Securities — Tipper and Tippee Scienter under Classical and Misappropriation Theories of Insider Trading — Scienter Requirement As Applied to Tippee Chains

Securities and Exchange Commission v. Obus, 693 F.3d 276 (2d Cir. 2012):

A. The [Classical vs. the] Misappropriation Theory of Insider Trading

Insider trading--unlawful trading in securities based on material non-public information--is well established as a violation of section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. See Dirks v. SEC, 463 U.S. 646, 653-54, 103 S. Ct. 3255, 77 L. Ed. 2d 911 (1983); Chiarella v. United States, 445 U.S. 222, 226-30, 100 S. Ct. 1108, 63 L. Ed. 2d 348 (1980); SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 847-48 (2d Cir. 1968) (en banc); In re Cady, Roberts & Co., 40 S.E.C. 907 (1961). Under the classical theory of insider trading, a corporate insider is prohibited from trading shares of that corporation based on material non-public information in violation of the duty of trust and confidence insiders owe to shareholders. Chiarella, 445 U.S. at 228. A second theory, grounded in misappropriation, targets persons who are not corporate insiders but to whom material non-public information has been entrusted in confidence and who breach a fiduciary duty to the source of the information to gain personal profit in the securities market. United States v. O'Hagan, 521 U.S. 642, 652, 117 S. Ct. 2199, 138 L. Ed. 2d 724 (1997); United States v. Chestman, 947 F.2d 551, 566 (2d Cir. 1991) (en banc). Such conduct violates section 10(b) because the misappropriator engages in deception (as required for liability under that section and Rule 10b-5) by pretending "loyalty to the principal while secretly converting the principal's information for personal gain." O'Hagan, 521 U.S. at 653 (internal quotation marks omitted). The requirement under section 10(b) that the deception be "in connection with the purchase and sale of any security" is met because the information is "of a sort that [can] ordinarily [be] capitalize[d] upon to gain no-risk profits through the purchase or sale of securities." Id. at 656; United State v. Falcone, 257 F.3d 226, 233-34 (2d Cir. 2001). This appeal is concerned only with liability under the misappropriation theory.

One who has a fiduciary duty of trust and confidence to shareholders (classical theory) or to a source of confidential information (misappropriation theory) and is in receipt of material non-public information has a duty to abstain from trading or to disclose the information publicly. The "abstain or disclose" rule was developed under the classical theory to prevent insiders from using their position of trust and confidence to gain a trading advantage over shareholders. See Chiarella, 445 U.S. at 227-30; Dirks, 463 U.S. at 660. "Abstain or disclose" has equal force in the misappropriation context, but the disclosure component operates somewhat differently. Because the misappropriation theory is based on a fiduciary duty to the source of the information, only disclosure to the source prevents deception; disclosure to other traders in the securities market cannot cure the fiduciary's breach of loyalty to his principal. O'Hagan, 521 U.S. at 655; see Moss v. Morgan Stanley Inc., 719 F.2d 5, 13 (2d Cir. 1983) (fiduciary duty of disclosure to employer does not imply duty to disclose to the public). Under either theory, if disclosure is impracticable or prohibited by business considerations or by law, the duty is to abstain from trading. See United States v. Teicher, 987 F.2d 112, 120 (2d Cir. 1993).

B. Tipping Violations of Insider Trading Laws

The insider trading case law is not confined to insiders or misappropriators who trade for their own account. Section 10(b) and Rule 10b-5 also reach situations where the insider or misappropriator tips another who trades on the information. In Dirks, 463 U.S. 646, 103 S. Ct. 3255, 77 L. Ed. 2d 911, the Court addressed the liability of an analyst who received confidential information about possible fraud at an insurance company from one of the insurance company's former officers. Id. at 648-49. The analyst relayed the information to some of his clients, and some of them, in turn, sold their shares in the insurance company based on the analyst's tip. Id. The Court held that a tipper like the analyst in Dirks is liable if the tipper breached a fiduciary duty by tipping material non-public information, had the requisite scienter (to be discussed momentarily) when he gave the tip, and personally benefited from the tip. Id. at 660-62. Personal benefit to the tipper is broadly defined: it includes not only "pecuniary gain," such as a cut of the take or a gratuity from the tippee, but also a "reputational benefit" or the benefit one would obtain from simply "mak[ing] a gift of confidential information to a trading relative or friend." Id. at 663-64. When an unlawful tip occurs, the tippee is also liable if he knows or should know that the information was received from one who breached a fiduciary duty (such as an insider or a misappropriator) and the tippee trades or tips for personal benefit with the requisite scienter. See id. at 660. The Supreme Court's tipping liability doctrine was developed in a classical case, Dirks, but the same analysis governs in a misappropriation case. See Falcone, 257 F.3d at 233.

C. Scienter

Liability for securities fraud requires proof of scienter, defined as "a mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, 96 S. Ct. 1375, 47 L. Ed. 2d 668 & n.12 (1976). Negligence is not a sufficiently culpable state of mind to support a section 10(b) civil violation. Id. While the Supreme Court has yet to decide whether recklessness satisfies section 10(b)'s scienter requirement, see Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1323, 179 L. Ed. 2d 398 (2011), we have held that scienter "may be established through a showing of reckless disregard for the truth, that is, conduct which is highly unreasonable and which represents an extreme departure from the standards of ordinary care," SEC v. McNulty, 137 F.3d 732, 741 (2d Cir. 1998) (internal citations and quotation marks omitted); see SEC v. U.S. Envtl., Inc., 155 F.3d 107, 111 (2d Cir. 1998) (recognizing that eleven circuits hold that recklessness satisfies the scienter requirement of section 10(b)). We read the scienter requirement set forth in Hochfelder (and the recklessness variation in McNulty) to apply broadly to civil securities fraud liability, including insider trading (under either the classical or misappropriation theory), and to tipper/tippee liability. See, e.g., Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 167-68 (2d Cir. 1980). In every insider trading case, at the moment of tipping or trading, just as in securities fraud cases across the board, the unlawful actor must know or be reckless in not knowing that the conduct was deceptive.

With this background, we turn specifically to the scienter requirements for both tippers and tippees under the misappropriation theory.

1. Tipper Scienter To be held liable, a tipper must (1) tip (2) material non-public information (3) in breach of a fiduciary duty of confidentiality owed to shareholders (classical theory) or the source of the information (misappropriation theory) (4) for personal benefit to the tipper. The requisite scienter corresponds to the first three of these elements. First, the tipper must tip deliberately or recklessly, not through negligence. Second, the tipper must know that the information that is the subject of the tip is non-public and is material for securities trading purposes, or act with reckless disregard of the nature of the information. Third, the tipper must know (or be reckless in not knowing) that to disseminate the information would violate a fiduciary duty. While the tipper need not have specific knowledge of the legal nature of a breach of fiduciary duty, he must understand that tipping the information would be violating a confidence. ***

Assume two scenarios with similar facts. In the first, a commuter on a train calls an associate on his cellphone, and, speaking too loudly for the close quarters, discusses confidential information and is overheard by an eavesdropping passenger who then trades on the information. In the second, the commuter's conversation is conducted knowingly within earshot of a passenger who is the commuter's friend and whom he also knows to be a day trader, and the friend then trades on the information. In the first scenario, it is difficult to discern more than negligence and even more difficult to ascertain that the tipper could expect a personal benefit from the inadvertent disclosure. In the second, however, there would seem to be at least a factual question of whether the tipper knew his friend could make use of material non-public information and was reckless in discussing it in front of him. Similarly, there would be a question of whether the tipper benefited by making a gift of the non-public information to his friend, or received no benefit because the information was revealed inadvertently through his poor cellphone manners.

2. Tippee Scienter

Like a tipper, a liable tippee must know that the tipped information is material and non-public. And a tippee must have some level of knowledge that by trading on the information the tippee is a participant in the tipper's breach of fiduciary duty. This last element of tippee scienter was addressed in Dirks, which held that a tippee has a duty to abstain or disclose "only when the insider has breached his fiduciary duty . . . and the tippee knows or should know that there has been a breach." 463 U.S. at 660 (emphasis added). In such a case, the tippee is said to "inherit" the tipper's duty to abstain or disclose. The parties dispute whether the Dirks rule is in conflict with Hochfelder's holding that negligence does not satisfy section 10(b)'s scienter requirement because the "knows or should know" rule, repeated in numerous Second Circuit cases, sounds somewhat similar to a negligence standard. See Restatement (Third) of Torts § 3, cmt. g (2010) (negligence requires foreseeability, which "concerns what the actor 'should have known'"). We think the best way to reconcile Dirks and Hochfelder in a tipping situation is to recognize that the two cases were not discussing the same knowledge requirement when they announced apparently conflicting scienter standards. Dirks' knows or should know standard pertains to a tippee's knowledge that the tipper breached a duty, either to his corporation's shareholders (under the classical theory) or to his principal (under the misappropriation theory), by relaying confidential information. This is a fact-specific inquiry turning on the tippee's own knowledge and sophistication, and on whether the tipper's conduct raised red flags that confidential information was being transmitted improperly. Hochfelder's requirement of intentional (or McNulty's requirement of reckless) conduct pertains to the tippee's eventual use of the tip through trading or further dissemination of the information. Thus, tippee liability can be established if a tippee knew or had reason to know that confidential information was initially obtained and transmitted improperly (and thus through deception), and if the tippee intentionally or recklessly traded while in knowing possession of that information.

D. Tipping Chains

One last question presented by this case is how a chain of tippers affects liability. Such chains of tipping are not uncommon, see, e.g., Dirks, 463 U.S. at 649-50; Falcone, 257 F.3d at 227; United States v. McDermott, 245 F.3d 133, 135-36 (2d Cir. 2001); and follow the same basic analysis outlined above. A tipper will be liable if he tips material non-public information, in breach of a fiduciary duty, to someone he knows will likely (1) trade on the information, or (2) disseminate the information further for the first tippee's own benefit. The first tippee must both know or have reason to know that the information was obtained and transmitted through a breach, and intentionally or recklessly tip the information further for her own benefit. The final tippee must both know or have reason to know that the information was obtained through a breach, and trade while in knowing possession of the information. Chain tippee liability may also result from conscious avoidance. See SEC v. Musella, 678 F. Supp. 1060, 1063 (S.D.N.Y. 1988) (finding scienter satisfied where the defendants, tippees at the end of a chain, "did not ask [about the source of information] because they did not want to know").

* * *

To summarize our discussion of tipping liability, we hold that tipper liability requires that (1) the tipper had a duty to keep material non-public information confidential; (2) the tipper breached that duty by intentionally or recklessly relaying the information to a tippee who could use the information in connection with securities trading; and (3) the tipper received a personal benefit from the tip. Tippee liability requires that (1) the tipper breached a duty by tipping confidential information; (2) the tippee knew or had reason to know that the tippee improperly obtained the information (i.e., that the information was obtained through the tipper's breach); and (3) the tippee, while in knowing possession of the material non-public information, used the information by trading or by tipping for his own benefit.

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