Insider Trading

Friends and Family Insider Trading

Insider Trading is using access to information not available to the public to trade a public company’s stock or other securities, such as bonds and options. In the United States, most insider trading is illegal. The illegality of insider trading prevents select individuals from benefitting from nonpublic information for their own benefit. One of the most well-known insider trading cases involved Martha Stewart and her shares in a pharmaceutical company called ImClone. In 2001, ImClone’s experimental drug called Erbitux failed to get approval from the U.S. Food and Drug Administration. Prior to the announcement that the drug won’t win approval, several ImClone executives, including the founder, sold their shares of ImClone based on information from the founder of ImClone that the FDA would not be approving the drug. It was later discovered that Martha Stewart had also sold shares prior to the announcement, based on information passed from ImClone’s founder to her stock broker. These sales all occurred prior to the announcement that the drug would not be approved. Once the announcement was made, the stock price of ImClone dropped, and thus the sales prior to the announcement allowed the sellers to avoid selling after the drop in the stock price. Those who sold stock with prior information about the disapproval of ImClone’s drug, such as Martha Steward, served prison time for benefiting from the information.

Prosecutors and courts have had some difficulty defining exactly what constitutes insider trading in other cases, though. Namely, courts have split over what constitutes a benefit of insider trading. Normally, a benefit is financial, as demonstrated in the ImClone case (the sellers avoided selling their stock after the announcement and thus avoiding the loss in the price of the stock). Courts had split on what other benefits may constitute insider trading, an issue which the Supreme Court reviewed recently.

Circuit Split

Two federal appeals courts returned different decisions on what constitutes insider trading. The U.S. Court of Appeals for the Second Circuit in Manhattan handed down a 2014 decision, United States vs. Norman, involving allegations that remote-tippees (individuals who received information about corporate earning’s reports prior to their release through analysts at hedge funds at which they worked that was traced back to sources within those corporations) used nonpublic information for their benefit. The Justice Department sued the tippees, but the Second Circuit found that the department had not shown that the tippers received any benefit for providing the information. The Second Circuit went further, finding that insider trading requires proof that there was a “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.”

This tangible benefit requirement conflicted with a Supreme Court decision, Dirks v. Securities and Exchange Commission, which found that insider trading violations can occur when there is a gift of confidential information, and this give need not be tangible, but can be met through good feelings of sharing information. The U.S. Court of Appeals for the Ninth Circuit relied on the Dirks decision in the conviction of Bassam Salman. In Salman’s case, information about some acquisitions in the health care industry was passed from an investment banker to his brother. The brother then passed the information to Salman, his future brother-in-law. Thus, no tangible benefit was required, as had been the case in Newman.

Supreme Court Decision

The Supreme Court agreed to review the circuit split between the Newman and Salman decisions in light of Salman’s conviction in Salman v. United States. Salman’s attorneys had argued he could not be prosecuted because the man who passed the original tip had not benefitted financially from passing the information, as would be required under Newman.

Nothing the contradiction between Newman and Dirks, the court upheld Salman’s conviction unanimously. In rejecting Newman, the Court noted that the requirement of a tangible benefit was in direct contradiction to Dirks. Passing information amongst family members is sufficient to constitute insider trading under Dirks, opined the Court. Justice Alito, writing for the Court, noted that “[i]n 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”

Thus, in upholding Salman’s conviction, the Supreme Court held that tips passed amongst relatives are illegal, even if the person passing the tip does not receive a financial benefit. A holding that required a financial benefit to the tipper was inconsistent with the prior holding in Dirks, per the Court. “Making a gift of inside information to a relative … is little different from trading on the information, obtaining the profits, and doling them out to the trading relative…The tipper benefits either way,” the Court noted.

Insider information can be easy to pass. Those within corporations often have access to nonpublic information, and it can be tempting to pass that information along to others to protect them from financial losses, or permit them to gain financially. With the recent Supreme Court decision, it is easier for prosecutors to convict for insider trading since a tangible benefit is no longer required. To discuss insider trading or what information can properly be passed, please contact Benjamin Long of Schmidt & Long.