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12 May 2017
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Second Circuit Court of Appeals Reconsiders the Parameters of Insider Trading

“Insider Trading 3” by Insider Monkey, licensed by CC Attribution No Derivs 2.0 Generic

Insider trading, a type of market manipulation, has been an hotly-contested area in the United States since the implementation of the Securities and Exchange Act of 1934, which implicitly condones insider trading in order to promote a fair financial market. Insider trading is defined as “trading by anyone (inside or outside of the issuer) on any type of material non-public information about the issuer or about the market for the security.”[1] The issues in United States v. Martoma arise because although the 1934 Act may have the intention of promoting fairness, it lacks clarity, which leads to inconsistent treatment in the Courts.

There are two types of insider trading, the classic form and misappropriation form; the latter applies to the Martoma case. The misappropriation form applies when an individual misuses non-public information to make a securities transaction and breaches a duty of trust and confidence. The Second Circuit in United States v. Newman decided that when tippees receive insider information they must know the tipper receives a personal benefit. The SEC must illustrate there is “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”. The tippee must also be aware the information is material non-public information. In Newman, because there was no close relationship between the tippees and tippers, they could not be found liable for insider trading.

This past December, however, the Supreme Court held a contentious decision in Salman v. United States that two brothers, who had an obviously close relationship, were found liable for insider trading. The Court held that a gift of non-public material information to a relative or friend satisfies the personal benefit test of Newman. Unfortunately, the Court did not address what constitutes a meaningfully close relationship (outside the scope of relatives and friends), which is the heart of the Martoma debate.

Matthew Martoma was sentenced to 9 years in prison for his involvement in the biggest insider trading case of all time. Martoma, who worked for Steven A. Cohen, a hedge fund manager of SAC Capital Advisors, received material nonpublic information from Dr. Sidney Gilman regarding an Alzheimer’s drug, which led SAC to sell its $960 million stake in Elan Corporation and Wyeth Pharmaceuticals, and avoid over $276 million in losses. Martoma asserts that Dr. Gilman, the tippee, did not provide material information in exchange for a personal benefit, and the information could not be considered as a gift due to the lack of a close relationship. Martoma did pay Dr. Gilman his regular consulting fee for his time, but not for material information.

Martoma wants to keep the decision from Newman where the government must prove there is a meaningfully close relationship, but the government wants to infer that the insider information was a gift and Dr. Gilman and Martoma’s relationship satisfied the Court’s test in Salman. On May 9, 2017, the Second Circuit was divided on whether the Martoma decision could stand under the tests of either Newman or Salman and whether Martoma was wrongly convicted. Judge Rosemary S. Pooler questioned the government’s fluctuating argument regarding the relationship between the tippee and tipperthroughout earlier arguments. There is a lack of consistency regarding how the courts determine what constitutes a close relationship. It is significant that the Second Circuit Court is reexamining its decision in Martoma in order to clearly define who is liable for insider trading and to promote what Congress intended — a fair financial market. However, Congress could have foreseen these interpretation issues and either at the time created a more succinct definition of insider trading or subsequently after the years of controversial case law provided clearer guidance for the courts. Christopher D. Jones explains how issues of liability regarding insider trading are contingent “less on [the] question of deception, honesty or fairness than … on geography.” A retrial in Martoma would give the Court an opportunity to mend this issue.

[1] Wang, W.K.S., Steinberg, M.I. (2010) Insider Trading (3d. edition) Oxford University Press: New York. pp.1. 

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