In a landmark ruling that is likely to reshape the landscape of insider-trading prosecutions of “tippees,” a three-judge panel of the U.S. Court of Appeals for the Second Circuit reversed the convictions of former portfolio managers from Level Global Investors LP (Anthony Chiasson) and Diamondback Capital Management LLC (Todd Newman), finding that they did not know the alleged sources of inside information had disclosed the tips in exchange for a personal benefit.  United States v. Newman, Nos. 13-1837-cr (L), 13-191-cr (con), slip op. at 4 (2d Cir. Dec. 10, 2014)

Chiasson and Newman were convicted in 2012 of illegally trading Dell and Nvidia stock on the basis of information they received from individuals three and four levels removed from the technology-industry insider tippers. The defendants had no contact with the tippers. Id. at 5. Moreover, the Government offered no evidence that the defendants were aware of the source of the information. Id. Instead, the Government relied on the fact that Newman and Chiasson were “sophisticated traders” and that “they must have known that information was disclosed by insiders in breach of a fiduciary duty, and not for any legitimate corporate purpose.” Id. at 6.

The Second Circuit noted that the Supreme Court previously “rejected the SEC’s theory that a recipient of confidential information (i.e., the ‘tippee’) must refrain from trading ‘whenever he receives inside information from an insider.’” Id. at 11. The Second Circuit also commented on “the doctrinal novelty of [the Government’s] recent insider trading prosecutions” and noted that such prosecutions have been “increasingly targeted at remote tippees many levels removed from corporate insiders.”Id. at 14. The Second Circuit concluded that the jury instructions with respect to the Government’s burden with respect to tippee liability were erroneous and held as follows:

to sustain an insider trading conviction against a tippee, the Government must prove each of the following elements beyond a reasonable doubt; that (1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by disclosing confidential information to a tippee in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade in a security or tip another individual for personal benefit.

Id. at 18 (emphasis added). The Second Circuit emphasized that there was “no support for the Government’s contention that knowledge of a breach of the duty of confidentiality without knowledge of the personal benefit is sufficient to impose criminal liability.” Id. at 15-16.  Moreover, the Second Circuit pointed out that while it had not previously addressed the issue of a tippee’s knowledge of the tipper’s breach, prior cases involving tippee liability generally involved tippees who directly participated in the tipper’s breach or tippees who knew about the tipper’s gain.

The Second Circuit’s decision will undoubtedly hinder future prosecutions of remote tippees such as Chiasson and Newman. It also clearly puts the brakes on the DOJ’s and SEC’s years-long efforts to push the limits of insider trading law. While it is not clear whether the Second Circuit’s opinion will apply to civil insider trading cases brought by the SEC, it is clear yesterday’s decision will have a significant impact on charging decisions in future cases for both the SEC and DOJ. In addition, while the opinion addresses the validity of the criminal convictions, it is likely that the SEC will have to deal with the collateral consequences of the convictions being reversed. For example, the SEC obtained civil judgments against Chiasson and Newman and industry bars based on their criminal convictions. It is unclear whether Chiasson and Newman will challenge those bars and judgments now that the underlying criminal convictions have been vacated.

Moreover, the Second Circuit’s decision likely will impact other pending high-profile SEC and DOJ prosecutions, including the sentencing of Danny Kuo, a former research analyst at Whittier Trust Co., and the SEC administrative proceeding claiming that SAC Capital founder Steven Cohen failed to supervise traders from that firm who were convicted of insider trading.

Finally, the Second Circuit’s decision demonstrates the importance of having the courts, not administrative law judges employed by the SEC, interpreting the federal securities law and developing a body of case law that is critical to the efficient operation of the U.S. financial markets.