In a closely followed appeal, the United States Court of Appeals for the Second Circuit on December 10, 2014, delivered an important decision in United States v. Newman [1] by vacating the insider trading convictions of two former hedge fund portfolio managers, Todd Newman and Anthony Chiasson, and directing that the charges against them be dismissed with prejudice.

This decision has significant implications for criminal insider trading prosecutions and those brought civilly by the United States Securities and Exchange Commission (SEC). Fundamentally, it will make it more difficult for the government to charge alleged remote tippees (like the defendants in this case who were three or four persons removed from the corporate insiders) with violations of the federal securities laws. Indeed, the Court appeared to be critical of the government for bringing criminal insider trading charges against Newman and Chiasson at a point when neither corporate insider had been charged criminally for insider trading and one has also not been charged administratively or civilly.

This decision is significant because in it the Second Circuit:

  • Grounds its analysis in the United States Supreme Court’s longstanding insider trading decisions of Dirks v. SEC [2] and Chiarella v. United States [3] from the early 1980s, which established that “insider trading liability is based on breaches of fiduciary duty”;
  • Clarifies the boundaries for tippee liability by holding that the government must prove beyond a reasonable doubt that a tippee has knowledge of the personal benefit to the tipper; and
  • Restricts what constitutes a personal benefit in the context of insider trading by now requiring a quid pro quo relationship.

According to the Second Circuit, the government’s criminal case against Newman and Chiasson suffered from similar flaws that contributed to its loss in the criminal insider trading prosecution of Rengan Rajaratnam,[4] as well as the SEC’s losses in eleven insider trading cases or claims over the past year. As we pointed out last month in a BNA Securities Regulation & Law Report article,[5] the SEC in all these cases stretched the law and/or the facts beyond fairness and reason. Like the judges and juries in those cases, the Second Circuit now appears to be setting the government straight.

Background

As part of a broader criminal insider trading investigation, the United States Attorney for the Southern District of New York, Preet Bharara (U.S. Attorney), brought insider trading charges against two hedge fund portfolio managers, Todd Newman (formerly at now-defunct Diamondback Capital Management, LLC) and Anthony Chiasson (formerly at now-defunct Level Global Investors, LP). At trial, the government provided evidence that Newman and Chiasson each traded shares of Dell and NVIDIA for their funds based upon information regarding earnings announcements that were not yet public.6 The government showed that the corporate insiders tipped a group of research analysts, who passed along the information within the group until it was ultimately provided to analysts where Newman and Chiasson worked. In turn, the defendants each traded on the information resulting in profits of $4 million and $68 million, respectively, for their funds.

At the close of the six-week trial, Newman and Chiasson moved for a judgment of acquittal arguing that the government failed to put forth sufficient evidence to establish that the corporate insiders exchanged confidential information for a personal benefit as required by Dirks. As the government failed to prove receipt of a benefit, and as tippee liability is derivative of the tipper’s liability, Newman and Chiasson argued that they could not be convicted. They further argued that they could not be found guilty of insider trading, as they had no knowledge of the personal benefit to the corporate insiders, and therefore “were not aware of, or participants in, the tippers’ fraudulent breaches of fiduciary duties to Dell or NVIDIA.”

On December 17, 2012, the jury returned a verdict finding Newman and Chiasson guilty on all ten counts of securities fraud and conspiracy to commit securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Following their sentencing,[7] Newman and Chiasson appealed, challenging among other things the instructions to the jury as failing to require that Newman and Chiasson had knowledge that the corporate insider received a personal benefit in exchange for providing confidential information, and the sufficiency of the evidence relating to their knowledge of the corporate insiders’ personal benefit.

Required Element of Tippee Liability: Knowledge of Personal Benefit to the Corporate Insider

On appeal, the government argued that it need not show that either defendant knew that the corporate insiders received a personal benefit to be found criminally liable. Instead, the government argued that, according to Dirks and certain cases decided by the Second Circuit after Dirks, criminal liability for insider trading only requires that the “tippee know that the tipper disclosed information in breach of a duty.”

The Court rejected the government’s argument as being inconsistent with the Supreme Court’s 1983 holding in Dirks and certain holdings in post-Dirks cases. According to the influential Second Circuit, the government was wrong because the Supreme Court in Dirks was “quite clear” on three points:

  • “[T]he tippee’s liability derives only from the tipper’s breach of a fiduciary duty, not from trading on material, non-public information”;
  • “[T]he corporate insider has committed no breach of fiduciary duty unless he receives a personal benefit in exchange for the disclosure”; and
  • “[E]ven in the presence of a tipper’s breach, a tippee is liable only if he knows or should have known of the breach.”

The Court criticized the government for “selectively parsing” dicta from the post-Dirkscases in an attempt to “revive the absolute bar on tippee trading that the Supreme Court explicitly rejected in Dirks.”

The Court further held that:

[T]o sustain an insider trading conviction against a tippee, the Government must prove each of the following elements beyond a reasonable doubt: (1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) 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.

The Court reasoned that this holding comports with “well-settled principles of substantive criminal law” that require a finding of mens rea by a defendant.

Insufficient Evidence: Personal Benefit to the Corporate Insider

The Court also rejected the government’s evidence, even when viewed in the light most favorable to it, because the evidence “was simply too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips.” This holding is significant because it limits an element of insider trading that many courts have viewed broadly to include personal relationships, pecuniary gains, and even “any reputational benefit that will translate into future earnings.” The Court emphasized this limitation, noting that holding otherwise would mean “practically anything would qualify.”

Specifically, the Court found that the Dell corporate insider and intermediary tippee “were not ‘close’ friends, but had known each other for years, having both attended business school and worked at Dell together.” Notably, the intermediary tippee testified that he would have given career advice to the corporate insider without receiving any tips because he routinely did so for colleagues. Similarly, the NVIDIA corporate insider and intermediary tippee were “family friends” or “merely casual acquaintances” who had “met through church and occasionally socialized together.”

As a result, the Court has made clear that in order to prove a personal benefit in the context of a personal relationship, the government must show a quid pro quo relationship or provide “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”

Insufficient Evidence: Knowledge of Trading on Information from Corporate Insider in Violation of Insider’s Duty

The Second Circuit also found that there was “absolutely no testimony or any other evidence” that Newman or Chiasson knew that they were trading on tips obtained from corporate insiders who received a personal benefit for breaching their duty, or even that they consciously avoided learning these facts. Importantly, for subsequent cases and guidance, the Court noted that “Newman and Chiasson were several steps removed from the corporate insiders.” In particular, Newman and Chiasson were remote tippees three and four levels removed from the alleged Dell corporate insider, respectively, and both were four levels removed from the alleged NVIDIA corporate insider. Further, the intermediary tippees “knew next to nothing about the insiders and nothing about what, if any, personal benefit had been provided to them.” Given all this, the Court found that “it is inconceivable that a jury could conclude, beyond a reasonable doubt, that Newman and Chiasson were aware of a personal benefit, when [the intermediary tippees], who were more intimately involved in the insider trading scheme as part of the ‘corrupt’ analyst group, disavowed any such knowledge.”

Impact of the Decision: Takeaways

Ultimately, the Newman decision is a stern rebuke of the U.S. Attorney’s recent aggressive insider trading prosecutions, which have been based upon unreasonably expansive interpretations of insider trading laws that are inconsistent with Dirks and Chiarella. This decision should set the boundaries for both the U.S. Attorney and the SEC in bringing insider trading cases going forward against truly remote tippees who have no knowledge of the corporate source or his or her benefit. It should also cause both the U.S. Attorney and SEC to reassess their current insider trading investigations and prosecutions given the significant financial and reputational damage individual defendants face by just being wrongly accused of insider trading.[8]

In particular, there are at least four significant takeaways from the Newman decision.

  • First, to be guilty of insider trading, you must know the information received is non-public. In this sense, it seems appropriate, and not a violation of the federal securities laws, to engage in a stock trade in a company where you hear information about a company from a friend or colleague who is unaffiliated with the company, and you have no reason to believe that the information came from someone at the company who is in a breach of a duty of confidentiality (or other fiduciary duty).
  • Second, to be guilty of insider trading, the information must be material and not the kind of information that merely fills in the gaps.[9] In this sense, it also seems appropriate, and not a violation of federal securities laws, to use public information (e.g., observing parking lots of retail stores) to flesh out or confirm investment hypotheses and/or assumptions—indeed, that is precisely what analysts are supposed to do.
  • Third, while the prior two takeaways further clarify the boundaries of insider trading prosecutions, these boundaries are far from bright lines. Given this, there is no guarantee that the government will refrain from investigating, charging, and possibly obtaining an insider trading conviction from a jury on conduct they believe to be unlawful even when it is completely legal.
  • Fourth, the Second Circuit’s decision in no way opens up the floodgates to indiscriminate trading on possible inside information. To the contrary, it clarifies what conduct is prohibited. Moreover, significant disincentives still exist for those who might think to engage in questionable or wrongful activities apart from any prosecutions. For example, individuals (whether they be corporate insiders or other tippees) may be fired for breaching an employment agreement or fiduciary duty, sued by an employer or third party for breaching a confidentiality agreement, or face other stiff consequences for cavalier activity.

So while hedge funds, investment banks, and other money managers should sleep a little better at night knowing that they are less likely to be caught in the prosecutorial crosshairs of the U.S. Attorney and the SEC (based on, for example, a casual conversation one of their analysts may have with a former classmate or other acquaintance), they should still take appropriate measures to protect themselves. This may even mean passing on an otherwise innocent trade when the surrounding facts and circumstances are questionable and might pique the government’s curiosity. After all, despite the Second Circuit’s Newmandecision, insider trading undoubtedly will continue to be a priority for the government, which has shown an increaseng interest in money managers in recent years.