On April 3, 2015, the United States Court of Appeals for the Second Circuit denied the government’s request for rehearing of U.S. v. Newman, in which that Court explicitly raised the bar for proving insider trading by tippees. U.S. Attorney Preet Bharara had requested either an en banc rehearing or a rehearing before the original panel of judges who heard and decided the case last year.

The Appeal

In May 2014, hedge fund portfolio managers Newman and Chiasson were convicted by a jury on charges of insider trading and conspiracy to commit insider trading. The indictment involved defendants’ alleged trading based on third- and fourth-hand information relating to unreleased earnings numbers for two publicly traded companies. At trial in the United States District Court for the Southern District of New York, the government argued that Newman and Chiasson could be liable for insider trading because, as sophisticated traders, they must have known that the information provided to them had been disclosed by insiders in a breach of the fiduciary duties owed to the company shareholders by those insiders.

In December, 2014, the Second Circuit reversed appellants’ convictions. The panel stated that “to sustain a conviction for insider trading, the Government must prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.” The Court remanded the case with instructions to dismiss the indictments pertaining to Newman and Chiasson because the government had presented no evidence that these defendants were aware that they were trading on inside information obtained in violation of any insider’s duties. The court stated that even if the evidence produced by the government could support an inference regarding the source of  the inside information, it failed to support any inference regarding the source’s motive or any benefit the source may have received in exchange for the disclosure.

In its ruling in Newman, the Second Circuit chastised the government for “selectively parsing” dicta from the Court’s prior cases to “revive the absolute bar on tippee trading that the Supreme Court explicitly rejected in Dirks.” In Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court held that a tipper does not breach his fiduciary duty regarding insider trading unless he receives some personal benefit, direct or indirect, from his disclosure, and because a tippee’s duty to disclose or abstain from trading is based solely on the duty of the tipper, a tippee cannot be held liable for insider trading if the tipper did not receive such a benefit. Dirks further stated that the tippee cannot be held liable unless the tippee knew or should have known about the benefit received by the tipper. Following Dirks, the Second Circuit often avoided directly addressing the personal benefit requirement in its opinions. In Newman, the Second Circuit stated that notwithstanding any ambiguous treatment of the requirements of tippee liability in the past, the Supreme Court had been clear that the government cannot meet its burden against a tippee if it cannot show that the tippee knew of the personal benefit received by the insider tipper. As the government failed to make such a showing against Newman and Chiasson, the evidence did not support their convictions.

Petition for Rehearing

In its petition for rehearing filed in January 2015, the government argued three points: (1) the panel’s definition of the personal benefit required to establish tipper liability conflicted with Supreme Court precedent, as well as that of the Second Circuit and other circuits; (2) the government produced sufficient evidence at trial to demonstrate both a sufficient personal benefit to the tippers and knowledge of that benefit by Newman and Chiasson; and (3) as a matter of public policy the Second Circuit’s definition of personal benefits in this context “threatens the integrity of the securities market.”

In denying the petition for rehearing, albeit without explanation, the court left standing a panel decision that expressed particular concern that the broadening concept of personal benefits used by the government in insider trading cases effectively eviscerated the Dirks decision. It was unswayed by the government’s argument that a broader standard leaving prosecutors with more discretion would more effectively police securities trading

Going Forward

In the years since Dirks, the government has repeatedly tested the personal benefit requirement by arguing that nearly anything qualified as a personal benefit. In its decision in Newman, the Second Circuit clarified that while a personal benefit may not require an immediate pecuniary gain, the “mere fact” of a friendship or acquaintance is not sufficient to prove such a benefit “[absent] 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.” This analysis by the Second Circuit should reinforce the test set forth under Dirks requiring a demonstration of tangible benefit rather than reliance on more tangential benefits such as “making a gift of information to a friend,: as in SEC v. Obus, 693 F.3d 276, 291 (2d. Cir 2012) or “maintaining a useful networking contact,” as in United States v. Whitman, 904 F. Supp. 2d 363, 372 n.7 (S.D.N.Y. 2012).

In light of the Court’s rejection of its petition for rehearing, the U.S Attorney’s Office could petition the Supreme Court for certiorari, offering the Court an opportunity to blaze new trails for insider trading law and enforcement. In addition, the Securities and Exchange Commission and the Department of Justice could push Congress to adopt new laws defining insider trading. Three such bills have been introduced, all of which would broaden existing prohibitions on insider trading by discarding the personal benefit requirement and could cover any trading based on confidential information. In the meantime, it is clear that at least in the Second Circuit, the government will be required to meet a higher standard of evidence in insider trading cases involving tippee liability.