What Is the Dirks Test?
The Dirks test (also referred to as the personal benefits test) is a standard used by the Securities and Exchange Commission (SEC) to determine whether someone who receives and acts on insider information (a tippee) is guilty of insider trading. The Dirks test looks for two criteria: 1) whether the individual breached the company's trust (broke rules of confidentiality by disclosing material nonpublic information) and 2) whether the individual did so knowingly.
Tippees can be found guilty of insider trading if they knew or should have known that the tipper had committed a breach of fiduciary duty. The Dirks test originated from a 1983 Supreme Court ruling which stated that the breach of duty must result in a personal benefit for the insider. The Court provided guidance to determine what constitutes a personal benefit, creating a test that treats tipping differently depending on whether the tips are given to relatives and friends versus strangers.
- The Dirks test is a standard the SEC and the U.S. court system uses to establish if someone who receives and acts on insider information (also known as a "tipee") is guilty of insider trading.
- The Dirks test stems from the 1983 Supreme Court case, Dirks v. SEC, which established a blueprint for evaluating insider trading.
- The Supreme Court ruled that a tipee assumes an insider's fiduciary duty to not trade on material nonpublic information if they knew or should have known of the insider's breach.
- There is no breach of fiduciary duty unless the insider tips for their own personal benefit, which refers to whether the insider will benefit personally—either directly or indirectly—from their disclosure.
- Examples of a personal benefit would be providing a tip in return for cash, reciprocal information, or a reputational benefit.
Understanding the Dirks Test
The Dirks test is named after the 1983 Supreme Court case Dirks v. SEC. The Supreme Court ruling reversed a lower court's affirmation of the SEC's censure of Raymond Dirks, a securities analyst, who had acted as a whistleblower in a case involving fraud at a high-profile insurance company.
The Dirks test established the conditions under which tippees can be held liable for insider trading. An individual does not actually have to engage in a trade to be guilty of illegal insider trading. Merely facilitating an inside trade by disclosing material nonpublic information about a company is sufficient to be liable for illegal insider trading.
Material Nonpublic Information
Examples of material nonpublic information include:
- Advance information about an upcoming earnings report
- Advance information about an upcoming initial public offering, merger or acquisition, stock buyback, or stock split
- Advance information about a Food and Drug Administration decision regarding a new pharmaceutical drug
This type of information can greatly impact a company's share price, causing it to swing up or down over several trading sessions. Some traders attempt to take advantage of this advanced knowledge by buying or selling a security before the information is made public.
It is not necessary to be a manager or employee of the company to be guilty of illegal insider trading. Friends and family members who have access to such information and disclose it can also be charged with committing an illegal act.
SEC rules require company insiders to disclose their transactions. They must disclose initial ownership, purchases and sales; and transaction prices.
A key result of the Dirks v. SEC decision was that it established a blueprint for evaluating insider trading. The Supreme Court ruled that a tipee may assume the insider's fiduciary duty to a corporation's shareholders not to trade on material nonpublic information if the tipee knows or should have known of the insider's breach.
The Court ruled that there is no breach unless the insider tips for their own personal benefit, rather than the tipee's personal benefit. There are several things that can constitute a personal benefit for the tipper. This includes providing the tip in return for cash, reciprocal information, or a reputational benefit that the tipper anticipates will lead to future earnings. The Court ruled that tips to trading relatives or friends are considered gifts of confidential information and also constitute a personal benefit to the insider.
The Dirks test also provides protection for those whose job it is to ferret out and analyze information provided by corporate insiders. This includes market and financial analysts who in the course of performing their duties receive a tip that enables them to expose a fraud. In this case, the tippee does not personally benefit and would not be liable for insider trading.
Real World Example of the Dirks Test
In subsequent court cases, U.S. v. Newman and U.S. v. Salman, the focus on the definition of "personal benefit" provided clarification of the Dirks test. Mathew Martoma, a former portfolio manager at a large hedge fund, was convicted in 2014 for insider trading involving shares of a biotechnology company conducting pivotal trials of an Alzheimer's drug.
His lawyers appealed the conviction on the grounds that the tipper, a prominent doctor and researcher at the University of Michigan, did not receive personal benefit for sharing material nonpublic data with Martoma. However, the federal appeals court upheld the conviction in 2017, citing that at least one tipper received a personal benefit from disclosing inside information in the form of $70,000 in consulting fees. Therefore, the Dirks standard was met and the appeals court affirmed the 2014 conviction.