In its important ruling on what the government must prove in a criminal insider trading prosecution, the Second Circuit reversed the convictions of two portfolio managers — throwing out their cases completely, with no new trial — and made it more difficult for prosecutors (at least in that Circuit) to convict corporate outsiders who receive material, nonpublic information (tippees) and then trade on it. The appeal in United States v. Newman and Chiasson, No. 13-137 (2d Cir. 2014), turned on whether the government was required to prove that the defendants, indirect and remote tippees, actually knew about the personal benefit the insiders received in exchange for their disclosure of confidential information. The Second Circuit held that, to prevail against the tippee defendants, the government was required to prove, among other elements, that the insiders received a personal benefit for disclosing confidential information (tipper) and that the defendants knew about both the disclosure and the benefit.

The prosecutors in this Southern District of New York criminal case admitted evidence at trial that showed that tech company employees had tipped analysts with their companies’ earnings data before they were publicly released. The portfolio managers whom the government prosecuted for trading on confidential information were tippees four levels removed from the tech company insiders. At trial, the District Court instructed the jury that the defendants must have known that the insiders’ original disclosures were in violation of a duty of confidentiality. The District Court had declined to give the defendants’ requested instruction requiring the jury to find that the defendants knew the insider had disclosed the inside information for a personal benefit in order to find them guilty.

The Second Circuit ruled that the trial court instructed the jury incorrectly — and not harmlessly — on the knowledge standard. It also held that, despite all inferences in the government’s favor, even the circumstantial evidence “was simply too thin” to infer that the tech company employees “received any personal benefit in exchange for their tips.” The defendants had disputed knowing that the tippers received any benefit and sought to establish that none was provided. Although the law does not require a pecuniary gain, the Court disallowed the government’s reliance simply on “career advice” of a fellow alumnus or “the mere fact of a friendship, particularly of a causal or social nature.” By contrast, demonstrating a relationship with at least a suggestion of a quid pro quo or intent to benefit was held to be required.

The government had argued — successfully in the District Court and unsuccessfully on appeal — that it had no obligation to prove that a tippee knew an insider benefited from his disclosure. It claimed that proving more limited knowledge was all that was necessary: that the defendants — remote tippees who traded on the information — knew that the insiders’ disclosure of material, nonpublic information was a breach of their duty of confidentiality to their employers. The Second Circuit rejected the argument, ruling that such knowledge was insufficient and inconsistent with the longstanding doctrine in Dirks v. SEC, 463 U.S. 646 (1983). Under the Dirks test, a corporate insider breaches his fiduciary duty if he benefits from his disclosure. Op. at 11. The Second Circuit underscored the Dirks standard at the heart of the issue on appeal in Newman: “Absent some personal gain, there has been no breach of duty … .” Id. at 655 (emphasis added by NewmanCourt). It also reiterated the Supreme Court’s rejection of the wholesale notion that a recipient is required to resist trading “whenever he receives inside information from an insider.” Id. Op. at 11.

Accordingly, the Court held that, to convict a tippee for insider trading, the government was required to prove that the tippee knew the corporate insider had breached his fiduciary duty by disclosing confidential information to a tippee in exchange for a personal benefit. The Court emphasized that the common law supported the additional element because the state of mind required to be proved in criminal cases “required that the defendant know the facts that make his conduct illegal.” The principle is particularly apt in insider trading cases where, as the Court reiterated, “it is easy to imagine a … trader who receives a tip and is unaware that his conduct was illegal and therefore wrongful.” Op. at 18 (citation omitted). Because only “willful” conduct — that which is intentional, purposeful and voluntary and not accidental — may be criminally prosecuted, as the Court noted, the ruling also comports with the statutory requirement.

The Court’s ruling restores an essential knowledge element in insider trading cases against tippees. Accordingly, before it seeks an indictment in the Second Circuit in future insider trading prosecutions, the government will be required to carefully assess whether tippees — especially those remotely removed from the corporate insider — knew of the insider’s personal benefit and thus the breach of any duty. That enhanced obligation will help determine whether there is sufficient evidence of an insider trading violation under the Second Circuit’s explicit standards for tippee prosecutions.