A recent decision by the U.S. Court of Appeals for the Second Circuit in New York has clarified the law of insider trading and significantly limited the criminal liability of market participants. In United States v. Newman & Chiasson, 2014 WL 6911278 (No. 13-1837-cr(L), 2nd Cir. Dec. 10, 2014), the Second Circuit overturned the criminal convictions of two portfolio managers who had traded securities on non-public information, on the ground that the Government had failed to prove that the “tippee” portfolio managers knew both that the insider (“tipper”) had disclosed confidential information and that the insider had done so in exchange for personal benefit. It was not enough to show that the tipper personally benefited; the Government must show that the tippee knew that the tipper did so. In other words, the evidence must show that the defendant knew that he or she was trading on information obtained from an insider in violation of that insider’s fiduciary duty. 2014 WL 6911278 at *1; slip op. at 4. This decision will make it more difficult for the Government to prosecute insider trading cases, particularly against tippees several steps removed from the insider source of the information. 

In Newman & Chiasson, the defendants were each charged with conspiracy and multiple counts of securities fraud. The Government’s theory was that a group of analysts at various hedge funds and investment firms obtained material, non-public information (advance earnings numbers) from insider sources, shared it with each other, and then passed the information to the portfolio managers at their companies, including the defendants here, who traded on this inside information. Significantly, the information passed through a series of individuals before reaching the defendants, who were four or five links away from the original inside sources. 

On appeal, the defendants challenged both the jury instructions and the sufficiency of the evidence. The central questions were, first, whether the trial court should have instructed the jury that the Government was required to prove that the defendants knew that the original inside source had received a personal benefit for disclosing the information, and second, whether the Government’s evidence established a personal benefit or knowledge of it. 

The Second Circuit began its analysis by reviewing the seminal Supreme Court decision Dirks v. SEC, 463 U.S. 646 (1983), which established outsider liability for insider trading, and the Second Circuit’s own “somewhat Delphic” prior opinions.Id. at *6; slip op. at 13. The appeals court concluded that this precedent required the Government to prove four elements to establish an insider trading charge against a tippee: ”that (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.” Id. at *8; slip op. at 18 (italics added). In short, the Government was required to prove not only that the defendant knew of a breach of a duty of confidentiality, but also knew that the tipper personally benefited from that breach. The Court then concluded that the jury in this case had not been instructed properly on this “knowledge of benefit” element. 

The Government argued that any error in instructing the jury was harmless, because it had established the required personal benefit to the tipper, and the defendants could have “inferred from the circumstances” that a benefit was provided. Id. at *9; slip op. at 19. The Government’s theory was that, as to one company, the tipper and tippee were “family friends” who had known each other for years, had attended business school together, worked together for a time, and occasionally socialized together, and that the tipper, who wanted to become an analyst like the tippee, had asked for and received advice on a variety of career topics (some before he started providing information), and had sent the tippee his resume for editing and forwarding. Id. at *10; slip op. at 21. The appeals court found that such a benefit did not rise to the level required by law, concluding that “[i]f this was a ‘benefit,’ practically anything would qualify.” Id. As to the other company, the tipper and tippee were merely casual acquaintances, there was no history of loans or personal favors between them, and the tippee, who was a Government witness, testified on cross-examination that he did not provide anything of value in exchange for the information to the tipper, who did not even know that he was trading on the company’s stock. Id. at *11; slip op. at 23. The Court concluded that this evidence was not sufficient to establish a personal benefit to the tipper. 

Even if it were, the appeals court ruled that the Government had not established that the defendants – several conversations away from the original tippers – actually knew of the personal benefit to the original tippers. Some of the intermediaries who had conveyed the information to the defendants testified that they themselves were not aware of the relationships between the original tippers and original tippees. Id. at *11-12; slip op at 24-25. 

The appeals court’s decision reaffirms several principles of insider trading liability the Supreme Court established in Dirks: (1) that the tippee’s liability derives only from the tipper’s violation of a fiduciary duty, not from simply trading on material, non-public information; (2) that the insider tipper has committed no breach of his fiduciary duty unless he receives a personal benefit in exchange for the disclosure; and (3) that a tippee is only liable if he knows or should have known of the tipper’s breach, including knowing of the tipper’s receipt of personal benefit.Id. at *6; slip op. at 13-14 (italics added). While the Government has been vigorously pursuing insider trading cases over the past few years, and casting its net over an ever-widening group of outsiders, this decision should cause the Government to narrow its focus to insiders and to those outsiders who do commit willful violations, rather than those who simply trade on confidential information. (The Government has stated that it has not yet determined whether it will appeal the decision to the Supreme Court.)