The US Second Circuit this Wednesday narrowed the scope of “tippee” liability for insider trading, rejecting the “doctrinal novelty” of recent government prosecution theories. In United State v. Newman, Nos. 13-1837-cr c/w 13-1917-cr (2nd Cir. Dec. 10, 2014), the Court reversed the insider-trading and conspiracy convictions of two portfolio managers. They were downstream tippees, who traded on information passed along from corporate insiders to securities analysts and, ultimately, Newman and Chaisson. The Court of Appeals reversed, because the jury instructions had not required findings that both (1) the tippee knew an insider had material nonpublic information in breach of a duty and (2) had done so in exchange for a personal benefit. Moreover, the Court held the government had introduced insufficient proof of the tippers’ benefit and no evidence the tippees knew of any benefit to the tippers.

Insider trading is not directly prohibited by ’34 Act §10 or by SEC Rule 10b-5; instead, it is a variation of securities fraud the Act addresses. In “Classical” insider-trading, a corporate insider trades on material non-public information for his own benefit, thus breaching his duty to the company’s shareholders. In a “Misappropriation” case, a corporate outsider breaches obligations of confidence or loyalty under which he received the information when he misappropriates it to tip or trade (as when a financial printer or executive’s CPA takes it for his own trading). In its 1983 Dirks decision, the Supreme Court rejected any absolute bar to trading on insider information (and thus any “information asymmetry” basis), and reasoned instead: (1) A tippee’s liability is derivative of the tipper’s liability; (2) A tipper does not breach his duty by mere disclosure, unless he benefits from it; and (3) So, the tippee must know of the disclosure and the breach (the benefit).

The Newman Court set out the required elements to convict for a tippee for insider trading: (1) The corporate insider had a fiduciary duty; that he (2) Breached by (a) disclosing confidential material nonpublic information to a tippee (b) in exchange for a personal benefit; (3) The tippee know of the tipper’s breach, that is, both confidentiality of the information and disclosure for personal benefit; and (4) The tippee used the information to trade or tip another for personal benefit. Id. at 18. Finally, the benefit involved must be significant and more than mere friendship, especially where casual or merely social.

The case was closely watched among the securities defense bar. The decision serves to rein in ever-more expansive prosecutorial theories in insider-trading cases.