As we predicted back in April, the Second Circuit Court of Appeals has dealt a significant blow to the Government’s ongoing efforts to successfully prosecute insider trading cases involving “downstream traders” or “tippees.” (United States v. Newman, 2d Cir., No. 13-1837, 12/10/14). In the ruling, the Panel court not only overturned the guilty verdicts of two hedge fund managers who traded on inside information received from other Wall Street analysts, it also took a shot at U.S. Attorney Preet Bharara’s aggressive enforcement of remote tippees, criticizing the “doctrinal novelty of (the Government’s) recent insider trading prosecutions….” This does not bode well for future prosecutions of downstream traders and will also limit civil enforcement activity against those traders who are two or three levels removed from the original insider source and imperils several high profile convictions and numerous guilty pleas.

In this case the defendant hedge fund managers “were several steps removed from the corporate insiders.” The Court also noted that the Government had failed to adduce evidence that either was aware of the source of the inside information or the circumstances under which it was conveyed. Despite this, the Government charged that the managers were criminally liable for insider trading because, as sophisticated traders, they must have known that information was disclosed by insiders in breach of a fiduciary duty, and not for any legitimate corporate purpose.

The Second Circuit disagreed. “In order 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.” (Emphasis in the original). Relying upon the Supreme Court’s decision in Dirks v. S.E.C., 463 U.S. 646 (1983), the Court explained “[t]he tippee’s duty to disclose or abstain is derivative from that of the insider’s duty.” Because the tipper’s breach of fiduciary duty requires that he “personally will benefit, directly or indirectly, from his disclosure a tippee may not be held liable in the absence of such benefit.” The jury instruction was therefore faulty because it permitted the jury to convict solely on a showing that the defendants knew that there had been a breach of fiduciary duty.

Having determined that the instruction was erroneous, the Court then turned to the evidence of personal benefit which it also found wanting.  It described the Government’s proof of personal benefit as “career advice” or the “ephemeral benefit… that one would expect to be derived from be derived from favors or friendship.” To accept such proof as sufficient would render the personal benefit requirement a nullity. Instead to maintain a conviction, the evidence of benefit must be “of some consequence” resembling “a relationship between the insider and the recipient that suggests a quid pro quo” or an intention to confer a future benefit. Finally and perhaps more significantly, even if the evidence of benefit were sufficient, the Government’s failure to prove the defendants’ knowledge of such benefit was fatal to the prosecution.

There is already debate as to the impact of this decision on efforts to regulate Wall Street professionals, with prosecutors downplaying it significance as limited to a “subset” of cases. This may be so but many of the Government’s highest profile cases have been built upon the cooperation of lower level “downstream” traders who will now be more embolden to resist the government’s efforts to secure that cooperation.