The Justice Department has been bullish over its rigorous enforcement of insider training over the past year, but on Tuesday a Second Circuit panel raised questions regarding the government’s theory of liability that led to the conviction of two “downstream” traders. Before the court was the issue of whether tippees – recipients of inside information – can be convicted if they did not know that the tipper received any personal benefit for disclosure of inside information. The case may implicate how far downstream from the insider prosecutors can go in prosecuting “remote tippees” for insider trading.

In United States v. Newman, two hedge fund managers were convicted for participating in an insider trading scheme. The fund managers received detailed inside information from a source, but did not know the identity of the original insider. Though not quite the level of six degrees of Kevin Bacon, the defendants contended that they were four degrees away from the original tipper and had no information regarding whether the tipper received any personal benefit. At trial, the judge instructed the jury that the defendants must have known that the material, nonpublic information upon which the defendants traded was disclosed by the insider in violation of a duty of confidentiality. The jury convicted both defendants under that standard.

At oral argument before the Second Circuit, both the defendants and the government sparred over the application of the Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1993), to downstream tippee liability. In Dirks, the Court held that an insider tipper does not violate the securities laws unless he has disclosed information in breach of a duty, which the Court defined as whether “the insider personally will benefit directly or indirectly from his disclosure.” Id. at 662. The Court also addressed tippee liability, holding that the tippee cannot be liable unless he “knowingly participates with the fiduciary in such a breach.” Id. at 659. In Newman, the defense asserted that Dirks thus requires that the tippee know that the tipper provided inside information for a personal benefit. The prosecution argued that it needed to prove only that the information was provided in violation of a duty of confidentiality.

According to reports, the Second Circuit panel pushed back at oral argument against the government’s theory of liability. Judge Barrington Parker observed:

We sit in the financial capital of the world and the amorphous theory you have gives precious little guidance to all these financial institutions and all these hedge funds out there about a bright-line theory as to what they can and cannot do.

Of course, attempting to determine how a court will rule based upon comments or questioning at oral argument (or better yet, based on “downstream” information from media reports) can be a fool’s errand (just as downstream inside information about a hot stock tip can be both factually wrong and legally perilous). But reports of the argument suggest a healthy skepticism of the government’s theory of liability. Ultimately, we must wait for the Second Circuit’s decision for guidance on what knowledge is necessary for a remote tippee’s liability and how the Second Circuit’s decision – assuming it provides clarity – affects the Department of Justice’s active insider trading prosecutions.