Source: https://www.professorbainbridge.com/professorbainbridgecom/insider-trading/page/2/
Timestamp: 2019-04-24 17:47:33+00:00

Document:
Did the Second Circuit lie about equal access in Texas Gulf Sulphur?
I think so. In working up an article for a symposium on the 50th anniversary of the seminal insider trading decision in SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir.), cert. denied, 394 U.S. 976 (1968), I've found something rather interesting.
The TGS opinion declares that Rule 10b-5 “is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information.” In support of that proposition, the court did not cite the text of the statute, which is hardly surprising because Securities Exchange Act § 10(b) nowhere mentions insider trading. Likewise, the court failed to cite any legislative history, which also is not surprising, because there simply is no legislative history that supports the court’s purported policy. Instead, to the extent Congress in 1934 addressed insider trading, it did so via the disclosure and short swing profit provisions of Exchange Act § 16.
The second article upon which the court relied was written by distinguished practitioner Arthur Fleischer, albeit when he was just a mid-level associate at Fried, Frank. In the pages identified by the Second Circuit’s pinpoint citation, there is but a single relevant statement; to wit, “As has been seen, an essential function of the Exchange Act was to create markets free from manipulation and from trading based on undisclosed corporate information.” The supporting footnote refers the reader to footnotes 21-26 and the accompanying text. But that passage simply asserts, without relevant reference to the legislative history, that Sections 10(b) and 16 were broadly directed at preventing abusive trading practices. Nowhere in the passage does Fleischer identify any relevant evidence of a Congressional intent that investors have equal access to information. Indeed, neither equal nor equality are used anywhere in the entire article.
The house TGS built was constructed on sand. The Second Circuit offered no credible evidence of a Congressional intent to ensure that investors had equal access to information. Put bluntly, it was an act of judicial fiat grounded on misrepresentations of authorities of dubious value.
Here's the really odd thing: In multiple searches on Westlaw, I can't find any prior discussion of this point. Did nobody ever bother going and reading the two articles?
 TGS, 401 F.2d at 848.
 See United States v. McGee, 763 F.3d 304, 313 (3d Cir. 2014) (observing that “§ 10(b) does not mention insider trading at all”).
 See Richard J. Morgan, The Insider Trading Rules After Chiarella: Are They Consistent with Statutory Policy?, 33 Hastings L.J. 1407, 1409 (1982) (“Congress failed to provide any legislative history to guide the section's application to insider trading transactions.”).
 See Michael P. Dooley, Enforcement of Insider Trading Restrictions, 66 Va. L. Rev. 1, 56-57 (1980) (“The conventional wisdom is that Congress ... expressed its concern with insiders' informational advantage by enacting section 16.”).
 James Farmer et al., Insider Trading in Stocks, 21 Bus. Law. 1009, 1010 (1966).
 Arthur Fleischer, Securities Trading and Corporation Information Practices: The Implications of the Texas Gulf Sulphur Proceeding, 51 Va. L. Rev. 1271, 1278-80 (1965).
Steve asks if CEO Tony Treadwell has violated Rule 10b-5 by sharing confidential information about a potential merger in the course of seeing his psychologist for therapy.
Steve asks if CEO Tony Treadwell has violated Rule 10b-5 by sharing confidential information about a potential merger in the course of seeing his psychologist for therapy. Salman does not tell us much about the outer limits of the personal benefit standard, other than to reaffirm what Dirks told us: a gift of information to a relative or friend for trading meets the standard. Steve’s hypothetical shrink, however, is neither a friend or relative, so we are relegated to the first prong of Dirks personal benefit standard: “whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.” Dirks v. SEC, 463 U.S. 646, 663 (1983).
Mental health is a personal benefit, I suppose, but it is well to remember that the personal benefit standard is simply refining the inquiry of whether the insider has breached a duty by making the disclosure, i.e., was the disclosure self-dealing. Dirks tells us the standard for liability under Rule 10b-5 is “whether the insider’s purpose in making a particular disclosure is fraudulent.” Id. The purpose of the disclosure by Steve’s stressed-out CEO is not to enrich the CEO, as Dirks requires, but to maintain his mental state. This is a personal purpose, as Steve notes, but it hardly constitutes a fraudulent purpose. A fraudulent purpose, within the meaning of Dirks, requires behavior that would be recognizable as self-dealing. Would any board of directors think that Treadwell’s disclosure was a form of stealing from the corporate till? Formulating Steve’s question this way, I am confident that Justice Powell would say no, and that would be the end of the inquiry from his perspective.
Salman does not change that answer, in my view. The only doctrinal news of note from Salman is the Court’s rejection of the Government’s “noncorporate purpose” standard. The Government’s standard might well have reached Treadwell’s hypothetical disclosure, which underscores the Court’s common sense in rejecting “noncorporate purpose” as the measure of a personal benefit. Absent an explicit broad-ranging prohibition enacted by Congress, what counts as fraud under Rule 10b-5 has to be defined by traditional categories of breach of duty, which give at least some guidance in finding the line between permissible and criminal behavior.
Steve’s hypothetical is excellent in testing the outer limits of the personal benefit test, which was recently at issue in Salman v. US. Steve asks the question: Does CEO Treadwell’s disclosure of the confidential information about the merger to his psychologist constitute an illegal tip under SEC Rule 10b-5? My opinion is no, unless the purpose of Treadwell’s disclosure was to impart a trading advantage to his psychologist. Based on the described facts, it seems that Treadwell disclosed the information without a purpose to impart a trading advantage. Most likely, he did so inadvertently: he could have just said that “an important transaction” was in the works. If he did so inadvertently, he breached the duty of care, but we are reminded by SEC v. Dirks that breaches of the duty of care do not fall within the ambit of the insider trading prohibition.
Now, one might object that I am introducing another (unnecessary) element into the tipping analysis or confusing “purpose” with “scienter.” Maybe so, but I strongly believe that knowing the “purpose” of the disclosure, which is not always easy to do from an evidentiary standpoint, is essential to ascertaining whether the disclosure is or is not improper. For example, to prosecute the crime of public bribery, the prosecution must show the donor’s intent to influence the donee in the exercise of his official discretion. That is, more or less, a “purpose” element.
Of course, there will be evidentiary difficulties. Bill Klein’s first variant of the hypothetical suggests that Treadwell may have a purpose to impart a trading advantage. The facts of the second variant, however, make Treadwell look more innocent.
Your hypothetical nicely demonstrates a potential problem with defining “personal benefit” to include non-monetary benefits. I would agree that it’s easiest to show a breach of fiduciary duty when the personal benefit is monetary. When someone receives money or something close to it in return for inside information, there will almost always be a strong case that there is a breach of fiduciary duty. It may also be the case, though, that passing on a non-monetary benefit could also look like such a breach. Consider a CEO who passes on inside information in hopes of wooing a potential love interest who trades on the information. The CEO does not receive anything monetary, but it seems like he is acting in a way at odds with his fiduciary duties with the shareholders.
In my view, your hypothetical demonstrates that we need something more to assess whether the receipt of personal benefit triggers a breach of fiduciary duty. One thought might be that we could also ask whether the receipt of a personal benefit reflects selfish behavior that is against the interests of the shareholders. Though you are careful to note that in your hypothetical part of the CEO’s motivation is personal, I would argue that the situation you describe would arguably not qualify as selfish behavior. The CEO is just trying to relieve his stress so he can work effectively on behalf of the shareholders. He does receive a personal benefit, but I’m not so sure that this benefit is substantially at odds with the interests of the shareholders. Thus, I think there’s an argument that the CEO would not be a tipper and that the psychologist would not be a tippee, at least under the classical theory of liability.
[S]ome tippees must assume an insider's duty to the shareholders . . . because it has been made available to them improperly. And, for Rule 10b-5 purposes, the insider's disclosure is improper only where it would violate his Cady, Roberts duty. Thus, a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.
463 U.S. 646, 660 (1983) (footnotes omitted). We care about that breach because the breach creates the deception necessary to violate Section 10(b) (which prohibits manipulation or deception in connection with the purchase or sale of a security) and Rule 10b-5 as the doctrinal roots of U.S. Insider trading law applicable to the problem posed by the hypothetical.
Starting at this place, I could just duck the precise question asked and merely assess whether the sharing of the information by the CEO to the psychologist is improper (because of personal benefit or otherwise—assuming the personal benefit test is just one way to determine that). Is it inconsistent with the CEO’s duty to disclose or abstain? That would be the case if the CEO shared the information in self-interest rather than for the benefit of the firm or its shareholders, the beneficiaries of the CEO’s duty to disclose or abstain. I might want more facts to be able to assess that matter, since the facts posed in the original hypothetical indicate no assessment by the CEO of the interests of those constituents.
When one of the constituents of an organizational client communicates with the organization's lawyer in that person's organizational capacity, the communication is protected by Rule 1.6. . . . This does not mean, however, that constituents of an organizational client are the clients of the lawyer. The lawyer may not disclose to such constituents information relating to the representation except for disclosures explicitly or impliedly authorized by the organizational client in order to carry out the representation or as otherwise permitted by Rule 1.6.
Again, I continue to think about all this and find the hypothetical and its focus on the tipper quite inviting . . . .
Steve describes a psychiatrist who trades after learning about a merger from one of his patients, raising the question, “Does Treadwell’s conduct constitute an illegal tip under SEC Rule 10b-5?” We can ask the same question of the psychologist. Steve’s hypothetical is meant to generate discussion, and the possibility for extended discussion is meant to demonstrate just how much Salmon v. US left unanswered.
Unanswered questions are not unusual in insider trading law, and securities litigation generally, but Steve’s question rings out because of how close we got to clarity.
The government argued that the Dirks personal benefit test is met “whenever the tipper discloses confidential trading information for a noncorporate purpose.” Under this permutation, the defendants would have faced long odds. The disclosure was not, say, to obtain strategic or legal advice vital to the merger; rather, the CEO sought only psychic relief. Perhaps a company benefits from a de-stressed CEO, but if that counts passes muster as a corporate purpose, a great many practices would have to be reevaluated.
Salman and several amici asked for clarity, too, but with the opposite polarity. In United States v. Newman, Salman’s counterpart in circuit-splitting, the Second Circuit Court of Appeals held that recipients of information can lawfully trade unless the tip was shared as part of an “exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” This requirement would clearly have helped our defendants. Among the few things I remember from 1L tort class is the notion that ordinary occupational stress is rarely a compensable harm, suggesting that its relief would not amount to “objective . . . pecuniary” benefit to the CEO-source.
However, the Court’s decision this month largely overruled Newman, restoring the status quo ante as to quid pro quo. Likewise, the Court declined the government’s invitation consolidate a tougher standard. By refusing both invitations to clarity, the Court again leaves us imagine increasingly puzzling variations on the tipping theme.
The psychologist almost certainly ran afoul the misappropriation theory, by betraying her confidential relationship with the CEO.
If we decide that the CEO’s disclosure didn’t violate a duty to his company, then there is a risk that this disclosure violated Reg FD, which prohibits senior officials of an issuer from sharing information with one shareholder before others.. Trading on the information would then expose the psychiatrist to civil liability.
If this merger was going to involve a tender offer, both defendants may have violated Rule 14e-3, which sets up especially pro-prosecutor rules in that special context.
So the only mystery is whether the government can nail them on the classical theory too. Is that a mystery worth solving? Well, it is a mystery with real consequences because of the way that various elements of insider trading law hang together.
For example, our resolution of the personal benefit question bears directly on the applicable standard in “Possession vs. Use” Debate. Must a trader use proscribed information to plan her trades, or is it enough that she traded (for whatever reason), after having come into possession of such information? Professor Donna Nagy has persuasively argued that the pro-government “use” standard is far more appropriate to the classical theory than the misappropriation theory.
Thus, if the psychologist avoids the classical theory pursuant to Salman, he can argue – successfully or unsuccessfully, as the case may be – that he had long planned to trade and that this information did not influence his conduct. That argument is off the table if we find a personal benefit to the CEO.
Mike Guttentag calls Salman "a Hollow Win for Prosecutors"
The Salman opinion is, however, most notable for how studiously the Court avoids addressing issues related to insider trading law more generally. There are only two footnotes in the opinion, and both are dedicated to clarifying the extent to which it does not address other related topics. Similarly, the opinion uses one paragraph to summarize the Government’s argument that the test for tipper liability should be whether a tip was made for a “noncorporate purpose,” without the additional requirement that the tipper receive a personal benefit. The rest of the opinion ignores the Government’s proposal without explanation.
Another example of this minimalist approach is the Court’s explanation of why it chooses to continue to rely on the Dirks personal benefit test to determine whether there was wrongdoing by the tipper. What little explanation is provided is problematic. The justices cite Dirks for the proposition that a prohibition against insider trading needs to include tipping, “because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.” But this rationale suggests that any gift of material nonpublic information should trigger insider trading liability, and Dirks prohibits only gifts to “a trading relative or friend.” That seems a significant gap in the logic of Dirks, as some commentators have noted. Yet there is no mention of this disconnect in the Salman opinion.
My post US Supreme Court’s ‘Salman v. US’ Decision Answers One Insider-Trading Question, Leaves Others Unresolved is now live on the WLF's Legal Pulse blog.
Beyond standing as a reaffirmation of Dirks with minor clarification, Salman also stands for the proposition that if securities regulation is to evolve, such evolution will have to come from Congressional action, rather than from the Court.
The Supreme Court, in an opinion written by Justice Samuel Alito, held that a jury could infer that the tipper personally benefited from making a gift of confidential information to a trading relative. The Court rejected the Second Circuit’s suggestion in its 2014 opinion in U.S. v. Newman that the tipper must also have received something of a “pecuniary or similarly valuable nature.” The Supreme Court’s December 6, 2016 opinion in the Salman case can be found here.
#SCOTUS Salman opinion: To extent 2nd Circ in Newman held tipper must receive something of “pecuniary nature," rule inconsistent w/ Dirks.
After Oral Argument in “Salman v. US,” Will Supreme Court Meaningfully Limit What Counts as Insider Trading?

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