In 9th Circ. insider trading case, Rakoff rejects broad read of 2nd Circ. precedent

July 8, 2015

(Reuters) – Running one of the busiest dockets in Manhattan federal court, sitting from time to time at the 2nd U.S. Circuit Court of Appeals and stirring up controversy in speeches and essays is apparently not enough to keep U.S. District Judge Jed Rakoff busy. On Monday, the 9th Circuit issued an important interpretation of insider trading law in its opinion in U.S. v. Salman. The author of this ruling was none other than Judge Rakoff, who sat on the 9th Circuit by designation when the appeal was argued last month in San Francisco.

Salman is the first appellate decision to review an insider trading conviction in light of the 2nd Circuit’s landmark December 2014 ruling in U.S. v. Newman – and one sentence in the opinion is written to suggest the 9th Circuit doesn’t entirely agree with its East Coast counterparts. That’s important because the Justice Department has to decide by August 1 whether to petition the U.S. Supreme Court to take the Newman case. But as I’ll explain, I don’t think Judge Rakoff and the 9th Circuit actually disagree with what the 2nd Circuit said. As I read the Salman decision, the 9th Circuit’s real concern is that defendants are attempting to read into Newman a restriction the 2nd Circuit didn’t intend.

In the Newman case, as you surely recall, a three-judge 2nd Circuit panel made two key findings. The first was expected: The appeals court said the government must show that downstream recipients of confidential information were aware the original tipster benefitted from passing it along. The second was a surprise: The 2nd Circuit found that the tipster’s benefit has to be more tangible than just helping out a friend. Corporate insiders must have a “meaningfully close personal relationship” with the initial recipient of confidential information, according to the opinion, or else stand to receive a pecuniary benefit from the disclosure.

That tightening of the definition of what constitutes a tipster’s “personal benefit” turned the 2nd Circuit’s Newman decision into a blockbuster. As of March, when the ruling prompted two U.S. senators to proposed a bill to redefine insider trading, seven defendants in federal court in Manhattan had convictions overturned or charges dropped because of Newman. In June, Securities and Exchange Commission chair Mary Jo White said the SEC is closely monitoring the ruling’s impact to decide whether to propose new insider trading regulations.

The 2nd Circuit denied the government’s motion to rehear the Newman case in April, which means the decision is the law of the land in New York, Connecticut and Vermont unless the Justice Department decides to appeal to the Supreme Court and the court takes the case.

Newman is not binding on the 9th Circuit, as Rakoff noted in Monday’s decision in the Salman case. But Bassam Salman’s lawyer, John Cline, urged the 9th Circuit to adopt the Newman definition of a personal benefit and overturn his client’s conviction for trading on the basis of confidential information passed to him by a family friend named Michael Kara. The tips originated with Michael Kara’s brother, Citigroup investment banker Maher Kara. Salman’s lawyer contended the government had not shown Maher Kara benefited from tipping his brother because he didn’t make money from the tips and, under Newman, their family relationship isn’t sufficient evidence of a personal benefit.

Judge Rakoff and his fellow panel members, 9th Circuit Judges Morgan Christen and Paul Watford, agreed that the Newman analysis merited their consideration because “we would not lightly ignore the most recent ruling of our sister circuit in an area of law that it has frequently encountered.” They said, however, that the Supreme Court has already answered the question of what constitutes a personal benefit to tippers in its 1983 decision in Dirks v. SEC, which said a tipster benefits when he or she “makes a gift of confidential information to a trading relative or friend.” Maher Kara’s disclosures to his brother Michael are precisely the scenario Dirks envisioned, Rakoff wrote for the 9th Circuit.

Rakoff and the 9th Circuit got a little squirrelly about whether the 2nd Circuit’s ruling in Newman narrowed the Dirks definition of a personal benefit. “To the extent Newman can be read to go so far, we decline to follow it,” the Salman opinion said. “Doing so would require us to depart from the clear holding of Dirks that the element of breach of fiduciary duty is met where an ‘insider makes a gift of confidential information to a trading relative or friend.'”

So was Rakoff schooling the 2nd Circuit (which has been known to school him) and creating a circuit split on tipsters’ personal benefit?

I don’t think so. As Judge Rakoff went on to acknowledge in the Salman opinion, the 2nd Circuit in Newman explicitly cited the Dirks definition, though it said Dirks should not be read to imply a breach of duty by the tipster “in the absence of proof of 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 close relationship between the Kara brothers, and Michael Kara’s financial assistance to Maher Kara, would seem to fit inside the Newman court’s boundaries.

And Rakoff has previously said Newman and Dirks are not inconsistent. Last week, the judge refused to vacate the insider trading conviction of Rajat Gupta, the former Goldman Sachs director who passed confidential information to Galleon Group founder Raj Rajaratnam. Like Salman, Gupta had argued that under Newman, there was no breach of duty because he did not make money by passing along confidential information.

Judge Rakoff said Gupta actually did benefit financially. But more fundamentally, he said, Gupta misread Newman. Rakoff said he viewed Newman to hold that “a tipper’s intention to benefit the tippee is sufficient to satisfy the benefit requirement so far as the tipper is concerned, and no quid pro quo is required.” That is in line with Dirks, he said – and it is also consistent with the new 9th Circuit opinion in Salman.

The 2nd Circuit panel in the Newman case smacked prosecutors for stretching insider trading laws to bring charges against ever more remote defendants. But Rakoff’s opinions in Salman and Gupta suggest that defendants are now trying to stretch Newman too far. The judge is snapping them back.

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