The saga surrounding the interpretation of insider trading and tipping prohibitions in the United States continues, with the United States Department of Justice announcing its intention to appeal the decision of the U.S. Court of Appeals for the Second Circuit in Newman. That case has been seen by observers as curtailing the ability of prosecutors and regulators to successfully prove certain insider trading and tipping allegations. On July 30, the Justice Department asked the U.S. Supreme Court to examine the Second Circuit court’s ruling in the high-profile case, in which the Circuit court overturned the convictions of two hedge fund managers for insider trading. As we have discussed in earlier blog posts, the Newman decision has frustrated prosecutors’ efforts to secure convictions in difficult insider trading and tipping cases by imposing what the government has characterized as additional (and inappropriate) evidentiary burdens on the state, just as the law governing insider trading and tipping in Canada appears to be moving in the opposite direction. The government’s decision to appeal to the Supreme Court – and risk having the Second Circuit’s decision enshrined as the law of the land in the U.S. – underlines the significance of the Newman decision and its impact on the landscape of insider trading law.
In Newman, the Second Circuit overturned a New York District Court’s convictions of two portfolio managers who were convicted in 2012 of conspiring with six others to illegally trade technology stocks, making $70-million in the process. In overturning the convictions, the Second Circuit addressed the test to establish “tippee liability” based on the seminal decision of the U.S. Supreme Court in S.E.C. v. Dirks: for a tippee to be found liable of illegal conduct, a prosecutor must prove beyond a reasonable doubt, among other things, that the corporate insider who provided the tippee with the inside information breached his/her fiduciary duty to the organization. In this sense, tippee liability is derivative of tipper liability: the tippee can only be found to have broken the law if the tipper (i.e., the corporate insider providing the information) himself broke the law. The Newman Court confirmed the Dirks decision by noting that the insider can only be found to have broken the law by disclosing confidential information to a tippee in exchange for a personal benefit. In addition, in order for the tippee to have broken the law, the tippee must know the original tipper/insider divulged the information for a personal benefit.
One of the key evidentiary and legal questions arising from these cases is what constitutes a “personal benefit”. In Dirks, the Supreme Court held that it would typically include, for example, “a pecuniary gain or a reputational benefit that will translate into future earnings.” However, the Supreme Court stated that “[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.”
Crucially, the Second Circuit in Newman held that while a personal benefit could be inferred from a personal relationship between a corporate insider and a tippee, the inference must be supported by evidence 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.” In other words, “a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the [latter].” Following Newman, proof of a quid pro quo is now a central requirement in tipping cases. It makes successful convictions in these cases much harder to obtain, since the “mere fact of a friendship, particularly of a casual or social nature” is insufficient to show a benefit to the tipper.
The Newman decision has been seen as a major blow to prosecutors and appears to reflect a sea change in the state of insider trading and tipping law in the U.S.. In its petition to the Supreme Court, the government has argued that the Newman decision “unjustifiably impedes the government’s ability to restrain and punish” tippers and tippees, and that the decision will “hurt market participants, disadvantage scrupulous market analysts and impair the government’s ability to protect the fairness and integrity of the securities markets.” Whether the Supreme Court agrees with the government or allows the Newman decision to stand remains to be seen.
In the meantime, Judge Rakoff referred to the Newman decision in his recent opinion for the Ninth Circuit in the Salman case, which dealt with tipping between brothers. There, Judge Rakoff held that, in his view, the Newman decision cannot be interpreted as going as far as holding that the tipper must have received some sort of “tangible benefit”, which the defendant in Salman argued. As Judge Rakoff held, in Salman, unlike in Newman, the government had presented “direct evidence that the disclosure was intended as a gift of market-sensitive information”.
The U.S. Supreme Court will need to consider whether and how the decisions in Newman and Salman are compatible, and whether the issue requires clarification on the national stage. These developments will be closely followed in Canada, where insider trading and tipping jurisprudence is also rapidly changing in the wake of the OSC’s recent Finkelstein decision and the Alberta Court of Appeal’s decision in the Walton case, which we discussed in recent Osler publications.