Suppose your brother-in-law has too much eggnog at Christmas dinner and starts blabbing about confidential inside information concerning the company where he works. If you trade the company’s stock based on that information, do you risk finding a subpoena from the SEC in your stocking?
The U.S. Court of Appeals for the Second Circuit recently decided United States v. Newman, a significant case clarifying and narrowing the law of criminal insider trading. (The Second Circuit includes New York, the site of most insider trading prosecutions.) As with many white collar crimes, however, even in the wake of the new decision a lot of gray areas remain.
The Classic White Collar Crime
Insider trading is a textbook example of a white collar crime. One reason is the breadth and vagueness of the statutes involved. There actually is no law defining insider trading as a crime. It is prosecuted under the Securities Exchange Act of 1934, which prohibits the use of any “manipulative or deceptive device” in contravention of the rules of the SEC. SEC Rule 10b-5, in turn, prohibits any “device, scheme, or artifice to defraud” in connection with the purchase or sale of any security.
The SEC has long considered insider trading to be a violation of Rule 10b-5, and the Supreme Court has agreed. Absent a statutory definition of “insider trading,” however, defining and fleshing out the parameters of the offense has been left to the SEC, prosecutors, and the federal courts – a not uncommon issue with white collar statutes.
Another common white collar characteristic featured in insider trading is the prominence of parallel proceedings – enforcement by multiple parties or agencies. Insider trading may be investigated by the SEC and punished by administrative sanctions or civil fines. Shareholders and other private individuals may file a civil lawsuit over the same conduct. And in the most serious cases, the SEC may make a criminal referral to the Department of Justice for prosecution.
The Law of Insider Trading
Insider trading is defined as buying or selling securities based on material, non-public information, in violation of a duty of trust and confidence. Trading on the basis of inside information alone is not a crime. In order to constitute fraud, there must be an accompanying breach of a legal duty in connection with the trading.
“Classical” insider trading involves a corporate officer or employee who knows confidential information about something going on at the company and trades in the company stock based on that information. In such a case, the insider is deemed to have violated the fiduciary duty that she owes to the company’s shareholders to act only in their best interests and not to appropriate confidential company information for her own personal gain.
The second type of insider trading is the “misappropriation theory.” In a misappropriation theory case, a company’s stock is traded based on information used in violation of a duty owed not to the shareholders but to the source of the information. For example, outside counsel for a corporation may gain confidential information about an upcoming deal and trade stocks based on that information. The attorney, as an outsider to the corporation, owes no fiduciary duty to the corporation’s shareholders so the classical theory would not apply. Under the misappropriation theory, the trade is unlawful because the attorney violated a duty to the client by using the client’s confidential information for the attorney’s own benefit.
The ban on insider trading would be rather easy to circumvent if a corporate insider could refrain from trading himself but simply give the information to a corporate outsider, such as a spouse or a child, and have them do the trading. Accordingly, the Supreme Court has long recognized that insider trading liability also may be based on the receipt of a “tip” of inside information.
The leading Supreme Court case on “tippee liability” is Dirks v. SEC. Under Dirks, in a tip case the government is required to prove two things: 1) the insider who leaked the information did so in violation of a duty owed to the company or the source of information; and 2) the recipient of the tip who trades on the stock knew or had reason to know that the breach of duty occurred. The Court also held that an insider who provides a tip violates his duty to the company when he does so in exchange for some monetary or other personal benefit.
The Second Circuit Decision: U.S. v. Newman and Chiasson
The recent Second Circuit case involved a question of tippee liability. The defendants, Todd Newman and Anthony Chiasson, were portfolio managers at two hedge funds. They and others were charged as part of a scheme in which various analysts and investment firms received and traded on inside information about the upcoming earnings of two companies, Dell and NVIDIA. Insiders at the companies leaked the information to other investment analysts, who then passed the word along. In each case, Newman and Chiasson were several steps removed from the original leak, receiving the inside information only after it had been first relayed between at least two or three other people.
At trial, Newman and Chiasson made two principal arguments. First, they claimed there was insufficient evidence that the original leakers within Dell and NVIDIA had leaked the information in exchange for some personal benefit, as required by Dirks. Second, they argued that even if there were sufficient evidence of such a benefit, the government had failed to prove that Newman and Chiasson personally knew that the corporate insiders had received the benefit.
Relying on somewhat conflicting Second Circuit precedents, the trial judge ruled against them. The judge found there was sufficient evidence that the insiders had received a personal benefit in exchange for leaking the information. The judge also agreed with the government that it was required to show only that the defendants knew that insiders had leaked the information in violation of their duties to the company – the government did not have to prove the defendants actually knew the insiders had received a personal benefit in exchange.
The jury ultimately found both defendants guilty. Newman was sentenced to 54 months in prison and nearly $2 million in fines and forfeiture; Chiasson was sentenced to 78 months and nearly $7 million.
The Second Circuit reversed the convictions. The court first addressed what the defendants must know in order to be convicted. The court agreed with the defendants that the law requires the government to prove the defendants knew not only that the tippers had breached a duty in leaking the inside information, but also that the tippers had received a personal benefit in exchange for doing so.
As the court recognized, the reasoning of Dirks compels this conclusion. The Supreme Court ruled that to be liable a tippee must know that the insider leaked the information in breach of a duty. The Court in Dirks also held that breach of a duty was established if the insider received some personal benefit in exchange for the leak. Logically, therefore, proof the tippee knew there was a breach of duty means proof the tippee knew that the insider received some personal benefit.
The Second Circuit went on to address what kind of “personal benefit” would suffice to establish an insider’s breach of duty. The government argued it had presented sufficient evidence that the tippers from Dell and NVIDIA had received a personal benefit in exchange for the inside information. One had received occasional career advice from an analyst to whom he leaked information (although apparently much of that took place prior to the leaks). The other insider was a family friend of one of the analysts; they went to the same church and occasionally socialized together.
The Court agreed that “personal benefit” is not limited to monetary gain and includes things like reputational benefits that may translate into future earnings or the intangible benefit one receives from making a gift to a relative or very close friend. But this does not mean, the court continued, that the government could prove this element simply by establishing that the tipper and tippee are friends. If that were sufficient this requirement would practically disappear, for at a minimum a casual friendship between tipper and tippee probably exists in almost all such cases.
Accordingly, the court held, proof of a personal benefit requires evidence of a “meaningfully close relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” The evidence of a casual friendship and other slight potential benefits in Newman did not meet that standard. Because the evidence produced was insufficient to establish insider trading, the court reversed the convictions and directed that the indictments be dismissed with prejudice – meaning the defendants cannot be retried.
Implications of the Second Circuit’s Decision
The court in Newman was clearly unhappy with the government’s expansive view of insider trading and moved to scale it back. In an unusual rebuke, it criticized the “doctrinal novelty” of the government’s recent insider trading prosecutions, which the court said have been “increasingly targeted at remote tippees many levels removed from corporate insiders.” The court noted it had not found a single case in which tippees as remote as Newman and Chiasson had been found criminally liable for insider trading.
The decision in Newman has two primary implications for future prosecutions. The first is simply that the legal standard is now clear concerning what the government must prove concerning a tippee’s knowledge. It is not enough to prove the tippee knows that the inside information was leaked in violation of a duty. The prosecution will also be required to establish that the defendant knew the tipper did so in exchange for a personal benefit.
Presumably knowledge of the benefit received by the tipper may be established either directly or through willful blindness – proof that the defendant deliberately closed his or her eyes to what was going on. But as tippees – such as Newman and Chiasson – become further removed from the original tip and knowledge of the tipper’s circumstances, this proof obviously becomes more difficult. As a result, cases against what the court termed “remote tippees” likely will be less frequent.
The more interesting question may be what sort of “benefit” to the tipper will qualify. The easy case is when a corporate insider leaks information to the tippee in exchange for some direct and tangible benefit, whether a cash payment, share in the trading proceeds, or some other direct reward. This transaction is akin to bribery and a quid pro quo relationship, with intent on the part of the tippee to benefit the tipper in exchange for the information.
The potential gray area for future cases involves tips to family, friends, or casual acquaintances. If the relationship is sufficiently close that the tip is basically equivalent to the insider trading on the information and then giving the profits to the tippee – think a spouse, child or sibling – a personal benefit to the tipper will almost certainly be found. On the other hand, the Newman decision suggests that any intangible benefit resulting from a tip to a more casual acquaintance or golfing buddy may not suffice. Where exactly the line gets drawn will be a very fact-specific question, with the standards to be hammered out in future cases.
In the meantime, as for that tip from your brother-in-law, the safest course is simply to pour him some more eggnog and pretend you didn’t hear a thing.
Update: On December 6, 2016, the U.S. Supreme Court decided Salman v. United States, which rejected the Second Circuit’s Newman decision discussed in this post. You can find my post on Salman here.
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