The Second Circuit has issued an important decision overturning two insider trading convictions and, in so doing, has clarified the standard for insider trading liability for tippees. The court’s holding—that the government must establish: (1) that the original tipper received a personal benefit in exchange for providing information; and (2) that the defendant-tippee knew of that personal benefit—provides both guidance and meaningful limitations on future prosecutions. Noting that the defendants were three or four steps removed from the corporate insiders who originally provided the information, the court stated that it had not found “a single case in which tippees as remote as [defendants] have been held criminally liable for insider trading.”

Lower Court Proceedings

In early 2012, a grand jury returned indictments against Todd Newman, a portfolio manager at Diamondback Capital Management LLC (Diamondback) and Anthony Chiasson, a portfolio manager at Level Global Investors LP (Level Global), for securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and conspiracy to commit securities fraud.

The case went to a jury trial in 2012. During the trial, the government presented evidence that insiders at Dell and NVIDIA disclosed company earnings numbers to a group of financial analysts prior to their public announcement. With respect to the Dell tipping chain, a member of the investor relations department provided information to an analyst at Neuberger Berman, who in turn provided that information to an analyst at Diamondback. The Diamondback analyst then provided the information to Newman and another analyst at Level Global. The Level Global analyst provided the information to Chiasson. With respect to the NVIDIA tipping chain, a member of NVIDIA’s finance unit provided information to a friend, who passed it on to an analyst at Whittier Trust. The Whittier analyst then provided that information to analysts at Diamondback and Level Global who told Newman and Chiasson. Thus, in both instances, Newman and Chiasson were at least three and four steps removed, respectively, from the corporate insider.

In an effort to establish the benefit flowing to the corporate insiders in exchange for tipping, the government presented evidence concerning the relationships between the corporate insiders and the first-level tippees. In connection with the Dell tips, the government attempted to show that the corporate insider and the Neuberger Berman analyst had known each other for years and that the insider sought and obtained career advice from the analyst—some of which was provided prior to any tip. In connection with the NVIDIA tips, the government attempted to show that the corporate insider was a family friend of the first-level tippee.

Newman and Chiasson moved for a judgment of acquittal, arguing that the government did not present sufficient evidence that the corporate insiders provided information in exchange for a personal benefit; and, in any event, there was no evidence Newman and Chiasson knew about that benefit. In the alternative, Newman and Chiasson sought a jury instruction requiring such knowledge to support a guilty verdict. Citing the Second Circuit’s recent decision in SEC v. Obus [see our previous Alert], which did not specifically identify knowledge of an insider’s personal benefit as a prerequisite to tippee liability, the lower court denied defendants’ motion, and the jury returned a guilty verdict.

The Second Circuit Decision

On December 10, 2014, the Second Circuit vacated Newman and Chiasson’s convictions. The main issues on appeal were: (1) whether the corporate insiders who originally provided the inside information derived a personal benefit from providing that information (and thereby breached their duty); and (2) whether, assuming a personal benefit to the original tippers, the government introduced sufficient evidence that Newman and Chiasson knew of that personal benefit. The Second Circuit decided both issues in defendants’ favor.

The court noted that, despite allegedly furnishing inside information in breach of a fiduciary duty and for personal gain, the corporate insiders were never charged administratively, civilly or criminally for any wrongdoing. Citing Dirks v. SEC, the Second Circuit observed that a tippee has no duty to refrain from trading simply because he received information from an insider. Rather, the tippee violates the law only when the tipper has himself breached his duty and the tippee knows, or should know, of that breach. Regarding the personal benefit, the Court held that in order to find a tippee liable for insider trading, the government must show the tippee knew of the personal benefit received by the insider, reasoning, “the exchange of confidential information for personal benefit is not separate from the insider’s fiduciary breach; it is the fiduciary breach that triggers liability for securities fraud under Rule 10b-5.”

Thus, in order for a tippee to be liable for insider trading, the government must prove beyond a reasonable doubt that: (1) the insider had a fiduciary duty; (2) the insider breached the duty by disclosing the information in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach (both that the information was confidential and that it was disclosed for personal benefit); and (4) the tippee used the information to trade or tip someone else for personal benefit.

Applying this standard to the facts, the Second Circuit had little difficulty reversing Newman and Chiasson’s convictions. First, the court determined that mere friendship between a tipper and a tippee does not confer a personal benefit on the tipper in exchange for providing inside information. Rather, the benefit must have been “objective, consequential, and represent[] at least a potential gain of a pecuniary or similarly valuable nature.”

Second, the court found no evidence that Newman or Chiasson knew who the insiders were or that the insiders received any benefit in exchange for providing the inside information.

Finally, the court rejected the government’s argument that the “specificity, timing and frequency” of the information provided to the defendants was sufficiently suspicious to warrant an inference that the information originated from corporate insiders and that those insiders obtained a personal benefit in exchange for disclosing the information. The court noted the contrary evidence that corporate investor relations departments routinely provide data to hedge fund analysts for use in their financial models.

Key Takeaways

The Second Circuit’s decision is an important milestone for insider trading downstream tippee prosecutions. Going forward, it will be much more difficult for the government to prevail— particularly in cases where the tippee/trader is several steps removed from the original tipper— because the government will have to demonstrate that the tippee knew that the corporate insider that originally furnished the information did so in exchange for a personal benefit. Moreover, while a pecuniary benefit is not required, the benefit “must be of some consequence” and cannot be something as ephemeral as friendship or a mere reputational enhancement without at least the potential for future pecuniary gain.

Importantly, the court rejected the notion—often relied upon by prosecutors and regulators— that the information was sufficiently detailed and specific that it could have only been furnished in breach of a fiduciary duty. Future prosecutions will have difficulty relying solely on the quality of the information (even where a sizeable trade is placed) to demonstrate that the tippee knew the information was conveyed illegally.