Introduction

The US Court of Appeals for the Second Circuit in United States v. Newman, 13-1837 (2d Cir. Dec. 10, 2014), vacated the convictions of two former hedge fund managers, Todd Newman and Anthony Chiasson, on insider trading charges. The Second Circuit held that the trial court's jury instructions were erroneous because the judge did not instruct the jury that, in order to sustain a conviction for insider trading, the government must prove beyond a reasonable doubt that a tippee who trades on inside information knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.

Furthermore, the court found that the evidence at trial was insufficient to support the convictions for two reasons. First, there was insufficient evidence that the alleged insiders received a personal benefit. Second, there was no evidence that the defendants knew they were trading on information disclosed by insiders in violation of their fiduciary duties.

The Court's ruling is an important setback to the government's insider trader program. This decision will make it difficult for the authorities to charge "downstream tippees" – traders who do not have a direct connection with the alleged insider who discloses material non-public information. The Court also significantly narrowed the definition of what can constitute the requisite "benefit" that the insider must have received. It will therefore limit the range of defendants who can be charged with insider trading violations. 

Background 

Todd Newman, a portfolio manager at Diamondback Capital Management, LLC ("Diamondback"), and Anthony Chiasson, a portfolio manager at Level Global Investors L.P. ("Level Global"), were charged with insider trading as part of the Department of Justice's ongoing investigation into suspected insider trading activity at hedge funds.  At trial, the Government presented evidence that, in 2008, a group of financial analysts exchanged information they obtained from company insiders at Dell and NVIDIA disclosing those companies' earnings numbers before they were publicly released. Analysts at Diamondback and Level Global passed the inside information to Newman and Chiasson, who, in turn, executed trades in Dell and NVIDIA stock, earning millions of dollars in profits for their respective funds.

The Court emphasized that both Newman and Chiasson were several steps removed from the corporate insiders and that there was no evidence that either was aware of the source of the inside information.  In fact, the evidence showed that Newman and Chiasson were three and four steps removed, respectively,  from the Dell insider who tipped the information about Dell's earnings.  Similarly, Newman and Chiasson were four steps removed from the NVIDIA insider. 

The requisite benefit that a corporate insider must receive in exchange for disclosing confidential information and the standard of knowledge for tipper liability were central issues at trial.  The defendants argued that there was no evidence that the corporate insiders provided inside information in exchange for a personal benefit which is required to establish tipper liability under The US Supreme Court's decision in Dirks v. SEC, 463 U.S. 646 (1983).  Because a tippee's liability derives from the liability of the tipper, Newman and Chiasson argued that they could not be found guilty of insider trading.  In addition, Newman and Chiasson also argued that, even if the corporate insiders had received a personal benefit in exchange for the inside information, there was no evidence that they knew about any such benefit. Absent such knowledge, the defendants contended that they could not have been participants in the tippers' fraudulent breaches of fiduciary duties to Dell or NVIDIA, and could not be convicted of insider trading under Dirks. In the alternative, Newman and Chiasson requested that the trial court instruct the jury that it must find that Newman and Chiasson knew that the corporate insiders had disclosed confidential information for personal benefit in order to find them guilty.

The district court declined to give the proposed jury instruction and on December 17, 2012, the jury returned a verdict of guilty on all counts. Newman was sentenced to an aggregate term of 54 months' imprisonment, to be followed by one year of supervised release, and was ordered to pay a $1 million fine and a $500 mandatory special assessment, and was ordered to forfeit $737,724.  Chiasson was sentenced to an aggregate term of 78 months' imprisonment, to be followed by one year of supervised release, and was ordered to pay a $5 million fine and a $600 mandatory special assessment, and was ordered to forfeit approximately $1.3 million. 

Discussion 

On appeal, the defendants argued that the trial court erred in its instructions to the jury because it did not require the jury to find that the government had proven beyond a reasonable doubt that Newman and Chiasson knew that the insiders at Dell and NVIDIA received a personal benefit in exchange for disclosing insider information.

The Second Circuit canvassed the law on tippee liability, which is where a person who has a duty to keep material non-public information confidential does not himself trade, but rather discloses the information to an outsider (a "tippee") who then trades on the information before it is disclosed. The Court held that "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 (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 therefore agreed with the defendants that the jury should have been instructed that the government was required to prove that the defendants knew about the benefit. The trial court's failure to instruct the jury properly was grounds for reversal.

Moreover, the Second Circuit held that the evidence was insufficient to sustain a guilty verdict against Newman and Chiasson for two reasons. First, the Court found that the evidence of any personal benefit received by the alleged insiders was insufficient to establish the tipper liability from which defendants' purported tippee liability would derive. The evidence showed that the original insiders provided the tips to friends from church and from business school. The evidence established only that the relationship between the tippers and the original tippees was casual and social. The court explained that a personal benefit may be inferred from a personal relationship between the tipper and tippee only where there is "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," and concluded that "[t]he circumstantial evidence in this case was simply too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips."

Second, even assuming that the evidence on the issue of personal benefit was sufficient, the court found that there was no evidence that Newman and Chiasson knew that they were trading on information obtained from insiders in violation of those insiders' fiduciary duties. Indeed, the court observed that the parties did not dispute that that Chiasson and Newman, and even their analysts, who testified as cooperating witnesses for the Government, knew "next to nothing about the insiders and nothing about what, if any, personal benefit had been provided to them." The Court further noted that there was evidence about the hedge fund industry demonstrating that it was routine for analysts to estimate corporate performance metrics such as revenue, gross margin, operating margin, and earnings per share through a variety of legitimate methods. For example, analysts typically prepare financial models based upon publicly available information and educated assumptions about industry and company trends. Moreover, there was evidence that analysts regularly solicit information from companies in order to check their models and that companies themselves routinely "leak" earnings data before earnings announcements before earnings announcements. Thus, the court concluded that,

In light of the testimony (much of which was adduced from the Government's own witnesses) about the accuracy of the analysts' estimates and the selective disclosures by the companies themselves, no rational jury would find that the tips were so overwhelmingly suspicious that Newman and Chiasson either knew or consciously avoided knowing that the information came from corporate insiders or that those insiders received any personal benefit in exchange for the disclosure.

The court reversed the verdicts and directed that the charges against the defendants be dismissed. 

The decision's impact on the government's insider trading cases 

This defense-friendly ruling is a significant setback to the Department of Justice and the US Securities and Exchange Commission in their prosecutions of insider trading. The ruling was foreshadowed by the court's hostility to the government's position at the oral argument in April, so the decision is not surprising. Here are the key takeaways.

First, the decision will make it more difficult to prosecute insider trading cases because it raises the standard for what the government must show in order to establish a "benefit" to a corporate insider who discloses inside information in violation of a duty of confidence. In the past, the government had sometimes relied on subtle forms of benefit, such as friendship, reputational enhancements or (as here) career advice from the tippee to the tipper in order to demonstrate that the tipper had received a benefit. After this decision, it is clear that there must be "an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature." As a practical matter, the decision means that the government will have to develop evidence of a financial relationship between the tipper and the tippee, rather than a purely social relationship. This will be easy in a case where the tipper and the tippee are engaged in a scheme to jointly profit from the trades on the inside information. It will be far more difficult in cases where information is shared for a variety of reasons, many of which do not result in any tangible financial benefit to the person sharing the information.

Second, the decision will make it difficult to prosecute a downstream tippee (like a trader at a hedge fund) who does not have direct contact with the tipper or an agreement with an intermediary who deals directly with the tipper. Cases like United States v. Whitman, 555 F. App'x 98 (2d Cir. 2014), where the defendant trader knew that his intermediary was providing a benefit to the tippers will remain viable. Cases such as the one against Newman and Chiasson, where the defendant was a trader several steps removed from the tipper, may not be.