In a December 2014 decision, United States v. Newman, the Second Circuit ruled that in order for someone to be guilty of insider trading by obtaining and trading on material non-public information (i.e. as a “tippee”), evidence must exist that the “tipper” (the insider) provided the information in exchange for personal benefit, and that the tippee knew the insider would gain personal benefit from it.
This case began with the government prosecution of a number of hedge fund portfolio managers (including at SAC Capital Advisors) who became privy to insider information shared amongst a group of analysts, and then traded on that information.
But what originally ended badly for a few of those involved, including the prosecution of and sentenced jail time for Todd Newman (formerly of Diamondback Capital Management) and Anthony Chiasson (co-founder of Level Global Investors), may have an unexpectedly happy ending for the defendants, thanks to a recent decision from the Second Circuit in the U.S. Courts of Appeals.
The defendants in Newman cited the U.S. Supreme Court’s decision in Dirks v. SEC to build their case. As a reminder, Dirks essentially states that a tippee is responsible for insider trading if he or she believes the tipper breached his or her fiduciary duty by disclosing material nonpublic information and gained personal benefit from it.
One twist in the Newman case was the degree of separation Newman and Chiasson had from the original tipper source. As emphasized in a client alert by law firm DLA Piper, the defendants were ultimately “three or four steps removed from the insiders” who had the information.
In Newman, the Second Circuit also decided there was not sufficient evidence to show that the defendants knew the tippers gained “personal benefit.” As the Second Circuit explained, under Dirks there is no violation of the insider trading laws if a tipper receives no personal benefit. And the tipper must have illegally tipped for there to be any liability for a tippee who trades on the information.
What Constitutes a “Personal Benefit”?
The concept of “personal benefit” is a nuanced one. The easy case, of course, is when a tipper exchanges material nonpublic information for cash or some other objectively valuable asset.
Another easy case is the one in which there is a quid pro quo, such as when a tipper gives a tippee material nonpublic information in exchange for a future benefit for the tipper, such as future business opportunities.
On the other end of the spectrum, the Newman court explicitly rejected the government’s efforts to characterize casual friendship or even career advice as a personal benefit, as the term is to be used in the context of tipper/tippee liability.
To count as a personal benefit in this context, the benefit must be consequential; for that reason, tipping in the context of a close personal relationship “where tippee trades resemble trading by the insider himself followed by a gift of the profits to the recipient” counts as a personal benefit.
(Note that for the tipping to be seen as a gift by the tipper, the tipper would have to know the tippee was trading.)
In Newman, the government failed to establish that there was a close personal relationship between any tipper and tippee, so the court rejected the government’s efforts to characterize the tips as a gift.
As law firm Gibson Dunn explains in its client alert on the topic:
In Newman, the Second Circuit held that the Government failed to present sufficient evidence that either corporate tipper received a “personal benefit” to trigger a breach of a fiduciary duty under Dirks. The Court explained that the Government must prove 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.” Though the tipper’s gain “need not be immediately pecuniary,” it must be “of some consequence.” The Court rejected the argument that the “mere fact of a friendship, particularly of a casual or social nature” is sufficient to show a benefit to the tipper, noting that “[i]f this was benefit, practically anything would qualify.”
No Inadvertent Tippee Liability
Moreover, there wasn’t evidence that defendants Newman and Caisson knew they were trading on information from the insiders, and as DLA Piper summarizes, “the analysts who provided the information to the defendants testified that they had not stated that the information came from insiders in exchange for personal benefit.”
As law firm Fenwick & West notes:
[T]he court rejected the government’s theory that, as sophisticated traders, the defendants “must have known” that the information came from corporate insiders who disclosed the inside information in exchange for a personal benefit.
Put simply: the state of the law in the Second Circuit is that if you trade on material nonpublic information and either the tipper did not receive a personal benefit for the tip or you did not know that the tipper received a personal benefit for tipping, you have not broken the law.
Still, No Slacking on Corporate Insider Trading Policies
A lot of press has been written about how, post-Newman, it will be harder for the government to pursue far-flung insider trading cases the way it has in recent years.
Certainly this new decision may make it seem like it’s now fine to relax when it comes to corporate insider trading policy. But don’t do it.
First, the recent Newman decision is from the Second Circuit, which includes Connecticut, Vermont and New York. There is no guarantee that you’d get the same outcome in, for example, California until the relevant circuit (the Ninth Circuit) rules on the question.
Other circuits may or may not find the reasoning of the Second Circuit to be persuasive.
Secondly, the Second Circuit’s decision in Newman may not stand. On January 23, 2015, the U.S. Attorney Preet Bharara announced that his office had petitioned the same three-judge panel that decided Newman to revisit the decision.
If the panel will not rehear the case, prosecutors are asking for the case to be heard en banc, which is to say the case be reheard in front of all the judges of the Second Circuit sitting as one panel.
And, clearly, if both requests are denied, we should expect the prosecutors to file an appeal with the United States Supreme Court.
Third, even if the Second Circuit succeeds in narrowing the definition of insider trading, anyone involved in such a case still faces dire consequences like losing their job, being excoriated in the press, and huge legal bills.
As author Walter Pavlo points out in a Forbes article on the Newman case, the outcome can be devastating to defendants even if they’re acquitted:
Judges can sentence, appeals courts can overturn and attorneys can claim victory, but since November 22, 2010, when Diamondback and Level Global were raided by the FBI, the lives of these two men have been turned upside down. For over four years they have fought their case in court and been subjected to televised perp walks and one-sided media coverage that pegged them as another pending “win” for U.S. Attorney Preet Bharara. While the ruling will help them move on with their lives, it will not give them back these four years of fighting for justice.
Finally, we know that the SEC shows no signs of slowing down when it comes to planned enforcement actions in 2015, and insider trading is at the top of its list, no matter how complex the circumstances in which it occurs.
SEC Chair Mary Jo White commented on the Newman ruling in December 2014, saying it was an “overly narrow view of the insider trading law, and that is a concern.”
Bottom line: The state of the law when it comes to tipper/tippee liability might be in flux, but the “win” is avoiding ever being accused of wrongdoing in the first instance.
Nothing about the recent ruling makes it a good idea to abandon the conservative insider trading policies that many corporations have implemented in the name of good governance.
And certainly don’t trade if you are doing so on the basis of what might be material nonpublic information from a tipper who may have received a personal benefit in exchange for the tip.