In what was described as a blow to the series of insider trading prosecutions in the Southern District of New York, the Second Circuit Court of Appeals yesterday reversed the insider trading convictions of Anthony Chiasson, a portfolio manager at Level Global Investors LP (Level Global), and Todd Newman, a portfolio manager at Diamondback Capital Management (Diamondback). That reversal flowed from the court’s holding that the government must prove that down-the-line tippees not only knew a tipper had violated a duty of confidentiality in disclosing the information but also knew the tipper had received a benefit “of consequence” for passing on the information.

The case, U.S. v. Newman, involved decidedly remote tippees. According to the government, the defendants had traded on inside information (specifically, earnings information obtained before the public announcement) relating to two stocks, Dell Inc. and NVIDIA Corporation. Each defendant was a portfolio manager at his respective company and each received the earnings information as follows: A company employee (the insider/tipper) passed the earnings information to a friend, who then passed the information to an analyst, and the analyst then shared the information with an analyst at the defendant’s company who in turn passed the information to the defendant, who then purchased the stock.

The Second Circuit’s decision turned on the extent to which the government was required to prove a tippee knew not only that information came from a tipper who breached his duty of confidentiality, but also knew the tipper divulged the information in exchange for a benefit. At trial, the defendants argued that a tippee’s criminal liability requires knowledge of both, but the trial court declined to include the latter element (the tippee’s knowledge of a benefit to the tipper), concluding that while the Supreme Court precedent established in Dirks v. SEC could allow for such a requirement, Second Circuit precedent foreclosed it. Thus, the trial court required that the government prove the defendants knew the information was disclosed by an insider in violation of his duty of confidentiality, but did not require a finding that the tippee knew that the tipper did so for a personal benefit.

The Second Circuit rested its decision squarely on the reasoning and holding in Dirks, emphasizing that a tippee’s liability is only a derivative byproduct of a tipper’s breach of a fiduciary duty, not simply the result of trading on material nonpublic information. And the nature of that underlying breach of fiduciary duty was clearly defined in Dirks: The disclosure of information and violation of trust alone does not establish a breach “absent [the tipper’s] receipt of a personal benefit; rather, a tippee is liable only if that underlying breach occurred and only if he knew or should have known of that breach.” Moreover, the tippee only knows of the breach if he knows of that critical element, i.e., that the tipper received a personal benefit. According to the Second Circuit, knowledge of a “breach of duty of confidentiality” is not enough. To sustain an insider trading conviction against a tippee, the government must demonstrate 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 for personal benefit.”

In response to the government’s contention that the trial court’s error was harmless, the court evaluated the evidence that the insiders/tippers received a personal benefit and the tippees knew of any such benefit. As to the Dell information, the government adduced at trial that the tipper knew the tippee from business school and prior employment with Dell, and the tippee had provided career advice to the insider, who wanted to become an analyst. The relationship of the tipper and tippee in the NVIDIA transaction was even more tenuous – they knew each other from church and “occasionally socialized together.” The Second Circuit concluded that, if the facts of the Dell and NVIDIA transactions were sufficient for the benefit element, “practically anything would qualify.”

Instead, the court held that an inference of personal benefit from the existence of a personal relationship between tipper and tippee “is impermissible in the absence of 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.” In other words, there must be evidence suggesting a quid pro quo from the recipient of the information. The Second Circuit found the evidence offered in the Newman case failed to establish either the conferral of a benefit to the tippers or the defendants’ knowledge “that the insiders received a personal benefit in exchange for disclosing confidential information.”

The Newman decision follows the government’s attempt to expand the critical concepts of knowledge and benefit to reach well beyond those who have actual knowledge of the circumstances of the breach to remote tippees who regularly receive the same kind of predictive and analytical information. Contrary to the abundant speculation about cases that have already been tried, it seems unlikely that the reasoning in Newman will be applied to upend any significant number of convictions. Instead, its effects will likely be seen more in cases brought in the future. The decision will unquestionably hinder the government’s determined effort to expand the scope of insider trading liability.