Time to Define InsiderTrading

Newman and Chiasson were several steps removed from original corporate sources. In securities law jargon, they were “remote tippees.” The Dell insider provided information about the company's earnings numbers to a securities analyst, who passed the information to another analyst, who passed it to Newman. Similarly, the NVIDIA insider tipped information to someone he knew from church, who conveyed the information to a securities analyst, who provided it to other analysts, who in turn passed it to Newman and Chiasson.

The government charged that Newman and Chiasson must have known the information originated with corporate insiders who violated their duty to keep such information confidential. Indeed, the government asserted the inside information was transmitted through a so-called expert network specifically created to benefit Wall Street professionals. The trial judge instructed the jury that they must find beyond a reasonable doubt that the corporate insiders violated a duty to keep information confidential. But the judge rejected the defendants' request for an instruction that the government prove they knew the corporate insiders received a personal benefit for their tips and the nature of any benefit. That was the issue teed up on appeal.

Underscoring this issue is that there is no federal statute defining insider trading. The Securities and Exchange Commission (SEC) and the Justice Department (DOJ) prosecute insider trading cases as violations of Section 10(b) of the Securities Exchange Act of 1934, the general anti-fraud provision of the securities laws. In the absence of a statutory definition, federal judges over decades have developed the contours of insider trading law.

The courts do not require that all participants in the stock market have equal information. See Chiarella v. U.S. , 445 U.S. 222 (1980). In Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court ruled that where a corporate insider reveals important, confidential information to an outsider ' the “tipper” and “tippee,” respectively ' the tippee can only be charged with wrongdoing if the tipper's disclosure was for an improper purpose and the tippee knew that fact. The Supreme Court held that the government must show that the insider would personally benefit, directly or indirectly, from the disclosure.

The three-judge panel of the Second Circuit agreed that the trial judge's jury instruction was erroneous, ruling that the government must show the defendants knew the Dell and NVIDIA insiders received a personal benefit for disclosing confidential information. The court noted the “doctrinal novelty” of prosecutions “increasingly targeted at remote tippees many levels removed from corporate insiders.” That holding significantly increases the government's difficulty in being able to prosecute remote tippees even if they are allegedly the ultimate beneficiaries of an insider trading network.

What's in It for Me?

Rather than simply remanding for a new trial, the court threw out the case entirely because there was insufficient evidence the insiders at Dell and NVIDIA received any personal benefit in exchange for their tips. It is this part of the decision that truly overturned settled notions of insider trading law.

Dirks suggested a corporate tipper need not obtain a concrete financial benefit for the disclosure of confidential information to be improper. The Supreme Court said the improper exploitation of nonpublic information may exist “when an insider makes a gift of confidential information to a trading relative or friend.” Based on this language, the SEC and the DOJ long have contended that there was no need to show a tangible financial gain, but only that a tip was provided to enhance the tipper's reputation in the eyes of the tippee through the gift of confidential information.

But the Second Circuit threw ice water on the notion that a putative “reputational benefit” could support insider trading charges. The court stated that while Dirks indicated that the tipper's gain need not be ” immediately pecuniary” (emphasis in original), a personal benefit may not be inferred from a personal relationship between the tipper and the tippee “in the absence of 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.”

If a personal benefit were based merely on a social or casual relationship, or because the tipper and tippee went to the same school or belonged to the same church, the personal benefit requirement “would be a nullity.” The fact that the Dell tipper received career guidance from his tippee did not suffice, because the tippee routinely gave such advice to industry colleagues. The NVIDIA tipper and his tippee were merely casual acquaintances, and there was no history of loans or personal favors between them.

Justice Might Be Served

The decision severely threatens the government's battle against insider trading. The government may sometimes show the tipper received a concrete financial benefit, such as sharing in trading profits or a future business quid pro quo. But there are many instances where the tipper received no obvious financial gain. The Second Circuit's decision would mean that in those cases, the corporate insider would be off the hook. If so, the tippee also would be scot-free, no matter the amount of any trading profits, since the tippee's liability is derivative of the tipper's. Thus, the court's decision permits insider trading commonly thought to be illegal. Indeed, as one commentator observed, if you are going to disclose inside information, make sure the tip is to a friend where no business quid pro quo could be implied and with no money changing hands.

Newman already has had a significant impact within the Second Circuit. Several individuals have sought to take back guilty pleas, and one federal judge in New York indicated that he is inclined to vacate four guilty pleas in an insider trading case arising from IBM's 2009 purchase of a software company. Other defendants have moved to dismiss charges in pending cases.

Analysis

The decision will bring no additional certainty to insider trading law. Courts will wrestle with the question of what is an “objective, consequential” financial benefit, and to what degree must the benefit be express or implied. For example, if someone discloses inside information to a mooching relative, could the government charge that the tipper benefitted by avoiding further requests for money?

Although Newman is not binding outside the Second Circuit, the court's securities opinions are extremely influential. Moreover, it would be bizarre to have one set of insider trading rules for New York and another for the rest of the country. The government might seek rehearing en banc , and the U.S. attorney has sought additional time to file a petition. The government could appeal to the Supreme Court, but even if it decided to hear the case, a pro-business court may not be receptive to the government's arguments. The SEC is now trying insider trading cases before administrative judges after losing a string of high-profile cases in federal court, but that approach would, as a prominent federal judge recently noted, create the risk of dueling insider trading law developed by federal courts and the SEC's in-house judges.

The obvious solution is for Congress to pass a law defining illegal insider trading. The government always has resisted such an approach in order to maintain the greatest discretion in determining the boundaries of insider trading, but that position has now backfired. Reasonable people may and do disagree on the boundaries, but market professionals and occasional stock traders alike should have some definite notion rather than waiting years for a judge to decide.

Jared Kopel is an affiliated counsel with Bergeson LLP, San Jose, CA. This article also appeared in The Recorder, an ALM sister publication of this newsletter.

The average person probably believes it is illegal for a corporate insider to purchase or sell stock based on confidential information or provide the information to an outside trader. However, a bombshell ruling by an influential federal appeals court could make such conduct perfectly legal. The decision also emphasized the need for a statutory definition of insider trading.

In U.S. v. Newman, Nos. 13-1837, 13-1917 (Dec. 10, 2014), the Second Circuit Court of Appeals, which covers New York, Connecticut and Vermont, reversed the convictions of two hedge fund portfolio managers, Todd Newman and Anthony Chiasson, after a jury trial. The two men were charged with trading on behalf of their funds in the stocks of Dell Computer and NVIDIA based on confidential financial information divulged by employees at both companies. Newman was sentenced to 54 months in prison and required to pay over $1.7 million, while Chiasson was sentenced to 78 months in prison and required to pay almost $6.4 million.

Far from Primary

Newman and Chiasson were several steps removed from original corporate sources. In securities law jargon, they were “remote tippees.” The Dell insider provided information about the company's earnings numbers to a securities analyst, who passed the information to another analyst, who passed it to Newman. Similarly, the NVIDIA insider tipped information to someone he knew from church, who conveyed the information to a securities analyst, who provided it to other analysts, who in turn passed it to Newman and Chiasson.

The government charged that Newman and Chiasson must have known the information originated with corporate insiders who violated their duty to keep such information confidential. Indeed, the government asserted the inside information was transmitted through a so-called expert network specifically created to benefit Wall Street professionals. The trial judge instructed the jury that they must find beyond a reasonable doubt that the corporate insiders violated a duty to keep information confidential. But the judge rejected the defendants' request for an instruction that the government prove they knew the corporate insiders received a personal benefit for their tips and the nature of any benefit. That was the issue teed up on appeal.

Underscoring this issue is that there is no federal statute defining insider trading. The Securities and Exchange Commission (SEC) and the Justice Department (DOJ) prosecute insider trading cases as violations of Section 10(b) of the Securities Exchange Act of 1934, the general anti-fraud provision of the securities laws. In the absence of a statutory definition, federal judges over decades have developed the contours of insider trading law.

The courts do not require that all participants in the stock market have equal information. See Chiarella v. U.S. , 445 U.S. 222 (1980). In Dirks v. SEC , 463 U.S. 646 (1983), the Supreme Court ruled that where a corporate insider reveals important, confidential information to an outsider ' the “tipper” and “tippee,” respectively ' the tippee can only be charged with wrongdoing if the tipper's disclosure was for an improper purpose and the tippee knew that fact. The Supreme Court held that the government must show that the insider would personally benefit, directly or indirectly, from the disclosure.

The three-judge panel of the Second Circuit agreed that the trial judge's jury instruction was erroneous, ruling that the government must show the defendants knew the Dell and NVIDIA insiders received a personal benefit for disclosing confidential information. The court noted the “doctrinal novelty” of prosecutions “increasingly targeted at remote tippees many levels removed from corporate insiders.” That holding significantly increases the government's difficulty in being able to prosecute remote tippees even if they are allegedly the ultimate beneficiaries of an insider trading network.

What's in It for Me?

Rather than simply remanding for a new trial, the court threw out the case entirely because there was insufficient evidence the insiders at Dell and NVIDIA received any personal benefit in exchange for their tips. It is this part of the decision that truly overturned settled notions of insider trading law.

Dirks suggested a corporate tipper need not obtain a concrete financial benefit for the disclosure of confidential information to be improper. The Supreme Court said the improper exploitation of nonpublic information may exist “when an insider makes a gift of confidential information to a trading relative or friend.” Based on this language, the SEC and the DOJ long have contended that there was no need to show a tangible financial gain, but only that a tip was provided to enhance the tipper's reputation in the eyes of the tippee through the gift of confidential information.

But the Second Circuit threw ice water on the notion that a putative “reputational benefit” could support insider trading charges. The court stated that while Dirks indicated that the tipper's gain need not be ” immediately pecuniary” (emphasis in original), a personal benefit may not be inferred from a personal relationship between the tipper and the tippee “in the absence of 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.”

If a personal benefit were based merely on a social or casual relationship, or because the tipper and tippee went to the same school or belonged to the same church, the personal benefit requirement “would be a nullity.” The fact that the Dell tipper received career guidance from his tippee did not suffice, because the tippee routinely gave such advice to industry colleagues. The NVIDIA tipper and his tippee were merely casual acquaintances, and there was no history of loans or personal favors between them.

Justice Might Be Served

The decision severely threatens the government's battle against insider trading. The government may sometimes show the tipper received a concrete financial benefit, such as sharing in trading profits or a future business quid pro quo. But there are many instances where the tipper received no obvious financial gain. The Second Circuit's decision would mean that in those cases, the corporate insider would be off the hook. If so, the tippee also would be scot-free, no matter the amount of any trading profits, since the tippee's liability is derivative of the tipper's. Thus, the court's decision permits insider trading commonly thought to be illegal. Indeed, as one commentator observed, if you are going to disclose inside information, make sure the tip is to a friend where no business quid pro quo could be implied and with no money changing hands.

Newman already has had a significant impact within the Second Circuit. Several individuals have sought to take back guilty pleas, and one federal judge in New York indicated that he is inclined to vacate four guilty pleas in an insider trading case arising from IBM's 2009 purchase of a software company. Other defendants have moved to dismiss charges in pending cases.

Analysis

The decision will bring no additional certainty to insider trading law. Courts will wrestle with the question of what is an “objective, consequential” financial benefit, and to what degree must the benefit be express or implied. For example, if someone discloses inside information to a mooching relative, could the government charge that the tipper benefitted by avoiding further requests for money?

Although Newman is not binding outside the Second Circuit, the court's securities opinions are extremely influential. Moreover, it would be bizarre to have one set of insider trading rules for New York and another for the rest of the country. The government might seek rehearing en banc , and the U.S. attorney has sought additional time to file a petition. The government could appeal to the Supreme Court, but even if it decided to hear the case, a pro-business court may not be receptive to the government's arguments. The SEC is now trying insider trading cases before administrative judges after losing a string of high-profile cases in federal court, but that approach would, as a prominent federal judge recently noted, create the risk of dueling insider trading law developed by federal courts and the SEC's in-house judges.

The obvious solution is for Congress to pass a law defining illegal insider trading. The government always has resisted such an approach in order to maintain the greatest discretion in determining the boundaries of insider trading, but that position has now backfired. Reasonable people may and do disagree on the boundaries, but market professionals and occasional stock traders alike should have some definite notion rather than waiting years for a judge to decide.

Jared Kopel is an affiliated counsel with Bergeson LLP, San Jose, CA. This article also appeared in The Recorder, an ALM sister publication of this newsletter.