On December 10, 2014, the Second Circuit Court of Appeals rendered a decision[1] regarding an insider trading case that affirmed the elements to prove tippee liability.  The Second Circuit was reviewing a district court’s conviction of Todd Newman, a portfolio manager at Diamondback Capital Management, LLC, and Anthony Chiasson, a portfolio manager at Level Global Investors, L.P., of insider trading based on tippee liability.  The Second Circuit found that the jury instruction given by the district court was erroneous because the jury instruction failed to state that the government must prove beyond a reasonable that the tipeee knew that an insider disclosed confidential information and that such insider did so in exchange for a personal benefit.

The Second Circuit notes that this case arises from the SEC’s investigation into suspected insider trading activity at hedge funds.  The SEC alleged that a group of financial analysts exchanged information they obtained from company insiders at Dell and NVIDIA who disclosed earnings numbers before public release.  Then, the analysts passed the inside information to their portfolio managers, who then executed the trades.  The Second Circuit noted that both defendants were at least three or four levels removed from the inside tippers at Dell and NVIDIA and that the SEC failed to submit evidence that either Newman or Chiasson was aware of the source of the inside information.  In fact, the Second Circuit notes that “the [SEC] has not cited, nor have we found, a single case in which tippees as remote as Newman and Chiasson have been held criminally liable for insider trading.”  The Second Circuit rejected the SEC’s argument that it was not required to prove that Newman and Chiasson knew that the insiders at Dell and NVIDIA received a personal benefit in order to be found guilty of insider trading.

The Second Circuit cited the U.S. Supreme Court case Dirks v. S.E.C., 463 U.S. 646 (1983) for articulating the general principle of tipping liability—that “insiders [are] forbidden by their fiduciary relationship from personally using undisclosed corporate information to their advantage, but they may not give such information to an outsider for the same improper purpose of exploiting the information for their personal gain.”  Further, the Second Circuit notes that the test for determining whether the corporate insider has breached his fiduciary duty is “whether the insider personally will benefit . . . from his disclosure.”  The Second Circuit states that Dirks sets forth the theory that without personal gain, the insider has not breached his fiduciary duty.

The Second Circuit went further to state that the “Supreme Court 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’ . . . Instead the [Supreme] Court held that ‘[t]he tippee’s duty to disclose or abstain is derivative from that of the insider’s duty.’”  The Second Circuit noted that the Supreme Court “held that a tippee may be found liable ‘only when the insider has breached his fiduciary duty. . . and the tippee knows or should know that there has been a breach.’”  Therefore, the Second Circuit reversed the district court’s conviction of Newman and Chiasson of insider trading because the district court failed to instruct the jury that the SEC “had to prove beyond a reasonable doubt that Newman and Chiasson knew that the tippers received a personal benefit for their disclosure.”

The Second Circuit expounded on the “clear” elements of establishing tippee liability in this seminal Newman decision.  First, the Second Court cites Chiarella v. United States, 445 U.S. 222 (1980) for establishing the principle that the “tippee’s liability derives only from the tipper’s breach of a fiduciary duty, not from trading on material, non-public information”  Second, the Second Circuit states that a “corporate insider has committed no breach of fiduciary duty unless he receives a personal benefit in exchange for the disclosure.”  Third, the Second Circuit states that “even in the presence of a tipper’s breach, a tippee is liable only if he knows or should have known of the breach.”  The Second Court states that “although [it has] not yet been presented with the question or whether the tippee’s knowledge of a tipper’s breach requires knowledge of the tipper’s personal benefit, the answer follows naturally from Dirks. . . without establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the [SEC] cannot meet its burden of showing that the tippee knew of a breach.”  The Second Circuit states that there is “no support for the [SEC]’s contention that knowledge of a breach of the duty of confidentiality without knowledge of the personal benefit is sufficient to impose criminal liability.”  The Second Circuit states that “nothing in the law requires a symmetry of information in the nation’s securities markets . . . and that the Supreme Court affirmatively established that insider trading liability is based on breaches of fiduciary duty, not on informational asymmetries.”

The Second Court held in the Newman decision that “to sustain an insider trading conviction against a tippee, the [SEC] 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 (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.”