Earlier today, the Second Circuit Court of Appeals issued its most significant ruling in an insider trading case in more than a decade. That opinion is available here (PDF). The Second Circuit vacated the criminal convictions of two hedge fund managers who were “downstream” or “remote” “tippees” several steps removed from the original source or “tipper” of the inside information. The opinion is significant for two reasons.

First, it is likely to limit significantly the government’s ability to bring cases against downstream tippees in the future, and will likely result in the reversal of various convictions currently pending on appeal. Previously, the Supreme Court has required the government to prove that the insider or tipper had received some benefit in exchange for the tip; today, the Second Circuit extended that holding to require the government to prove that the downstream tippees were aware of and understood that benefit. Developing this kind of proof against defendants who are several steps removed from the original insider, and who may not even know that insider, will often be challenging for the government. In fact, in several recent insider trading trials, the government offered little or no such proof.

Second, while many commentators had expected the Second Circuit to impose this knowledge of the benefit requirement – and thereby to limit remote tippee cases – the opinion also contains a separate holding that will affect almost all insider trading cases. In that part of the opinion, the Second Circuit held that the underlying benefit received by the tipper must be much more substantial than previously thought. In short, prior to this opinion, if the government could show that the original tipper and tippee were friends or had some professional relationship, a benefit flowing between them could largely be presumed. Today the Second Circuit held that the government must show a true quid pro quo – that the tipper gave over the information in exchange for some concrete benefit beyond just friendship or the hope of developing a professional relationship. Because proof of a more substantial benefit is now required in virtually all insider trading cases – not just those involving remote tippees – this holding has the potential to affect all insider trading enforcement involving any tip at all.

One word of caution though – this fight may not be over. Given that the government’s loss in this case was so complete, and that the effects are potentially so far reaching, the government may seek further review of the decision, either before the Second Circuit en banc or before the U.S. Supreme Court.