US v. Newman and the Rewriting of the Law of Insider Trading (Part 15)
Perhaps the most interesting foray into the case was an amicus brief filed by three law professors arguing that the case was correctly decided. The brief correctly noted the policy goal of Dirks.
As the analyst-insider communication, a liability standard that is overly broad or unclear will deter market participants from seeking quality information on which to trade and thereby damage the healthy functioning of capital markets. The Supreme Court fashioned the personal benefit test accordingly, to draw a clear line between permissible and impermissible information gathering, so that analysts and investors would know when trading was permissible and not be needlessly deterred from seeking the best information available to them.
Likewise, the brief rightfully noted that a test based upon friendship did not depend upon the purpose of the tip. Professor's Amicus Brief ("Unlike the personal benefit test, the fact that an analyst can be characterized as a social “friend” of the insider who discloses information, does nothing to illuminate the purpose for which the disclosure was actually made."). But of course, neither did the pecuniary benefit test. An insider benefiting from the disclosure of material non-public information could still be acting in the best interest of the corporation and shareholders.
The brief concluded from this that the government's position would undermine the purposes set out in Dirks.
- the rule advocated by the government and the SEC would undermine in a fundamental way the policy purpose for which the Supreme Court adopted the personal benefit test. If mere evidence of “friendship” is presumptive evidence of personal benefit, then virtually all disclosures are potentially subject to prosecution, because insiders are far more likely to be involved in discussion of their companies with people they know than with strangers. As such, analysts and insiders who are engaged in industry activity that the Supreme Court correctly understands to be normal, socially beneficial, and important to the integrity of capital markets, and that it explicitly seeks to protect, would operate at peril of prosecution for securities fraud simply because they talk regularly, have common friends with whom they socialize, or have some other point of social interaction that could lead to their characterization as “friends.” Based only on such arbitrary and amorphous facts, the disclosure of material information in good faith, or for a permissible purpose under Rule 10b, presumptively criminal. That rule would have the same predictable chilling effect on analyst-insider communications that the Supreme Court set out to avoid in Dirks. It cannot possibly be what the Supreme Court intended.
The analysis is flawed. It conflicts with an approach in Dirks that treated tips to friends and relatives differently than tips to market professionals. It is Dirks that indicated that the nature of the relationship rather than the purpose of the disclosure was what mattered.
To the extent that there is some concern that the friendship standard can interfere with corporate communications (the two alleged tippees in this case were in fact market participants), the solution is to narrow the definition of friendship. The approach taken in Newman is to instead require some kind of pecuniary/objective gain in all cases. Such a test would apply not just where the friend was an analyst or other market participant but also to tips by parents to children, wives to husbands, etc. In those circumstances, there is no need to immunize the communications in order to protect the market disclosure process (which is what Dirks intended) yet the test in Newman would do exactly that.
We will include one more post that will provide a possible basis for predicting the outcome of any en banc hearing. With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site. The amicus filed by a small group of law professors that supports the decision is here.