In a widely anticipated decision, the Second Circuit on Wednesday clarified the standard for insider trading actions against tippees, downstream recipients of inside information who trade on that information. The court overturned the criminal convictions of two hedge fund portfolio managers who were convicted in 2013 as part of a massive sweep by New York federal prosecutors targeting insider trading on Wall Street and beyond. The court held that it is not enough for the government to prove that a tippee knew the corporate insider disclosed confidential information; it must also prove that the tippee knew the tipper did so in exchange for personal benefit. This decision calls into question the multiple insider trading convictions recently secured by the Manhattan U.S. attorney’s office, and may pave the way for other similarly situated defendants, including former SAC Capital Advisors LP manager Michael Steinberg, to seek an acquittal.
Todd Newman and Anthony Chiasson were both charged in 2012 with violations of sections 10(b) and 32 of the 1934 Act, Rule 10b-5, Rule 10b5-2, 18 U.S.C. § 2, and 18 U.S.C. § 371. Newman and Chiasson allegedly received the May and August 2008 earnings numbers of Dell and NVIDIA before public release, and subsequently executed trades capitalizing on this information to a profit of $4 million and $68 million respectively. At trial, the government presented evidence that the two received inside information from financial analysts who were themselves two and three levels removed from the actual corporate insiders at Dell and NVIDIA. The government presented no evidence that either defendant knew he was trading on information obtained from insiders in violation of those insiders’ fiduciary duties to shareholders. Instead, the government argued that as sophisticated traders, Newman and Chiasson must have known that the information was not disclosed for any legitimate corporate purpose. The traders were subsequently convicted of insider trading and sentenced to 54 months’ and 78 months’ imprisonment, respectively.
On appeal, the Second Circuit held that the government and the district court had applied the wrong standard for tippee liability. In doing so, the court relied on the U.S. Supreme Court’s 1983 ruling in Dirks, which held that tippee liability is derivative of the related tipper liability, and that a personal benefit to the tipper is therefore a required element of tippee liability as well. While Dirks did not specifically consider whether a tippee must have knowledge of the tipper’s personal benefit, it did define a tipper’s breach of fiduciary duty as a breach of the duty of confidentiality in exchange for a personal benefit. Because a tippee’s knowledge of a breach of a fiduciary duty is an element of tippee liability, it follows naturally that a tippee must know the tipper disclosed confidential information for personal benefit. As for what constitutes sufficient evidence of a “personal benefit,” the court noted that mere friendship between the tipper and tippee, such as what was presented at the trial of Newman and Chiasson, was not enough. Instead, proof is required of a “meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary of similarly valuable nature.”
In its appeal, the government relied on prior Second Circuit decisions that enumerated the elements of tippee liability without mentioning knowledge that the tipper disclosed the information for personal gain. The Second Circuit made short work of that argument, blaming any ambiguity in the law not on its prior decisions but on the “doctrinal novelty” of the government’s recent insider trading prosecutions, “which are increasingly targeted at remote tippees many levels removed from corporate insiders.” The court also noted that while it had been accused of being “somewhat Delphic” with respect to the elements of tippee liability, Judge Sullivan’s opinion in fact was the only district court opinion to hold that tippee knowledge of the tipper’s benefit was not required.
The Second Circuit’s opinion highlights the reality that the wrongfulness of insider trading lies not in the unequal access to market information, but in the knowingly wrongful use of that information. The court noted, “Although the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets.”