US Court of Appeals overturns insider trading convictions, raising the bar required for conviction

Dealing a significant blow to the US Government’s campaign against insider trading, the US Court of Appeals for the Second Circuit overturned the convictions of two hedge fund managers yesterday. In United States v. Newman, et al., Nos. 13-1837-cr (L), 13-1917-cr (con) (2d Cir. Dec. 10, 2014), the court reversed and ordered that the indictments be dismissed, because the Government failed to prove that the defendants had traded on confidential information that they specifically knew had been disclosed by corporate insiders in exchange for a personal benefit. The defendants in Newman, both of whom were hedge fund managers, were several layers removed from the insiders or “tippers” and had no knowledge of any personal benefit that the insiders may have received, a not uncommon occurrence in insider trading situations. The court's ruling demonstrates that there are limits on the prohibitions against insider trading and recognizes that the flow of even nonpublic, material information from public companies to analysts and traders can be unlawful.

Factual background and procedural history

In Newman, a jury found that two hedge fund managers (Todd Newman, of Diamondback Capital Management, LLC (“Diamondback”) and Anthony Chiasson, of Level Global Investors, LP (“Level Global”)) had unlawfully traded in the stock of Dell and NVIDIA based on inside information provided to them through a long chain of people.

In the Dell scheme, nonpublic earnings information made its way from a Dell employee to an analyst at Neuberger Berman, to an analyst at Diamondback, and then to Newman and a Level Global analyst, who relayed it to Chiasson. The NVIDIA scheme was similarly attenuated.

On December 10, 2014, the Second Circuit overturned the defendants’ convictions, finding that the Government had failed to prove a necessary element of the offense. Specifically, the Second Circuit held that the Government had failed to establish that the alleged tippees knew (or should have known) that the tippers had received a personal benefit in exchange for disclosing confidential information. 

When information should raise a red flag

In Newman, the court found that the relationship between the insiders and the tippees was more attenuated than in any prior case and noted that it was “largely uncontroverted that Chiasson and Newman, and even [the] analysts who” passed the information to them, “knew next to nothing about the insiders and nothing about what, if any, personal benefit had been provided to them.”

The court also rejected the Government’s argument that the information that the defendants received was “so overwhelmingly suspicious” in its accuracy, detail, and timing that it supported inferences that supported the conviction. Analysts testified at trial that they routinely create models to predict companies’ earnings based on publicly available metrics and solicit information from companies to “check assumptions in their models in advance of earnings announcements.” Thus, the court concluded, the precision of the information that the defendants obtained did not necessarily signify that the information had come from an inside source, much less that the source had received a personal benefit for having disclosed it. 

The Second Circuit acknowledged, however, that “information about a firm’s finances could certainly be sufficiently detailed and proprietary to permit the inference that the tippee knew that the information came from an inside source.” 

Clarification on what constitutes a “personal benefit”

The Second Circuit also clarified what type of personal benefit – beyond pure cash – could support a conviction for insider trading. In the case of the Dell trades, the Government argued that the tipper had passed along information in exchange for career advice. The Second Circuit stated that things like offering minor suggestions on a resume or advice before an interview “was little more than the encouragement one would generally expect of a fellow alumnus or casual acquaintance” and was not sufficient to support a criminal conviction for insider trading.

The court found the Government’s evidence of receipt of a personal benefit by the NVIDIA tipper “even more scant” and rejected the Government’s suggestion that a personal benefit could be inferred from the mere fact that the key individuals were “family friends” who had met at church and occasionally socialized. To justify such an inference, the court said, there must be “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.” The court concluded that under the Government’s interpretation “practically anything would qualify” as a personal benefit.

Impact of the decision

The court's ruling reinforces the notion that insider trading law has limits and further recognizes that some flow of information from companies to analysts and traders is lawful and expected. Financial institutions, analysts, hedge funds, and others that deal with securities should still remain vigilant. When information is so detailed that it may very likely have originated with an insider in breach of a duty, diligence should be conducted into the source and circumstances from which the information was obtained.