Second Circuit Rejects Government's Expansive Theory of Insider Trading

On December 10, 2014, the United States Court of Appeals for the Second Circuit reversed the convictions of two hedge fund portfolio managers accused of insider trading. In United States v. Newman,¹ the Second Circuit held that under the securities laws, in order to sustain a conviction against the recipient of insider information—a "tippee"—the government must prove beyond a reasonable doubt that the tippee actually or constructively knew that an insider disclosed confidential information and that the insider did so in exchange for a personal benefit. The Second Circuit further clarified that the "personal benefit" must be "objective" and "consequential" and represent "at least a potential gain of a pecuniary or similarly valuable nature." Concluding that the jury was incorrectly instructed on the law and that the prosecution failed to introduce sufficient evidence that insiders received a personal benefit or that the defendants knew that they received a personal benefit, the Second Circuit reversed the convictions. While the basic theory of insider trading laws remains intact following the Newman decision, the court expressed concerns about the broad scope of recent government prosecutions. The US Department of Justice has requested an additional month to decide whether to seek further review in the Second Circuit, but if the decision stands, it will make it more difficult for the government to prosecute certain types of insider trading cases.

Background and Trial Court Proceedings

The government has long prosecuted insider trading by traditional corporate insiders (e.g., corporate officers) who trade based on material, non-public information, or where an individual "misappropriates" information to trade in breach of a duty owed to the owner of that information.² The government has also prosecuted "tippers" and "tippees" where corporate insiders or others who misappropriate information ("tippers") do not themselves trade in the stock, but provide the information to an outsider (the "tippee") who trades based on that information.³

The Newman case arose from the US government's ongoing investigation into suspected insider trading activity at hedge funds. Defendants Todd Newman, a portfolio manager at Diamondback Capital Management, LLC, and Anthony Chiasson, a portfolio manager at Level Global Investors, L.P., were charged with securities fraud and conspiracy to commit securities fraud based on insider trading.

At trial, the evidence showed that employees at two technology firms disclosed material, non-public quarterly earnings information to investment analysts prior to its public release. These investment analysts shared the information with hedge fund analysts who, in turn, shared the information with portfolio managers, including Newman and Chiasson. Newman and Chiasson used the information to execute trades in the stock of the technology firms, earning substantial profits for their respective funds. Although Newman and Chiasson were three or four levels removed from the "tippers" who first disclosed the non-public information, the government prosecuted them on the theory that, as sophisticated traders, they must have known that information was disclosed by firm insiders in breach of their fiduciary duties, and not for any legitimate corporate purpose.

At the close of evidence, Newman and Chiasson moved for judgment of acquittal. They argued that there was no evidence that the company insiders disclosed inside information in exchange for a personal benefit or evidence that Newman and Chiasson were aware that the insiders had received a personal benefit, which they argued was required to establish liability under the Supreme Court's decision in Dirks v. SEC. As an alternative to acquittal, Newman and Chiasson requested that the district court instruct the jury that in order to find them guilty, the jury had to find that Newman and Chiasson knew that the corporate insiders had disclosed confidential information in exchange for a personal benefit.

The district court denied the motion for judgment of acquittal, and it declined to give Newman and Chiasson's requested jury instruction. Instead, the district court instructed the jury that the government had the burden of proving beyond a reasonable doubt that (a) each of the insiders intentionally breached the duty of trust and confidence they owed to their employer, and (b) each defendant knew that the material, non-public information had been disclosed by the insider in violation of a duty of confidentiality. The jury returned a verdict of guilty on all counts. The district court sentenced Newman and Chiasson to terms of 54 and 78 months imprisonment, respectively, and ordered each to pay a criminal fine, a forfeiture, and a mandatory special assessment. Newman and Chiasson appealed.

Second Circuit Decision

The Second Circuit reversed, relying primarily on its analysis of the Supreme Court's decision in Dirks v. SEC, and distinguishing a number of intervening decisions.  Specifically, the Second Circuit noted that in Dirks, the Supreme Court explained that there is no "general duty between all participants in market transactions to forgo actions based on material, non-public information," and that a "tippee's" liability can be based only on a "tipper's" breach of fiduciary duty to shareholders.⁴ The court noted that in Dirks, "the Supreme Court rejected the SEC's theory that a [tippee] must refrain from trading whenever he receives inside information from an insider."⁵ The Second Circuit also held that under Dirks, the corporate insider "tipper" does not breach a fiduciary duty "unless he receives a personal benefit in exchange for the disclosure" of material, non-public information, and the "tippee" is "liable only if he knows or should have known of the breach." The Second Circuit concluded that it "follows naturally" from Dirks that to be liable for insider trading, a "tippee" must know that the "tipper" disclosed information in exchange for a personal benefit.

In reaching this conclusion, the Second Circuit criticized the "doctrinal novelty of [the government's] recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders," which the court characterized as being premised on an "overreliance on our prior dicta."⁶ The court noted that the prior decisions cited by the government to support these prosecutions concerned situations where "tippees directly participated in the tipper's breach...or who were explicitly apprised of the tipper's gain."

The Second Circuit also concluded that the evidence was insufficient to show that the corporate insiders derived any personal benefit. The evidence showed that the "tippers" and first-level "tippees" had personal relationships in varying forms: as casual acquaintances (former colleagues and classmates) who provided career advice, family friends, or otherwise. The court rejected the government's argument that these facts were sufficient to prove that the "tippers" derived a "personal benefit," reasoning that while the standard for a "personal benefit is broadly defined... [i]f this was a 'benefit,' practically anything would qualify."⁷ The court concluded that under Dirks, a personal benefit cannot be inferred from a personal relationship between "tipper" and "tippee" absent "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."⁸ The court also concluded that the evidence was insufficient to show that Newman and Chiasson knew that the "tippers" received any such benefit.

Government Reaction

Both the US Department of Justice and the Chairman of the SEC reacted promptly to the issuance of the decision. In a statement, the US Attorney for the Southern District of New York, Preet Bharara, noted that the decision "interprets the securities laws in a way that will limit our ability to prosecute people who trade on leaked inside information."⁹ Speaking at a conference, SEC Chairman Mary Jo White said that the decision took an "overly narrow view of the insider trading law and that is a concern."¹⁰ Bharara also noted that the decision "affects only a subset of our recent cases" and that his office was "considering our options for further appellate review." To that end, on December 12, the Department of Justice requested (with the consent of the Defendants) an additional month (until January 23, 2015) to decide whether to seek a rehearing or an en banc hearing before the full Second Circuit.

While the government is currently evaluating further appellate review, if the Newman decision stands, the government has acknowledged that it will be more difficult to prosecute certain types of individuals accused of trading on inside information. It is not clear whether and by what means the government will continue its pursuit of remote "tippees" who are several levels removed from the source of inside information. While the decision clarifies the elements of insider trading in "tipper" and "tippee" cases, it also raises new questions for courts. For instance, in future cases, courts may have to ascertain when a corporate insider has received an intangible benefit. Similarly, courts may have to grapple with the circumstances in which a "tippee's" knowledge of a personal benefit can be inferred, and in particular where such knowledge can be inferred from the "tippee's" deliberate avoidance of the source of information. Given the significant resources the government has committed to prosecuting individuals suspected of insider trading, we can expect to see what strategies the government will deploy to address the issues and concerns raised by the Second Circuit in this important decision and how the courts will react in the near future.