In a significant decision, the Second Circuit has reversed criminal convictions for insider trading and conspiracy to commit insider trading in an appeal following a six-week jury trial in a closely-watched prosecution brought by the United States Attorney’s Office for the Southern District of New York.

The court’s decision in United States v. Newman, ___ F.3d ___, Nos. 13-1837-cr (L) etc. (2d Cir. Dec. 10, 2014) makes clear that to establish illegal insider trading by a recipient of material nonpublic information (a “tippee”) from a corporate insider (the “tipper”), the government must prove that the tipper provided the information in exchange for a personal benefit and that the tippee knew this.

The decision is likely to have implications for the type of insider trading prosecutions that are brought in the future and how the litigants will prosecute and defend those cases. It also may affect civil securities fraud litigation based on insider trading allegations.

Background from the district court case

The defendants in Newman are two portfolio managers at different hedge funds. The government alleged that they had traded in securities based on information provided to a ring of analysts from certain employees of two public companies. The employees had disclosed information about the companies’ quarterly earnings before it was publicly released.i  The analysts shared this information among themselves and some passed it on to the portfolio managers at their respective firms, including the defendants. This meant, as the court explained, that the defendants were three or four steps removed from the insiders. The defendants traded in the stocks of the two companies, earning approximately $12 million between them. The insiders at the two companies who started the tipping chains have yet to be charged with any wrongdoing, either criminally or civilly.

After the close of the evidence at trial, the defendants made three requests. Each was based on the proposition that they could not be convicted unless the government proved that they knew the insider employees \ tippers disclosed confidential information for a personal benefit, a proposition defendants drew from the US Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1983). The defendants moved for a judgment of acquittal based on the insufficiency of evidence that the tippers had obtained any benefit. The defendants also moved for acquittal based on the insufficiency of evidence that they knew that the tippers had obtained any benefit. (At trial, the defendants had denied any such knowledge and had introduced evidence to the contrary.)  In the alternative, the defendants asked the court to instruct the jury that it must find that the defendants knew that the employees had disclosed confidential information for personal benefit in order to convict.

The district court acknowledged the strength of the defendants’ position but believed it was constrained by the absence of a personal benefit requirement in an earlier decision from the Second Circuit. The court therefore instructed the jury that in order to convict the defendants, it had to find the insiders had a fiduciary or other relationship of trust and confidence which they breached for their own benefit and that the defendants knew that the material nonpublic information had been disclosed by the insider in breach of a duty of trust and confidence. The court left out the requirement that the defendants must have known that the insider had disclosed information in exchange for a personal benefit.

After the jury voted to convict, the trial court denied the motions for judgment of acquittal.

Knowledge that a tipper received a personal benefit in exchange for disclosing confidential information is a prerequisite to tippee liability

On appeal, the Second Circuit started by explaining the foundational case law. Under the “classical” theory of insider trading, a corporate insider violates section 10(b) and SEC rule 10b-5 by trading in a corporation’s securities “on the basis of material, nonpublic information about the corporation.”  The relationship of trust and confidence between the insider and the shareholders of the corporation gives rise to a duty on the insider’s part to either disclose the nonpublic information before trading or abstain from trading. Under the “misappropriation” theory of insider trading, liability may exist for an “outsider” who is not a fiduciary of the corporation but nevertheless “possesses” material nonpublic information about the corporation “and another person uses that information to trade in breach of a duty owed to the owner.” 

The Supreme Court in Dirks held that liability may exist where an insider or misappropriator does not himself trade but instead discloses material information to an outsider (the tippee) who then trades “on the basis of the information before it is publicly disclosed.”  However, this “tipping” liability exists only if the tipper provided the information for a personal benefit, direct or indirect, from the disclosure. Absent some personal gain, “there has been no breach of fiduciary duty.”  Dirks also held that a tippee cannot be liable unless he or she also knew or should have known that the tipper had breached his fiduciary duty.

In Newman, the government argued that this language from Dirks, when combined with what the Second Circuit characterized as “selective parsing” from dicta in its post-Dirks decisions, meant that the prosecutors did not have to prove that the defendants knew that the insiders had disclosed information for their own personal benefit.

The Second Circuit responded that this argument “seeks to revive the absolute bar on tippee trading that the Supreme Court explicitly rejected in Dirks,” when the Court had been “quite clear” in holding that a tippee’s liability derives only from the tipper’s breach of a fiduciary duty, not from the mere fact of trading on material nonpublic information.ii  In fact, Dirks held that a corporate insider does not breach his fiduciary duty unless he receives a personal benefit in exchange for the disclosure and that a tippee is liable only if he or she knew or should have known of the tipper’s breach. According to the Second Circuit, it “follows naturally from Dirks” that the tippee must know of the tipper’s personal benefit, because the receipt of a personal benefit is part and parcel of an insider’s breach of fiduciary duty for insider trading purposes. The disclosure by itself is not a breach, and hence a tippee’s knowledge of the disclosure alone cannot give rise to liability.

For these reasons, the Second Circuit held that the government must prove that the corporate insider had breached his fiduciary duty by disclosing confidential information to a tippee “in exchange for a personal benefit.”  The district court’s failure to instruct the jury on this element was not a mere harmless error, because the instructions could have led a jury to believe that the defendants could be criminally liable merely by knowing that the insider had divulged information that was required to be kept confidential.

A likely consequence of this portion of Newman is that fewer prosecutions will be brought where there were several intermediate tippers between the original source of the information and the tippee-defendant. This factor did not escape the Second Circuit. The government’s erroneous argument that knowledge of personal benefit is not required followed from the “doctrinal novelty” of recent insider trading prosecutions, “which are overwhelmingly targeted at remote tippees many levels removed from corporate insiders.”  The court noted that the government had not cited a single case in which tippees as remote as the defendants had been held criminally liable for insider trading. Rather, past cases had involved tippees who had directly participated in the tipper’s breach and provided the personal benefit or had been explicitly apprised of the tipper’s gain by an intermediary tippee.

There was no evidence that the defendants knew the tippees had provided confidential information in exchange for a personal benefit

The analysis of insider trading law did not end the appeal. The government argued that the failure to properly instruct the jury was harmless error because the jury could have found that the defendants had “inferred from the circumstances that some benefit was provided to (or anticipated by) the insiders.”  The Second Circuit rejected this argument and held that the evidence was insufficient to support a guilty verdict in this criminal case even after drawing every inference in favor of the government. Rather, this was a case in which the evidence was so meager or nonexistent that it would create a reasonable doubt on the part of a rational jury that the government had proven its case for two reasons.

First, there was insufficient evidence that the tippers had obtained any personal benefit from their tips. To be sure, “benefit” in this context is not limited to pecuniary gain but can include reputational benefits and the benefit one would expect from simply gifting confidential information to a trading relative or friend. However, while the government argued that the personal relationships between the insider \ tippers and the immediate persons to whom they had disclosed the information sufficed to prove that the tippers had received a benefit,iii the Second Circuit sharply disagreed:  “If this was a ‘benefit,’ practically anything would qualify.”  There must be a “meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of pecuniary or similarly valuable nature,” which was not evident here. The court concluded that it would not have been possible for a jury to find beyond a reasonable doubt that the tippers had received a personal benefit in exchange for confidential information.

Second, there was “absolutely no testimony or other evidence” that the defendants knew they were trading on information obtained from the insiders, that the insiders received any benefit in exchange for confidential information or even that the defendants “consciously avoided learning of these facts.”  Dirks explicitly rejected the premise that a tipper who discloses confidential information necessarily does so in order to receive a personal benefit. Here, the analysts who provided the information to the defendants testified that they had not stated that the information came from insiders in exchange for personal benefit. At most, the analysts testified, they had told the defendants that they were “talking to someone within [the company].”  It therefore was inconceivable that the defendants were aware of a personal benefit to the insiders when the analysts who had received the information disavowed any such knowledge. The court also rejected the government’s argument that the specificity, timing and frequency of the information provided by the analysts to the defendants was so “overwhelmingly suspicious” as to support a guilty verdict. The evidence established that analysts routinely conduct the type of analyses provided to the defendants and routinely ask for such information from public companies in order to conduct their research; and that the companies themselves routinely (and selectively) “leak” earnings data in advance of quarterly earnings through their investor relations personnel. Any inference that the defendants knew or should have known that the information originated from a corporate insider was unwarranted − and even if the situation were otherwise, that would not permit an inference of an improper motive for an insider’s disclosure.

A likely consequence of this portion of Newman is that the litigants in insider trading prosecutions will devote more effort to proving what the defendants knew or did not know about the circumstances by which information was provided. In addition, Newmanreminds issuers that selective disclosure of material nonpublic information can only lead to trouble and that they should be sure to have robust policies and procedures to address such matters. The two issuers whose stocks were traded by the defendants (and others) undoubtedly were not pleased to be involved in the case.

We expect that further decisions will discuss the extent to which Newman applies outside of the criminal context.