Explaining Dirks

• Published date: 01 July 2021
• Date: 01 July 2021

FEATURED ARTICLE

EXPLAINING DIRKS

Andrew N. Vollmer*

ABSTRACT

The personal benefit element of the tipping violation established in Dirks v.

SEC has been misunderstood. Courts, the SEC, and criminal prosecutors have

broadly construed it to create liability for insiders who received remote, specula-

tive, immaterial, or intangible returns after disclosing confidential company in-

formation. Several situations, such as an insider’s gift of confidential information

to a relative or friend or an intention to benefit the recipient of the information,

do not require the insider to receive anything at all.

The drafting history of the majority opinion in Dirks in the papers of its author

Justice Lewis Powell reveals that the current wide interpretations of personal

benefit in tipping cases are not consistent with the test the Court intended. The

principal test of personal benefit was meant to be the insider’s receipt of cash or

something of value within a short time.

The special fact situations mentioned in Dirks, including a disclosure as a gift

or with an intention to benefit, were not independent and sufficient grounds for

finding that an insider received a personal benefit. Rather they were situations

that often could create an inference of personal benefit. The drafting history and

Justice Powell’s previous opinions show that Powell carefully used the word in-

ference in the final opinion. He wanted proof of a fact situation to allow but not

require a fact finder to conclude a tipper received a personal benefit. He did not

intend proof of a fact situation to create a presumption or ultimate liability.

Lessons from the drafting history show that the Supreme Court misapplied the

gift situation in Salman. They also show that the Second Circuit’s Martoma deci-

sion misinterpreted the intention to benefit language in the fact situations.

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524

I. THE FOUNDATIONS OF THE PROHIBITIONS ON INSIDER TRADING AND TIPPING 529

A. Chiarella v. United States . . . . . . . . . . . . . . . . . . . . . . . . . . . 529

B. Dirks v. SEC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530

* Senior Affiliated Scholar, Mercatus Center at George Mason University. Former Professor of Law, General

Faculty, University of Virginia School of Law; former Deputy General Counsel of the Securities and Exchange

Commission; and former partner in the securities enforcement practice of Wilmer Cutler Pickering Hale and

Dorr LLP. I benefitted from comments from Joseph Grundfest, Andrew Hayashi, Brian Knight, Adam Pritchard,

Alexandra Shapiro, Walter Valdivia, and two anonymous peer reviewers. © 2021, Andrew N. Vollmer.

523

II. APPLICATIONS OF THE PERSONAL BENEFIT TEST . . . . . . . . . . . . . . . . . . 533

III. THE DRAFTING HISTORY OF DIRKS . . . . . . . . . . . . . . . . . . . . . . . . . . . 537

A. The Chazen Article . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537

B. Early Chambers Drafts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539

C. Justice O’Connor’s Suggestion . . . . . . . . . . . . . . . . . . . . . . . 543

D. Final Drafts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544

IV. LESSONS FROM THE DRAFTING HISTORY . . . . . . . . . . . . . . . . . . . . . . . 545

A. Cash and Things of Value as Personal Benefit . . . . . . . . . . . . 546

B. Personal Benefit as an Inference from the Fact Situations . . . . 549

C. The Martoma Dispute About an Intention To Benefit . . . . . . . . 557

V. THE RELEVANCE OF DRAFTING HISTORY . . . . . . . . . . . . . . . . . . . . . . . 559

CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 562

INTRODUCTION

Dirks v. Securities and Exchange Commission

1

is a consequential Supreme

Court decision. It gave the Supreme Court’s stamp of approval to a fraud claim for

tipping as part of the insider trading prohibition in the federal securities laws.

2

The

decision also determined the elements for a tipping claim and catalyzed a new area

for law enforcement and legal practice. The Securities and Exchange Commision

(“SEC”) and criminal prosecutors bring a large number of tipping cases every

year.

3

Many of the most famous insider trading decisions involved tipping allega-

tions, such as Salman,

4

Martoma,

5

Newman,

6

and Chestman.

7

The government

charged Ivan Boesky,

8

Martha Stewart,

9

and Raj Rajaratnam

10

as tippees. As a

legal or practical matter, hedge funds, broker-dealers, and financial analysts must

have policies and procedures in writing to avoid the possibility that their receipt of

information will be viewed as a tip.

11

1. 463 U.S. 646 (1983).

2. The prohibition against fraud in the purchase or sale of a security in Rule 10b-5, 17 C.F.R. § 240.10b-5,

issued under authority of section 10(b) of the Securities Exchange Act, 15 U.S.C. § 78j(b), forbids insider

trading.

3. See SEC, DIVISION OF ENFORCEMENT ANNUAL REPORT 7, 15, 20–21, 24–25, 27 (2019), https://www.sec.

gov/files/enforcement-annual-report-2019.pdf.

4. Salman v. United States, 137 S. Ct. 420, 423 (2016).

5. United States v. Martoma, 894 F.3d 64, 67 (2d Cir. 2018).

6. United States v. Newman, 773 F.3d 438, 443 (2d Cir. 2014), abrogated in part by Salman v. United States,

137 S. Ct. 420 (2016).

7. United States v. Chestman, 947 F.2d 551, 564 (2d Cir. 1991) (en banc).

8. Government’s Memorandum with Regard to the Sentencing of Ivan F. Boesky at 2–3, United States v.

Boesky, 1989 WL 46628 (S.D.N.Y. 1989) (No. 86 Cr. 378 (MEL)), http://3197d6d14b5f19f2f440-5e13d29

c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/1980/1987_1214_BoeskySentencing

GovernmentT.pdf.

9. Press Release, SEC, SEC Charges Martha Stewart, Broker Peter Bacanovic with Illegal Insider Trading

(June 4, 2003), https://www.sec.gov/news/press/2003-69.htm.

10. SEC v. Rajaratnam, 918 F.3d 36, 39 (2d Cir. 2019).

11. 15 U.S.C. §§ 78o(g), 80b-4a (requiring broker-dealers and investment advisers to have written policies

and procedures to prevent insider trading); see also Andrew N. Vollmer, How Hedge Fund Advisers Can Reduce

524 AMERICAN CRIMINAL LAW REVIEW [Vol. 58:523

For all that, Dirks has been misunderstood. It meant to authorize a tipping claim

in a narrow, specific set of circumstances when the insider’s wrongdoing was not

in doubt, but law enforcement agencies, courts, and legal writers have construed it

broadly. They have skipped over a critical feature of the opinion and constantly

stretched liability for tipping.

The misunderstanding centers on the meaning of the personal benefit element of

a tipping violation. In a majority opinion written by Justice Lewis Powell, the

Dirks Court reasoned that, to be liable, an insider must have disclosed confidential

information to an outsider in breach of the insider’s fiduciary duty of trust and con-

fidence. How do investigators and courts evaluate whether an insider tipped in

breach of a duty? Dirks said: “[T]he test is whether the insider personally will ben-

efit, directly or indirectly, from his disclosure. Absent some personal gain, there

has been no breach of duty to stockholders.”

12

This is the personal benefit element

or test.

A paragraph in Dirks explained the personal benefit test. An insider needs to

receive “cash, reciprocal information, or other things of value.”

13

The opinion then

listed certain fact patterns that often create an inference that the insider expected to

receive a personal benefit: the insider’s gift of information to a trading relative or

friend or a relationship between the tipper and the tippee suggesting a quid pro quo

or the insider’s intention to benefit the tippee (the “fact situations”).

14

Since the

opinion was issued, it and the personal benefit element have been the subject of

considerable commentary.

15

As the SEC, criminal prosecutors, and courts applied the personal benefit ele-

ment in enforcement cases after Dirks, the test expanded and became easier to

meet. Dirks referred to the insider’s gain and receipt of cash or things of value, but,

over time, less tangible and more remote, speculative, and immaterial returns to

the insider satisfied the test.

16

Maintaining a good relationship with a friend and

Insider Trading Risk, 3 J. SEC. L., REG. & COMPLIANCE 106 (2010) (describing internal policies and procedures

to avoid tipping issues).

12. Dirks v. SEC, 463 U.S. 646, 662 (1983).

13. See infra note 149.

14. Dirks, 463 U.S. at 663–64.

15. JOHN P. ANDERSON, INSIDER TRADING: LAW, ETHICS, AND REFORM 71–75 (2018); STEPHEN M.

BAINBRIDGE, INSIDER TRADING LAW AND POLICY 59–64 (2014); 4 THOMAS LEE HAZEN, TREATISE ON THE LAW

OF SECURITIES REGULATION § 12:167 (7th ed. 2020); DONALD C. LANGEVOORT, INSIDER TRADING: REGULATION,

ENFORCEMENT & PREVENTION § 4 (2015); LOUIS LOSS, JOEL SELIGMAN & TROY PAREDES, FUNDAMENTALS OF

SECURITIES REGULATION (7th ed. 2018); Karen E. Woody, The New Insider Trading, 52 ARIZ. ST. L.J. 594

(2020); Michael D. Guttentag, Selective Disclosure and Insider Trading, 69 FLA. L. REV. 519 (2017); Jonathan

R. Macey, Beyond the Personal Benefit Test: The Economics of Tipping by Insiders, 2 U. PA. J.L. & PUB. AFFS.

25 (2017); Ronald J. Colombo, Tipping the Scales Against Insider Trading: Adopting a Presumption of Personal

Benefit To Clarify Dirks, 45 HOFSTRA L. REV. 117 (2016); Donna Nagy, Beyond Dirks: Gratuitous Tipping and

Insider Trading, 42 J. CORP. L. 1 (2016); A.C. Pritchard, Dirks and the Genesis of Personal Benefit, 68 SMU L.

REV. 857 (2015); Sarah S. Gold & Richard L. Spinogatti, Consequences of Justice Powell’s Slippery Slope in

“Dirks,” 254 N.Y. L.J. 3 (2015).

16. See discussion infra Part II; Pritchard, supra note 15, at 869–70 (SEC “persuaded lower courts to adopt

broad interpretations of Dirks’ personal benefit requirement”).

2021] EXPLAINING DIRKS 525