Steak And A Small Kickback — An Insider Trading Personal Benefit
What constitutes a personal benefit that results in a breach of duty for insider trading may be resolved by the Supreme Court in the coming term when U.S. v. Salman, 792 F. 3d 1087 (9th Cir. 2015) is decided. In the meantime the Second Circuit is following its much discussed decision in U.S. v. Newman, 773 F. 3d 438 (2nd Cir. 2015) which the Supreme Court declined to review. The Ninth Circuit is following Salman. Both cases claim to be faithful applications of the Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1983). Both claim to have properly followed and applied the Dirks personal benefit test. While the standards used in each are similar, they are not identical (here).
In the wake of Newman – Salman, the First Circuit has handed down two decisions in related insider trading cases which decline to follow either case on the question of what constitutes a personal benefit. Both also raise a fundamental question regarding SEC Rule 10b5(b)(2) on proof of the relationship between tippor and tippee. In U.S. v. Parigian, No. 15-1994, 2016 WL 3027702 (1st Cir. May 26, 2016) the court adhered to earlier panel decision of the circuit to define personal benefit while raising, but not deciding, the question regarding the SEC’s rule (here). Recently, in U.S. v. McPhail, No. 15-2106 (decided July 26, 2016) the court took a similar position.
McPhail and Parigian arise from the same factual background, centered on a group of golf friends. Mr. McPhail is a tile salesman. He became friends with Angelo Santamaria, an executive at American Superconductor Corporation. After meeting at a country club in 2007 the two men became fast friends, traveling together and frequently socializing. At times Mr. Santamaria loaned his friend money. When Mr. McPhail’s divorce jeopardized his spousal membership at the golf club, Mr. Santamaria stepped in and helped save it. Later Mr. Santamaria’s wife sought the assistance of her husband’s friend to resolve a serious marital dispute.
During their conversations Mr. Santamaria frequently talked about his firm, its prospects and the stock price – a topic with which he was pre-occupied because his retirement account held a substantial block of firm stock. At times Mr. Santamaria told Mr. McPhail facts regarding the company which were material and non-public or inside information. On at least two occasions the men discussed the fact that the business information was never to be repeated.
Mr. McPhail did not maintain the confidence. He communicated the information orally and in emails to a group of golfing buddies, including Mr. Parigian. The buddies traded, reaping nearly $500,000 in profits. Mr. McPhail did not trade.
Mr. McPhail’s conviction by a jury on insider trading was affirmed by the First Circuit. Two issues were key on appeal, one regarding the SEC rule and the other focused on the Dirks personal benefit test. First, in assessing the application of the misappropriation theory of insider trading the court focused on whether there was a relationship of trust and confidence between the two men which was breached. The issue focused in part on SEC Rule 10b5-2(b)(2) which defines a duty of trust and confidence, requiring that “the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality.” A critical question is whether the “knew or should have known” standard conflicts with the proof requirements in criminal cases. In Parigian the court noted that this was an open issue, although two cases contained dicta suggesting the Rule was valid. In McPhail the court discussed the point but again declined to rule on it, finding the issue had been waived by a failure to object to the instructions.
Second, the court considered the Dirks personal benefit test. Mr. McPhail argued that there was a failure of proof on this question. In addressing this issue the court noted that Mr. McPhail was “[a]ssuming that this principle extends to tippers in misappropriation cases . . .” raising, but not deciding, an issue that was rejected by Newman. Following its approach from Parigian, the court then applied the 2006 panel decision in SEC v. Rocklage, 470 F. 3d 1 (1st Cir. 2006) rather than analyzing the later decided Second and Ninth Circuit rulings. Under that standard the court concluded that personal benefits of 1) a free dinner, wine and a massage parlor visit and 2) a payment from his grateful buddies of $3,000 was sufficient. Stated differently, the court concluded that there was a breach of duty because Mr. McPhail communicated the information in breach of his close personal relationship with Mr. Santamaria in return for a steak dinner.