On December 10 2014, in United States v Newman, the US Court of Appeals for the Second Circuit clarified the elements required to establish insider trading in tipper/tippee cases. It held that:
"in order to sustain a conviction for insider trading, the government must prove beyond a reasonable doubt that the tippee knew that the insider disclosed confidential information and that he did so in exchange for a personal benefit."(1)
The court also rejected the long-held government position that the personal benefit to the tipper can be inferred from mere friendship between the tipper and tippee. Instead, the court held that this inference is impermissible without "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".(2) Newman will likely make it significantly more difficult for the government to win insider trading convictions based on a tipper/tippee theory of liability.
Modern insider trading law is rooted in the Securities Exchange Act of 1934. Sections 10(b) and 10b-5 of the act make it:
"unlawful for any person, directly or indirectly [to] use or employ, in connection with the purchase or sale of any security registered on a national securities exchange... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate."(3)
Under this framework, the classic theory of insider trading prohibits corporate insiders, such as directors and officers, from trading in a corporation's securities on the basis of "material, non-public information" about the corporation.(4) Insider trading law expanded to include the misappropriation theory of liability, which makes it illegal for certain corporate 'outsiders' who have no independent fiduciary duty to a corporation, but have access to material non-public information, to trade in that corporation's securities.(5)
Liability for insider trading is not limited to persons trading for their own benefit. A person may also be subject to liability when an insider or misappropriator in possession of material, non-public information (the 'tipper') discloses the information to an outsider (the 'tippee'), who then trades on the basis of the non-public information. However, under these circumstances a tipper is liable for insider trading only if he or she receives a benefit for disclosing the information. For instance, in Dirks v Securities and Exchange Commission(6) the insider divulged the confidential information to a tippee in order to expose corporate fraud. The Supreme Court found that because Dirks did not personally benefit from disclosing the non-public information to the tippee, he was not guilty of insider trading. Moreover, the court held that in order for liability to extend to a tippee:
"the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach [by a tippee]."(7)
In Newman the Second Circuit clarified the proof required for insider trading in a tipper/tippee case by holding that:
"in order to sustain a conviction for insider trading, the government must prove beyond a reasonable doubt that the tippee knew that the insider disclosed confidential information and that he did so in exchange for a personal benefit."(8)
The Second Circuit overturned the defendants' convictions, finding that the government did not present sufficient evidence that the defendants had wilfully engaged in substantive insider trading or conspiracy to commit insider trading in violation of the federal securities laws.
This case involved former Level Global Investors LP manager Anthony Chiasson and former Diamondback Capital Management LLC manager Todd Newman who, following a six-week jury trial, were found guilty of conspiracy to commit insider trading and insider trading in violation of federal securities laws.(9)
The government alleged that Chiasson and Newman had illegally traded stock in Dell, Inc and NVIDIA Corp based on tips that originated with technology insiders at each of these companies. The sources of the non-public information in this case were several steps removed from both Chiasson and Newman. In the NVIDIA tipping chain, for instance, the evidence indicated that an employee of NVIDIA's finance unit tipped information to a person he knew from church, who was also a former executive at two major corporations. The government claimed that this former executive then passed the information to an analyst at Whittier Trust. The Whittier Trust analyst allegedly circulated this information to several of his analyst friends, who then gave the information to Chiasson and Newman. As such, both Chiasson and Newman were four levels removed from the inside tipper. The Second Circuit noted in its decision that there was no evidence that either of the defendants were aware of the source of the inside information. Nevertheless, Chiasson and Newman were convicted at trial and the district court sentenced them to six-and-a-half and four-and-a-half years' imprisonment, respectively.
On appeal, the government argued that criminal liability can be imposed by proving only a tippee's knowledge of the breach of the duty of confidentiality, without knowledge of any personal benefit. The defendants argued that the Supreme Court's holding in Dirks dictates that trading on material, non-public inside information is illegal only if the insider engaged in self-dealing by disclosing the inside information for a personal benefit. The Second Circuit agreed with the defendants, holding that in order to sustain a conviction for insider trading liability, the government must prove each of the following elements beyond a reasonable doubt:
- The corporate insider was entrusted with a fiduciary duty;
- The corporate insider breached this fiduciary duty by:
- by disclosing confidential information to a tippee; and
- in exchange for a personal benefit;
- The tippee knew of the tipper's breach, in that he or she knew that the information was confidential and divulged for a personal benefit; and
- The tippee still used the information to trade in a security or tip another individual for personal benefit.
Newman's heightened standard mandates that in order to sustain an insider trading conviction on the tipper/tippee theory of liability, the government must establish beyond a reasonable doubt that a tippee knew of the personal benefit received by the insider in exchange for the disclosure. In other words, a tippee must have actual knowledge not only of the tipper's breach of the duty of confidentiality, but also of the personal benefit received by the tipper in exchange for disclosure. The Second Circuit flatly rejected the government's contention that the 'personal benefit' requirement could be met by showing that a tippee gave career advice, passed along a person's résumé, attended the same social gatherings or attended the same educational institutions as the tipper. The court noted that if these types of association and small favour constituted 'personal benefits', that requirement would essentially be rendered a nullity. Moreover, the court clarified that a personal benefit cannot be inferred from a personal relationship between the tipper and tippee:
"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."(10)
The Second Circuit's decision has important implications for the future of insider trading law. The Second Circuit has now adopted a stricter standard for proving tipper/tippee liability. In overturning the convictions of individuals three or four levels removed from the insider tipper, the court essentially narrowed the group of people that can be effectively prosecuted for insider trading on the tipper/tippee theory of liability. In the wake of this decision, the government will have a much more difficult time prosecuting remote tippees and will be required to obtain more evidence to secure these convictions. This landmark decision signifies a welcome clarification in insider trading law.
Richard Rosenfeld , Joseph De Simone, Matthew Rossi, William Michael Jr.
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