On Wednesday, December 10, 2014, a three-judge panel of the United States Court of Appeals for the Second Circuit issued a decision that significantly raises the bar for prosecuting individuals who are at least one layer removed from sources of confidential information, overturning the convictions of two hedge fund managers. The Second Circuit held that, in order to sustain a conviction for insider trading, the Government must prove both (1) that the tippee knew that an insider disclosed confidential information, and (2) that he did so in exchange for a personal benefit.  The decision is likely to reshape the landscape for insider trading prosecutions, which has been a significant recent focus of the U.S. Department of Justice and the U.S. Securities and Exchange Commission’s enforcement efforts.

The case, United States v. Newman, involved two former hedge fund managers, Todd Newman and Anthony Chiasson, who were convicted after a six-week jury trial of illegally trading stock based on tips that originated with technology-industry insiders.  At trial, the Government alleged that a group of analysts at various hedge funds and investment firms obtained material, nonpublic information from employees of publicly traded companies, shared it amongst each other, and subsequently passed this information to the portfolio managers at their respective companies. On appeal, Newman and Chiasson argued, among other things, that the district court improperly failed to instruct the jury that a tippee must know that the insider’s disclosure of confidential information was made in exchange for a personal benefit.

The Second Circuit panel of Circuit Judges Winter, Parker, and Hall agreed.  Reversing the holding of the district court, the Second Circuit held that the jury decision was erroneous because the Government failed to prove beyond a reasonable doubt both (1) that Newman and Chiasson (the tippees) knew that an insider disclosed confidential information to them, and (2) that the insider (the tipper) did so in exchange for a personal benefit.  As to Newman and Chiasson’s specific convictions, the Court held that the evidence was insufficient to sustain a guilty verdict for two reasons.  First, the Government’s evidence of personal benefit was insufficient. Second, even assuming that evidence was sufficient, the Government presented no evidence that the defendants knew that they were trading on information obtained from insiders in violation of those insiders’ fiduciary duties.

In an opinion authored by Judge Parker, the panel rejected the Government’s attempt to revive the absolute bar on tipping that the Supreme Court explicitly rejected in Dirks v. S.E.C., 463 U.S. 646 (1983), finding that the Supreme Court was “quite clear” in that the tippee’s liability derives only from the tipper’s breach of a fiduciary duty, not from the trading of non-public information.  Consequently, this landmark ruling, with its harsh words for the Government’s position, poses a serious roadblock to Preet Bharara, the Manhattan United States Attorney who has undertaken a significant five-year insider trading crackdown, and the Department of Justice and the Securities and Exchange Commission more broadly.

It is certainly clear that after Newman, at least in the Second Circuit, the Government must offer significantly more proof to obtain a conviction for insider trading by a tippee.  Lower courts may apply Newman with varying stringency, but as already evidenced by the several district court judges who had put several high-profile cases on hold while awaiting guidance from the Second Circuit, Newman marks a fundamental shift in the landscape for insider trading prosecutions.