What is the 'Dirks Test'

Dirks 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.

BREAKING DOWN 'Dirks Test'

The Dirks Test is named after the 1984 Supreme Court case Dirks v. SEC, which 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. It is also not necessary to be a manager or employee of the company; friends and family members who have access to such information and disclose it can also be charged with committing an illegal act.

Testing the Dirks Test

The Dirks Test was unclear on one key element — whether an insider breached a duty if he or she did not receive personal benefit. Indeed, the Supreme Court highlighted that "absent some personal gain [to the insider] there has been no breach of duty to stockholders. And absent a breach by the insider there is no derivative breach [by the tippee]." 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 hedge fund manager with a checkered past, 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 his conviction in 2017, citing the precedent set in the U.S. v. Salman case that a benefit need not be "pecuniary." According to the ruling, a "gift" of inside information to a relative or friend was to be considered in and of itself a personal gain to the tipper. The tipper and tippee, in this case, were deemed to be friends; therefore, the standard was met.

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