Tipper-Tippee Liability in Insider Trading Cases.

Under Dirks v. SEC, 463 U.S. 646, tippee liability for insider trading is derivative. According to the SEC, tippee liability “derives from the tipper’s breach of his fiduciary duty to the issuer’s shareholders.” In other words, if the insider trader who provided the information (the tipper) did not breach a fiduciary duty, the trader who received and traded on the information (the tippee) cannot be liable for insider trading.

For the SEC or DOJ (or a private plaintiff) to establish a Rule 10b-5 insider-trading claim, it must generally show that:

• An insider (tipper) breached a fiduciary duty by disclosing information (generally, a breach of a tipper’s fiduciary obligation requires proof of a personal benefit received in exchange for the disclosure, although this requirement is now construed broadly);
• The trader received information by reason of the breach;
• The trader knew, or had reason to know, of the breach (i.e., that the information was disclosed in breach of the tipper’s fiduciary obligation);
• The trader possessed material nonpublic information (MNPI);
• The trader traded on the basis of the MNPI;
• The transaction involved deception (i.e., the transaction involved a breach of a fiduciary obligation owed to the investor or investors); and,
• The transaction involved scienter (i.e., the trader traded with the intent to defraud).

Possession of material nonpublic information, by itself, cannot establish liability for insider trading under Rule 10b-5. To establish Rule 10b-5 liability, a showing of deception is also required, which requires showing that the insider trader breached his fiduciary duty to the company’s shareholders. Finally, a showing of scienter is also required, which requires showing that the transaction was made with fraudulent intent.

What Duties and Personal Benefits Make a Tip Unlawful?

When the Tipper and the Recipient Have a Close Personal Relationship

Under Dirks, if a tipper and the recipient of a tip have a close personal relationship, the tipper’s disclosure will be regarded as a gift of information. Disclosure of information to a close relative or friend will constitute a breach of the tipper’s fiduciary duty to the company’s shareholders unless there is reason to believe that the recipient will not use the information to trade. Similarly, in Salman v. United States, the Supreme Court established that a tipper who gives a trading opportunity to a relative receives a personal benefit from the recipient’s subsequent trade.

Under Martoma, a tipper who discloses information with the intent to benefit the recipient will receive the “personal benefit” necessary to create insider-trading liability. Martoma does not require evidence of a close personal relationship between the tipper and recipient; the intent to benefit the recipient is enough. Martoma clarifies that this includes instances where a tipper “discloses material nonpublic information for the purposes of gaining reputational benefit or for the purposes of promoting himself or his business.”

Other forms of “personal benefit” under Dirks and Martoma also include “money, a reciprocal trade recommendation, or any other pecuniary benefit.” The SEC and DOJ frequently argue, and the Second Circuit has accepted, that the mere “feeling good” from gifting a “trading opportunity” to a recipient also constitutes a personal benefit that renders an insider trade unlawful.

When the Recipient is Not an Insider (i.e., a Non-Insider Tippee)

When the recipient of a tip is not an insider (or a corporate fiduciary who owes a duty to shareholders), the recipient will still face insider-trading liability in some circumstances, among others. One scenario is when the recipient of a tip is not an insider but owes a fiduciary duty to the source of the information he possesses. Rule 10b5-2 establishes this type of fiduciary duty under several circumstances:

• When the recipient “has knowledge that he or she has received information from someone who owes a duty of trust or confidence to the source,” and the recipient knows (or should know) that the information was shared in breach of that duty;
• When the recipient “has knowledge that he or she has received information from someone who owes a duty of trust or confidence to the source,” and the recipient agrees to keep the information confidential;
• When the recipient “agrees to keep information confidential provided by someone who owes a duty of trust or confidence to the source,” and the recipient trades or discloses the information; and,
• “As a presumptive duty of trust or confidence for purposes of this section, spouses, parents, children, and siblings are presumed to have a duty of trust or confidence to each other.”

Insider-trading liability involves deception. ordinarily, this means breaching a fiduciary duty to shareholders or the source of the information. While lawfully receiving confidential information does not impose insider-trading liability (and, as far as the SEC and DOJ are concerned, lawfully receiving confidential information does not limit the ability to trade or disclose such information), it can have consequences. For example, lawfully receiving confidential information can impose a duty of confidentiality. If the information then comes from a “confidential source,” then, under Rule 10b5-2, trading or disclosing the information can be deemed a breach of trust and confidence, thus raising insider-trading liability for the trader (or the individual disclosing it).

What Knowledge Must a Remote Tippee Have to be Liable?

An insider, or a tipper, can face liability without personally buying or selling securities. While most insider trading involves trades in the market, if a tipper provides material nonpublic information (MNPI) to a downstream tippee and the downstream tippee makes a trade, then the tipper can face liability for facilitating the downstream tippee’s trade.

Along with establishing scienter, criminal liability under the Exchange Act also requires proof of a willful violation of the law. If a defendant did not act with the intent to violate the law, the defendant should generally be shielded from criminal liability.

When is a Recipient Liable as a “Remote Tippee”?

A recipient can face insider-trading liability as a “remote tippee” in two scenarios. In the first scenario, the recipient trades on the basis of the MNPI he has received. In the second scenario, the recipient “retips” the information to a downstream tippee who then trades on the basis of the MNPI. In either case, the result is considered a “remote chain” of insider trading.

When facing criminal insider-trading charges as a remote tippee, a defendant is generally shielded from liability unless the government can prove that he knew, or should have known, that the insider trader (the tipper) received a personal benefit from disclosing the MNPI, and that the insider trader breached a fiduciary duty by disclosing the MNPI to the defendant or another trader.

In other words, criminal liability generally cannot rest on the defendant’s “should have known” (e.g., mistakes, ignorance) or the insider trader’s “did know.” The defendant’s own knowledge and intent must be proven, and generally not just based on a failure to inquire in the face of an appropriate opportunity to do so.

Both knowledge and intent are notoriously difficult to prove. As a result, most defendants charged with insider trading will not (and should not) admit having knowledge or intent, and the government will establish knowledge and intent through circumstantial evidence. Knowledge and intent can be established without a specific admission of guilt (i.e., via circumstantial evidence).

Circumstantial Evidence Used to Establish Knowledge and Intent

As a result, the following circumstances are commonly used to establish knowledge and intent (including knowledge or constructive knowledge of the insider trader’s personal benefit):

• Communications between the insider and the recipient;
• The relationship between the insider and the recipient;
• Timing of the information transfer and the trade;
• Trading volume;
• Profitable trades;
• Profitable trades during events that are not publicly known;
• Other communications between the insider and the remote tippee; and,
• Attempts to conceal communications.

These are just some of the circumstances the SEC and DOJ use to establish that a remote tippee knew, or should have known, that an insider trader received a personal benefit (and therefore made his or her disclosure a breach of a fiduciary duty) and that the remote tippee knew, or should have known, that the trade was illegal.

Todd Spodek and the attorneys at Spodek Law Group handle federal cases of this kind from New York, Brooklyn, Queens and Los Angeles.

Do Tender-Offer and Securities-Fraud Statutes Use the Dirks Test?

Do Tender-Offer Tips fall Under a Dirks-Like Test?

When securities-fraud information concerns tender offers, Rule 14e-3 governs the tipper-tippee relationship. Rule 14e-3 applies to tender offers after “substantial steps” have been taken toward commencing the tender offer. Rule 14e-3 does not require a Dirks fiduciary breach, and, unlike Rule 10b-5, does not require the insider trader (the tipper) to have received any personal benefit in exchange for his or her disclosure of MNPI.

Under Rule 14e-3(d), an insider (or anyone who possesses tender-offer MNPI) cannot “directly or indirectly, communicate” a tender offer to any other person knowing, or having reason to know, that the other person has received or is likely to receive the information from that person and that the other person may trade on the basis of the information, provided that trading is “reasonably foreseeable.”

Does Section 1348 Require Proof of a Personal Benefit?

While insider trading liability under Rule 10b-5 is established through Dirks and its progeny, the Supreme Court has not yet established the tipper-tippee requirements under 18 U.S.C. § 1348. Section 1348 requires proof of a scheme to defraud any person in connection with a commodity for future delivery or a security, or to obtain money or property by false or fraudulent pretenses in connection with the purchase or sale of such an instrument.

In 2019, the Second Circuit decided United States v. Blaszczak, which involved allegations that a defendant had received nonpublic information about upcoming government-funded Medicare and Medicaid reimbursement changes from a source at the Centers for Medicare & Medicaid Services (the insider). The defendant then traded on information and tipped another defendant. The majority opinion held that Section 1348 of the Exchange Act does not impose the requirements of the Dirks “personal benefit” rule because Congress enacted Section 1348 in response to concerns over insider trading violations and violations of the Securities and Exchange Act of 1934.

However, the Supreme Court vacated Blaszczak’s judgment in 2021 without addressing the question of insider-trading liability. The Supreme Court found that the information used to trade was not “property” under the federal government’s fraud statutes. The Supreme Court then remanded the case back to the Second Circuit for further action.

How Does Section 1348 Differ from Rule 10b-5?

Rule 10b-5 implements the prohibition against securities fraud contained in Section 10(b) of the Exchange Act. Section 1348 and Rule 10b-5 both apply to insider-trading cases. The primary difference between the two is that Section 1348 contains a broader definition of fraud, prohibiting not just fraud in the purchase or sale of securities and commodities, but all fraud related to the purchase or sale of securities or commodities. However, based on the SEC and DOJ’s enforcement record to date, this distinction has generally gone unexploited. The SEC and DOJ continue to rely on Section 10(b) in most insider-trading cases.

With the 2021 decision in Blaszczak, a circuit split developed. The Second Circuit concluded that Section 1348, unlike Rule 10b-5, does not require proof of a personal benefit. However, the Tenth Circuit of the United States Court of Appeals disagreed, and held that prosecutors must prove that an insider trader received a personal benefit for a successful Rule 10b-5 prosecution under Section 1348.

When Can Investors Recover from Tippers Under Section 20A?

Section 20A of the Exchange Act (15 U.S.C. § 78t-1) establishes a private right of action for investors who “trade on the opposite side” of unlawful trades in violation of federal insider trading laws. Under Section 20A, aggrieved investors can pursue claims against tippers and tippees. The five main requirements for a successful Section 20A claim are:

• The investor must prove that the tipper or tippee committed a predicate violation of federal insider-trading laws;
• The investor must have traded contemporaneously with the unlawful trade (i.e., either on the same day or during an extraordinarily narrow window);
• The investor must have traded “on the opposite side” of the insider trade;
• The investor must be an “investor” (i.e., the investor traded in his or her own or his or her client’s account on the relevant day or days); and,
• The damages must fit within the limits established by Section 20A(b), which caps damages at the tipper’s or tippee’s profits (or the amount of losses avoided).

When is a Trade Considered Contemporaneous under Section 20A?

Section 20A does not establish a numerical nationwide window for when a trade is contemporaneous with the unlawful trade in question. Instead, a trade is generally deemed contemporaneous if the investor’s trade was on the same day as the unlawful trade. More recently, court decisions have allowed for trades that occur shortly after (i.e., a day or two after the unlawful trade) to be deemed contemporaneous.

How are Aggregate Damages Calculated Under Section 20A?

Under Section 20A(b)(2), aggregate damages available to individual plaintiffs are limited. The statute requires that the amount of damages that “would otherwise be awarded” are limited to the tipper’s or tippee’s profits (or losses avoided). If there is more than one unlawful trade, the damages are limited to the profits from each trade (or the total of the losses avoided), regardless of the number of traders involved. Importantly, SEC disgorgement will reduce the private damages pool available under Section 20A. The tipper or tippee’s profits minus SEC disgorgement will be the damages amount available to any potentially eligible investor.

When is a Tipper Jointly and Severally Liable Under Section 20A?

While Rule 10b-5 imposes individual liability for the tipper and the tippee, Section 20A(c) imposes joint and several liability on an unlawful tipper if the tipper’s direct tippee commits an insider trade. Joint and several liability means that the tipper can be held 100% liable for all of the tippee’s insider profits and that the tipper will have to pay the investors who traded on the opposite side if the insider trader is unable or unwilling to do so. This provision makes it much easier for investors to recover damages from unlawful tippers.

What is the Statutory Deadline for Bringing a Section 20A Private Lawsuit?

Under Section 20A(d), a private lawsuit under Section 20A must be filed with the appropriate district court within five years after the last transaction constituting the violation. With the failure to file a lawsuit, the investor’s right to claim damages under Section 20A will effectively end. With this limitation, time is of the essence, and investors must make decisions regarding their lawsuits promptly.

When is Information Public Enough to Trade Safely?

Rule 10b-5 liability for insider trading requires proof that information is material and not publicly available.

What is a “Material” Piece of Information?

With respect to materiality, the question is, would a reasonable investor find this information important? If the information would significantly alter a reasonable investor’s investment deliberations, this would likely satisfy the materiality test.

What Makes Insider Trading Information “Public”?

With respect to nonpublic information, any information that is publicly available cannot support the nonpublic-information element of insider trading. Information becomes publicly available after broad dissemination and after giving the market time to absorb the information. This can include dissemination via a press release, announcement, filing of a pertinent public record with the appropriate agencies, or broadcast media.

The market reaction to the information will also be key in these cases. With respect to materiality, the market price movement will be treated as evidence that the information was material, but this is not a stand-alone legal test.

What Is the Disclosure Requirement Under Regulation FD?

Investors and traders must also be wary of selective disclosures. Under Regulation FD, covered issuers that intentionally disclose MNPI to selected people must simultaneously disclose the information publicly. While this disclosure does not establish a Rule 10b-5 insider-trading violation, it does establish a liability under Regulation FD, which gives the SEC an additional means of enforcement in these cases.

Do Executives and Corporate Officers Need to Establish Rule 10b5-1 Plans?

For executives and corporate officers, the best protections come with adopting a Rule 10b5-1 insider trading plan. Establishing a Rule 10b5-1 trading plan requires setting out specific parameters for trading stocks and bonds in the company’s equity securities. Typically, Rule 10b5-1 plans require a 90-day cooling-off period after the plan’s adoption or any subsequent modification before the stock sales (or purchases) can begin. If a defendant adopts or modifies his or her plan, the defendant’s trading within the cooling-off period can still create liability, even if the defendant has established a valid Rule 10b5-1 insider trading plan. If the trader is caught in the cooling-off period, he or she will likely not be able to use Rule 10b5-1 as an affirmative defense.

Speak With a Federal Defense Lawyer

If you are dealing with any part of what this article describes, the next step is a conversation with a lawyer who handles these cases. Spodek Law Group is a second generation criminal defense firm practicing since 1976, representing clients nationwide from offices in New York, Brooklyn, Queens and Los Angeles. Call 212-300-5196 to speak with our team.