In a much publicized rebuke of the U.S. Attorney’s Office in Manhattan, the U.S Court of Appeals for the Second Circuit on December 10 reversed two high-profile insider trading convictions of persons who had traded on information obtained from securities analysts who were several steps removed from the original source of the corporate information. In issuing its decision in United States v. Todd Newman and Anthony Chiasson, Case No. 13-1837, the Court of Appeals reaffirmed important limitations on the scope of insider trading liability under the federal securities laws.
First, the Court affirmed that a recipient of non-public information – the “tippee” – may be found liable only if the initial source of the information – the insider who discloses the non-public corporate information in the first place (the “tipper”) – has breached a fiduciary duty to the company in disclosing its information. In other words, the tippee can be liable only if the original source of the information is himself liable for disclosing the information.
Second, the Court ruled that the Government must prove beyond a reasonable doubt that (i) the insider received an actual benefit for sharing the material non-public information (“MNPI”) and (ii) the ultimate tippee knew that the tipper had received that benefit.
Third, perhaps most striking to those led to believe that all trading on “confidential information” violates the insider trading laws, the Court explained that insider trading liability requires more than mere proof of trading on non-public information. Quoting the words used in another insider trading case some 20 years ago, the Court explained:
[T]he policy rationale [for prohibiting insider trading] stops well short of prohibiting all trading on material non-public information. Efficient capital markets depend on the protection of property rights in information. However, they also require that persons who acquire and act on information about companies be able to profit from the information they generate.
Background of the Case
Todd Newman and Anthony Chiasson were convicted in the Southern District of New York, on May 9, 2013, for conspiracy to commit insider trading and insider trading in Dell and NVIDIA securities. Newman and Chiasson – both hedge fund managers – were three and four steps removed, respectively, from the corporate insiders who allegedly had the fiduciary duty to maintain the confidentiality of the company information at issue. The defendants did not even know the insiders, much less the circumstances under which either insider allegedly had shared MNPI. The Government, however, argued that it need only prove that Newman and Chiasson were aware of the insiders’ breach of fiduciary duty and did not need to prove that they knew the tippers had received a personal benefit in exchange for sharing the inside information. The lower court agreed, charging the jury on this basis, and the jury convicted. Newman and Chiasson then appealed.
On December 10, 2014, the Second Circuit Court of Appeals reversed both convictions. The Court ruled that the evidence was insufficient to sustain the guilty verdicts because: (i) the evidence did not show that the alleged insiders had received a benefit sufficient to establish their own liability; and (ii) even if this evidence had been sufficient, the Government had no evidence that Newman and Chiasson knew the tippers had received a benefit from disclosing the information in question.
What Qualifies as a Benefit?
Prior to the Second Circuit’s opinion, the parameters of what qualifies as a “personal benefit” sufficient for insider trading purposes had not been clearly defined. The Court made an effort to clarify this issue.
The Second Circuit acknowledged that “personal benefit” may include not only monetary gain, but also any reputational benefit that will translate into future remuneration. But the Court made clear that the mere fact of a friendship, particularly of a casual or social nature, is not enough.
In Newman’s case, the Government argued that the friendship between the original tipper and an intermediate tippee (not Newman, but another analyst in the chain who had passed the information along) cleared the hurdle of establishing a personal benefit, because they had known each other for years, attended the same business school and worked together. The tipper also sought career advice and assistance from this intermediate tippee, and this tippee had advised the tipper on a range of topics, from how to pass the qualifying examination to become a financial analyst to editing the tipper’s resume. In Chiasson’s case, the Government pointed to the tipper and an intermediate tippee being family friends who occasionally socialized together.
The Second Circuit found the evidence in both cases insufficient to prove any personal benefit. The Court stated, “If this was a ‘benefit,’ practically anything would qualify.” Instead, the Court required:
[P]roof of 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…this requires evidence of ‘a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the [latter].'
Practical Implications of the Second Circuit’s Decision
The Second Circuit’s effort to limit the reach of the nation’s insider trading laws will impact prosecutors, defense lawyers, and, most important, the financial community. Insider trading liability has been expanded by the courts over the last two decades, with prosecutors exercising ostensibly limitless discretion in the targets they prosecuted. The Second Circuit has now reminded prosecutors – and the U.S. Attorney in Manhattan, Preet Bharara, in particular – that not all sharing of information is criminal, and that trading on confidential information is not necessarily illegal insider trading.
The Government also will likely focus more on the original source of the non-public information – i.e., the initial tipper. (Over the last few years, the Government has chosen to prosecute high-profile remote tippees without ever criminally pursuing the original source.) The closer the trader is to the original source of the non-public information, the greater the chance that the Government may be able to prove with sufficient evidence that the trader knew both that the source breached a fiduciary duty in disclosing the information and also received the requisite personal benefit in doing so. The more steps in the chain between the original corporate insider and the ultimate trader – i.e., the greater the number of intermediate tippees – the harder it will be for the Government now to bring a successful insider trading prosecution.
In the near term, the business community should expect prosecutors and other government enforcement lawyers to pause before bringing the next high-profile insider trading case. Because the Court of Appeals has now sharply focused prosecutors on the original source of the corporate information and whether that tipper – as opposed to the remote tippee – is himself liable for insider trading, it is likely that the Government will be much more selective in bringing criminal insider trading suits – at least within the Second Circuit – than it has been in the recent past.
This decision thus represents some good news for the financial industry, especially hedge funds, arbitrage funds, and other financial entities, that may come into possession of information about public companies where it is difficult to determine if the information is non-public and where the ultimate source is unknown and may be several steps removed from the trader himself. Still, the financial industry should remain extremely cautious in regard to trading on any potentially non-public information. This is one decision from one court in a criminal case, where the standards of proof for the Government are much higher than in a civil insider trading action: the Securities and Exchange Commission may seek to push the limits of this ruling in future civil enforcement actions. And even if only civil in nature, government investigations into insider trading can be costly, distracting to business operations, and damaging to a firm’s reputation.