his hedge fund investors about the money he was earning for them and other issues related to their investment. The twist is that Shkreli created kind of a Ponzi stepladder; he had a series of hedge funds and companies, and when one went belly up he fraudulently used money from the subsequent ones to pay off his earlier obligations. And although he was allegedly misappropriating some of the money, he was actually making investments as well — albeit spectacularly bad ones. The picture that emerges is of someone who was very good at fraud but really, really bad at investing.

MSMB Capital Management Scheme – the first alleged scheme involved MSMB Capital Management, a hedge fund focused on health care companies that Shkreli created and ran from September 2009 to December 2012. Shkreli allegedly lied to investors and potential investors about the returns he was earning, whether the fund had an independent auditor, and how much money the fund was managing. For example, the indictment alleges he told one potential investor MSMB Capital had $35 million under management; in fact, at that point investors had given him only $700,000, and he had already lost it all in a series of disastrous trades.

Shkreli allegedly received a total of about $3 million from eight different investors in MSMB Capital and lost it all – all the while telling those investors they were earning returns of up to 40%. When he ultimately sent an e-mail to the investors telling them he was going to wind down the fund, Shkreli told them he had “just about doubled their money net of fees,” when in truth all the money had been lost.

The indictment also alleges that Shkreli and the co-founder of the fund, identified only as “Co-Conspirator 1,” misappropriated funds from MSMB Capital by taking out money well in excess of the fees to which the fund managers were entitled.

MSMB Healthcare Scheme – MSMB Healthcare LP was another hedge fund created by Shkreli after MSMB Capital. Once again, he allegedly solicited funds from investors by lying to them about things such as his past performance as a portfolio manager, the returns he was earning, and the amount of money he had under management. The indictment alleges that thirteen investors ultimately invested a total of about $5 million in MSMB Healthcare.

Shkreli allegedly misappropriated funds from MSMB Healthcare by taking out money for personal use well in excess of the disclosed fees. In addition, in the first rung of the Ponzi ladder, Shkreli allegedly defrauded his investors by using funds from MSMB Healthcare to pay off some of the debts he had incurred through bad trades and fraud at MSMB Capital, even though MSMB Healthcare was not responsible for those debts.

Retrophin Misappropriation Scheme – Retrophin Inc. is a publicly-traded pharmaceutical company where Shkreli served as CEO from February 2012 to September 2014. In the next rung of the Ponzi ladder, the indictment alleges that Shkreli and his co-defendant, Retrophin’s outside counsel Evan Greebel, defrauded Retrophin by using millions in company assets to pay off Shkreili’s debts and obligations related to MSMB Capital and MSMB Healthcare.

The indictment charges that Shkreli, with Greebel’s help, fraudulently transferred Retrophin shares to MSMB Capital, fraudulently used Retrophin shares to settle liabilities owed to investors in MSMB Capital and MSMB Healthcare, and entered into sham “consulting agreements” between Retrophin and defrauded MSMB Capital and MSMB Healthcare investors as a way to pay off the debts owed to those investors.

The Structure of the Indictment

The indictment contains seven counts; Shkreli is charged in all seven, while Greebel is charged only in the seventh and final count.

Counts One, Two, and Three are based on the MSMB Capital scheme, and charge Shkreli with conspiracy to commit securities fraud, conspiracy to commit wire fraud, and securities fraud. These are just different legal theories for charging essentially the same acts: the alleged defrauding of the MSMB Capital investors, as described above.

Counts Four, Five, and Six are based on the MSMB Healthcare scheme, and again charge Shkreli with conspiracy to commit securities fraud, conspiracy to commit wire fraud, and securities fraud, based on his alleged defrauding of the investors in that fund.

Count Seven charges both Shkreli and Greebel with conspiracy to commit wire fraud, based on their alleged actions that defrauded Retrophin by using its assets to help Shkreli pay off his investors and try to resolve his other legal and financial problems related to his hedge funds.

Conspiracy to commit securities fraud has a maximum penalty of five years in prison; all the other charges carry a maximum penalty of twenty years each. Shkreli also faces millions of dollars in potential criminal fines and asset forfeiture.

What to Watch Going Forward

The indictment looks pretty grim for Shkreli; there certainly is nothing that leaps out in terms of potential defenses. They are only allegations, of course, but if true they paint a devastating picture.

There are likely additional revelations to come concerning others involved in the misconduct. Most of the charges are conspiracy, and a conspiracy requires the criminal participation of two or more people. For example, in connection with the MSMB Capital scheme, the indictment alleges that the co-founder of MSMB Capital, identified only as “Co-Conspirator 1, a individual whose identity is known to the Grand Jury,” conspired with Shkreli and engaged in some of the same criminal conduct.

MSMB Capital’s co-founder was reportedly another New York hedge fund manager name Marek Biestek (“MSMB” comes from the initials of the two men). That suggests Biestek may be Co-Conspirator 1. But whoever he is, Co-Conspirator 1 would seem to be facing criminal problems of his own. The fact that Co-Conspirator 1 wasn’t charged suggests he may be cooperating and may have already pleaded guilty under seal, or he may have been granted immunity. It’s also possible that charges against him are still to come.

The indictment also refers to additional individuals involved in the schemes, using pseudonyms such as “Corrupt Employee 1” and “Corrupt Employee 2,” as well as unidentified “others” involved in the various conspiracies. Again, look for their identities to be revealed as the case progresses; some may already be cooperating in the investigation.

The sham consulting agreements with Retrophin also raise some interesting questions. The indictment alleges the defendants used these agreements as a way to pay off defrauded investors in MSMB Capital and MSMB Healthcare. The phony agreements said those investors would provide consulting services to Retrophin, which allowed the defendants to use Retrophin funds to pay off the defrauded investors. In short, these were really settlement agreements for Shkreli’s personal obligations, disguised as consulting agreements in order to make it possible to have Retrophin foot the bill.

It will be interesting to see what additional information comes out about these sham consulting agreements and the investors involved. For example: if the agreements were signed by the defrauded investors who were being paid off, presumably they knew they were not in fact providing consulting services to Retrophin. If they knowingly executed the sham agreements, aren’t they also implicated in the fraud against the company?

Shkreli’s legal woes are not limited to the criminal case (although of course that’s the only proceeding that can land him in jail). The SEC also filed civil securities charges against him, and Retrophin is suing him for civil fraud. He was released on $5 million bail and ordered not to leave New York.

And in response to his plight, a leading joke on social media is the suggestion that Shkreli’s lawyers should increase their fees by 5,000%.   Shkrelifreude, indeed.

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