Articles / Corporate Governance
Salman v United States: Insider Trading
It is universally acknowledged and understood that it is illegal in the United States for all except members of Congress to purchase or sell publicly traded securities when they possess confidential non-public information. [For those who noticed my “except for members of Congress” qualification, I won’t digress into a political rant here and will simply note the exception in passing and provide a couple of links in the READ section, below.]
While the general concept that insider trading is illegal is well understood, what constitutes insider trading and when it occurs is less clear. Courts, in an effort to clarify what conduct is illegal and what conduct is permissible, have crafted “rules.” Generally, these “rules” hold that for a trade based on non-public confidential information to be illegal, there must be a benefit to both the tipper (the person disclosing the confidential inside information) and the tippee (the person who receives the information). Seems simple. It’s not. As one commentator put it: “Given that information sources are fragmented and access to information provides a competitive advantage to market participants – hedge funds, expert networks, and individual traders – courts. . . have difficulty determining whether an insider received a personal benefit for disclosure of confidential information, and perhaps even more difficulty determining whether a remote tippee knew the insider disclosed confidential information in breach of his or her duty in exchange for a personal benefit.”
This is the background for the December Supreme Court decision in Salman, a case which was closely watched because among other issues it would decide whether a relatively narrow “rule” set out by the United States Court of Appeals in New York, or a much broader “rule” applied by the United States Court of Appeals in California would become the law of the land. The California, broad, “rule” was adopted by the US Supreme Court.
Disclaimer: to understand the issues and Court’s decision, one requires some understanding of the law regarding insider trading. Thus, I’ve set forth more legal detail than usual for the governance portion of this newsletter. Hopefully, readers won’t find it too dry.
Step 1 in understanding the issues and discussion is to understand the basic underpinnings of the insider trading prohibition. Justice Alito states it simply and clearly in the opening paragraph of his opinion in the Salman decision:
Section 10(b) of the Securities Exchange Act of 1934 and the Securities and Exchange Commission’s Rule 10b–5 prohibit undisclosed trading on inside corporate information by individuals who are under a duty of trust and confidence that prohibits them from secretly using such information for their personal advantage. [citation omitted] Individuals under this duty may face criminal and civil liability for trading on inside information (unless they make appropriate disclosures ahead of time).
Ok – maybe his prose isn’t so simple. My try: it is illegal for a person who receives information about a company in confidence (either because s/he works for the company or was told the information in confidence by someone who does) to buy/sell shares in that company expecting the company’s stock to go up or down when the confidential information becomes publicly known.
Continuing, J Alito writes:
These persons also may not tip inside information to others for trading. The tippee acquires the tipper’s duty to disclose or abstain from trading if the tippee knows the information was disclosed in breach of the tipper’s duty, and the tippee may commit securities fraud by trading in disregard of that knowledge. In [the 1983 US Supreme Court decision, Dirks,] this Court explained that a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty by disclosing the information. A tipper breaches such a fiduciary duty, we held, when the tipper discloses the inside information for a personal benefit. And, we went on to say, a jury can infer a personal benefit—and thus a breach of the tipper’s duty—where the tipper receives something of value in exchange for the tip or “makes a gift of confidential information to a trading relative or friend.”
In the Salman case, the defendant Salman received valuable “trading tips” from his brother-in-law. Salman claimed that he could not “be held liable as a tippee because the tipper (his brother-in-law) did not personally receive money or property in exchange for the tips and thus did not personally benefit from them.” Thus, the Salman case squarely presented the issue: what is the nature of the benefit required for liability for insider trading?
There were 3 defendants in the Salman case: Salman and two brothers, Maher Kara and Michael Kara. Maher Kara (“Maher”) was an investment banker in Citigroup’s healthcare investment banking group. His older brother, Michael Kara, had a degree in chemistry. Maher began sharing with Michael confidential insider information he learned through his job as an investment banker at Citigroup to “help [Maher] grasp scientific concepts relevant to his new job.” Later, “while [Michael’s and Maher’s] father was battling cancer, the brothers discussed companies that dealt with innovative cancer treatment and pain management techniques.”
Michael began trading on the information Maher shared with him, and while Maher was initially unaware of Michael’s trading, “eventually he began to suspect that it was taking place.” “Ultimately, Maher began to assist Michael’s trading by sharing inside information with his brother about pending mergers and acquisitions.” “Without [Maher’s] knowledge, Michael fed the information to others— including Salman. The Salman and Kara families were close. More specifically, during this period Salman married the Kara brothers’ sister, becoming Michael’s and Maher’s brother-in-law. Thus, Michael was sharing his brother’s inside information not just to a friend, but to a member of his family.
By the time the authorities caught on, Salman (and by extension Michael’s and Maher’s sister) had made over $1.5 million in profits. Salman split these profits with another relative (unrelated to the Kara brothers) – the person who executed the trades on Salman’s behalf via a brokerage account at another firm.
Michael and Maher pleaded guilty when charged and testified at Salman’s trial. Salman’s defense: “there was no evidence that Maher received anything of ‘a pecuniary or similarly valuable nature’ in exchange [for giving Michael his inside information] — or that Salman knew of any such benefit.” Therefore, Salman argued that under the Supreme Court’s 1983 Dirk decision he did nothing illegal.
Further, Salman argued that a 2015 decision by the Second Circuit Court of Appeals in New York supported his position. The New York court’s decision held that there must be “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.” Again, Salman argued that no such exchange occurred, hence he did nothing illegal.
As explained by the Supreme Court in its decision:
In this case, Salman contends that an insider’s “gift of confidential information to a trading relative or friend,” [citation omitted] is not enough to establish securities fraud. Instead, Salman argues, a tipper does not personally benefit unless the tipper’s goal in disclosing inside information is to obtain money, property, or something of tangible value. He claims that our insider-trading precedents, and the cases those precedents cite, involve situations in which the insider exploited confidential information for the insider’s own “tangible monetary profit.” [citation omitted]
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More broadly, Salman urges that defining a gift as a personal benefit renders the insider-trading offense indeterminate and overbroad: indeterminate, because liability may turn on facts such as the closeness of the relationship between tipper and tippee and the tipper’s purpose for disclosure; and overbroad, because the Government may avoid having to prove a concrete personal benefit by simply arguing that the tipper meant to give a gift to the tippee. He also argues that we should interpret [our 1983 decision in Dirks] narrowly so as to avoid constitutional concerns. [citation omitted] Finally, Salman contends that gift situations create especially troubling problems for remote tippees — that is, tippees who receive inside information from another tippee, rather than the tipper — who may have no knowledge of the relationship between the original tipper and tippee and thus may not know why the tipper made the disclosure.
The US Supreme Court rejected Salman’s arguments and thus rejected the narrow “rule” put forth by the New York Second Circuit court. It reasserted its 1983 decision in Dirks,holding: “Dirks makes clear that a tipper breaches a fiduciary duty by making a gift of confidential information to ‘a trading relative,’ and that rule is sufficient to resolve the case at hand.”
Further explaining that holding, J. Alito writes:
In determining whether a tipper derived a personal benefit, we instructed courts to ‘focus on objective criteria, i.e., 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.” [citation omitted] This personal benefit can “often” be inferred “from objective facts and circumstances,”. . . such as “a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient.” [citation omitted] In particular, we held that “[t]he 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.” [citation omitted] In such cases, “[t]he tip and trade resemble trading by the insider followed by a gift of the profits to the recipient.” [citation omitted]
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[W]hen a tipper gives inside information to “a trading relative or friend,” the jury can infer that the tipper meant to provide the equivalent of a cash gift. 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. Here, by disclosing confidential information as a gift to his brother with the expectation that he would trade on it, Maher breached his duty of trust and confidence to Citigroup and its clients—a duty Salman acquired, and breached himself, by trading on the information with full knowledge that it had been improperly disclosed.
The decision has been hailed as an important victory for prosecutors and the SEC. Preet Bharara, U.S. Attorney for the Southern District of New York, issued the following statement when the Salman decision was announced:
Today, the U.S. Supreme Court unanimously and ‘easily’ rejected the Second Circuit’s novel reinterpretation of insider trading law in U.S. v. Newman. In its swiftly decided opinion, the Court stood up for common sense and affirmed what we have been arguing from the outset – that the law absolutely prohibits insiders from advantaging their friends and relatives at the expense of the trading public. Today’s decision is a victory for fair markets and those who believe that the system should not be rigged.
The full decision in Salman v United States, Supreme Court of the United States, No. 15–628. Decided December 6, 2016
Statement of U.S. Attorney Preet Bharara On the Supreme Court’s Decision In Salman v. U.S.
Regarding Congress’ Insider Trading
CBS News, “Congress: Trading stock on inside information? Steve Kroft reports that members of Congress can legally trade stock based on non-public information from Capitol Hill,” June 11, 2012
Lee Fang, The Intercept.com, “Congress Tells Court That Congress Can’t Be Investigated for Insider Trading”
Zynga, Inc. v Pincus et, al.: When is an Independent Director Not Independent?
The Delaware Supreme Court, in the case Zynga, Inc. v Pincus et. al. examined when a director is independent and when his/her relations with the company or others impair, as a matter of law, that director’s impartiality.
In Zynga, a shareholder, Sandys, brought a derivative shareholder suit alleging that the board improperly permitted several senior officers of the company, including its former CEO, Chairman and controlling shareholder Mark Pincus, to sell shares of Zynga stock contrary to the company’s “standing rule preventing sales by insiders until three days after an earnings announcement.” Sandys further alleged that the resulting sales by these individuals constituted a breach of their fiduciary duties to the company and its shareholders.
More specifically, Sandys asserted that the board permitted Pincus and the other selling shareholders to sell 20+ million shares at $12/share as part of a $236.7 million secondary offering. The company’s founder and CEO, Mark Pincus, alone pocketed $192 million from the sale. Three weeks after the sale, when Zynga’s earnings were announced, Zynga’s stock dropped nearly 10%, to $8.52. The stock price then continued to fall over the next 3 months, to $3.18, following the release of additional negative news – news that Sandys alleged was in the possession of Pincus and the other selling shareholders when they sold their shares.
To place the Delaware Supreme Court’s decision into its proper context, a bit of background regarding the technicalities of a derivative shareholder suit is required.
First – one needs to understand just what a derivative shareholder suit is. Simply, a derivative lawsuit is one brought by a shareholder on behalf of a corporation against a third party. Essentially, the shareholder is standing in the shoes of the corporation and acting on behalf of the corporation because the corporation itself did not act or will not act. Typically, derivative suits are used when shareholders believe that company officers are self-dealing or mismanaging the company.
In the Zynga case, for reasons that are technical and need not be explained, the proper party to bring the lawsuit was the company itself – Zynga, Inc. – and not an individual shareholder. Thus, when the company failed to bring the lawsuit on its own, Sandys, a shareholder, brought it on behalf of the company under the derivative shareholder suit rules and procedures. However, under Delaware law, before a shareholder may commence a derivative suit, s/he must make a demand of the company’s board to bring the suit. Sandys did not do this. Instead, he relied on an exception to the demand requirement that provides that if making a demand will be futile, the demand requirement is waived.
The case before the Delaware Supreme Court was, narrowly speaking, a case construing this demand requirement. The trial court dismissed Sandys’ suit because he failed to make the requisite demand. The trial court found that the Zynga board of directors was comprised of a majority of independent directors, hence making the demand was not “futile” and Sandys’ case must be dismissed for failure to make the demand.
The Delaware Supreme Court agreed that the demand question was the key to the case, but in a split 4-1 decision it disagreed with the trial court’s conclusion that the board possessed a majority of independent directors. Instead, it found that a majority were not independent, hence a demand would have been futile and thus the case should proceed.
Both the trial court and the Supreme Court agreed upon the status of several directors. For example, the director and former CEO Pincus was never considered independent. Another director, Hoffman, was also never considered independent. Thus, the case turned upon the independence of 3 directors: Ellen Siminoff, William Gordon and John Doerr.
Ms. Siminoff’s status was at issue because she and her husband co-owned an airplane with Pincus. Per Sandys, this demonstrated a close personal relationship with a controlling shareholder and thus called into question her independence. William Gordon and John Doerr were partners at the investment firm Kleiner Perkins Caufield & Byers (“KPCB”). KPCB controlled approximately 9.2% of Zynga‘s equity. Additionally, KPCB and Hoffman (a director all agreed was not independent) had overlapping investments. Thus, Sandys asserted that Gordon and Doerr were not independent. If all three were found not independent, a majority of Zynga’s board would not be independent and therefore it would have been futile for Sandys to make a demand of the board.
So much for background. Now to the important part – the reasoning. When is a director independent and when is s/he not?
Beginning with director Siminoff, both the majority and dissenting opinions called the question of Siminoff’s independence a close call. At issue was the relationship between the Siminoff family and the Pincus family, and the fact in question was whether their joint ownership of an airplane demonstrated a relationship that created a reasonable doubt that Siminoff “could have properly exercised [her] independent and disinterested business judgment in responding to” Sandys’ demand that the company sue Pincus.
Per Chief Justice Strine, writing for the majority:
The Siminoff and Pincus families own an airplane together. Although the plaintiff made some strained arguments . . ., it made one argument in relation to this unusual fact that does create a pleading stage inference that Siminoff cannot act independently of Pincus. That argument is that owning an airplane together is not a common thing, and suggests that the Pincus and Siminoff families are extremely close to each other and are among each other‘s most important and intimate friends. Co-ownership of a private plane involves a partnership in a personal asset that is not only very expensive, but that also requires close cooperation in use, which is suggestive of detailed planning indicative of a continuing, close personal friendship. In fact, it is suggestive of the type of very close personal relationship that, like family ties, one would expect to heavily influence a human‘s ability to exercise impartial judgment.
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A plaintiff is only required to plead facts supporting an inference . . . create a reasonable doubt that a director cannot act impartially. Here, the facts support an inference that Siminoff would not be able to act impartially when deciding whether to move forward with a suit implicating a very close friend with whom she and her husband co-own a private plane.
With respect to directors Gordon and Doerr, the Supreme Court placed heavy reliance on the fact that the Zynga board, applying the NASDAQ exchange rules, “did not consider [Gordon and Doerr] to be independent directors.” Per J. Strine: “to have a derivative suit dismissed on demand excusal grounds because of the presumptive independence of directors whose own colleagues will not accord them the appellation of independence creates cognitive dissonance that our jurisprudence should not ignore.”
Continuing, J. Strine stated:
The Court further noted that the fundamental determination a board must make to classify a director as independent under the NASDAQ rules—whether a director has a relationship which, in the opinion of the Company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director—is also relevant (but not dispositive) under Delaware law.
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[T]he criteria NASDAQ has articulated as bearing on independence are relevant under Delaware law and likely influenced by our law. The NASDAQ rules outline the following list of relationships that automatically preclude a finding of independence:
(A) a director who is, or at any time during the past three years was, employed by the Company;
(B) a director who accepted or who has a Family Member who accepted any compensation from the Company in excess of $120,000 . . . other than the following:
(i) compensation for board or board committee service;
(ii) compensation paid to a Family Member who is an employee (other than an Executive Officer) of the Company; or
(iii) benefits under a tax-qualified retirement plan, or non-discretionary compensation. . .
(C) a director who is a Family Member of an individual who is, or at any time during the past three years was, employed by the Company as an Executive Officer;
(D) a director who is, or has a Family Member who is, a partner in, or a controlling Shareholder or an Executive Officer of, any organization to which the Company made, or from which the Company received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient‘s consolidated gross revenues for that year, or $200,000, whichever is more, other than the following:
(i) payments arising solely from investments in the Company‘s securities; or
(ii) payments under non-discretionary charitable contribution matching programs.
(E) a director of the Company who is, or has a Family Member who is, employed as an Executive Officer of another entity where at any time during the past three years any of the Executive Officers of the Company serve on the compensation committee of such other entity; or
(F) a director who is, or has a Family Member who is, a current partner of the Company‘s outside auditor, or was a partner or employee of the Company‘s outside auditor who worked on the Company‘s audit at any time during any of the past three years.
(G) in the case of an investment company, in lieu of paragraphs (A)-(F), a director who is an ―interested person of the Company as defined in Section 2(a)(19) of the Investment Company Act of 1940, other than in his or her capacity as a member of the board of directors or any board committee.
Most importantly, under the NASDAQ rules there is a fundamental determination that a board must make to classify a director as independent, a determination that is also relevant under our law. The bottom line under the NASDAQ rules is that a director is not independent if she has a relationship which, in the opinion of the Company‘s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.
In addition to relying on the Zynga Board’s own determination applying the NASDAQ rules that directors Gordon and Doerr were not independent, the Delaware Supreme Court focused on the interrelationships between their firm’s other investments and other directors on the Zynga board. As noted above, both Gordon and Doerr are partners at the investment firm KPCB. As also noted, KPCB owns approximately 9.2% of Zynga‘s equity. Also of significance to the Delaware court, KPCB is also invested in One Kings Lane, a company that Pincus‘s wife co-founded and which another Zynga director, Hoffman, has invested.
Per J. Striner:
[T]he reality is that firms like [KPCB] compete with others to finance talented entrepreneurs like Pincus, and networks arise of repeat players who cut each other into beneficial roles in various situations. There is, of course, nothing at all wrong with that. In fact, it is crucial to commerce and most human relations. But, precisely because of the importance of a mutually beneficial ongoing business relationship, it is reasonable to expect that sort of relationship might have a material effect on the parties’ ability to act adversely toward each other.”
Bottom line. There is no bright-line of demarcation which places a director’s relationships with other members of the Board or company on one side or the other of the independence determination. All relationships are examined. When any single relationship, or the totality of relationships, “create reasonable doubt that a director cannot act impartially,” then the director must be found not to be independent. My take-away: when considering independence – especially with respect to derivative shareholder suits – it’s probably prudent to be conservative and err on the side of non-independence.
The full opinion: Thomas Sandys, derivatively on behalf of Zynga, Inc. v Mark Pincus et. al., Supreme Court of the State of Delaware, No. 157, 2016, decided December 5, 2016