On December 10, the US Court of Appeals for the Second Circuit
issued an opinion in United States v. Newman1 that could be the most
consequential insider trading decision in a generation, but for
reasons that virtually no one anticipated. In short, the
Newman decision held (i) that a tippee can be liable for
insider trading only if he or she has knowledge that the (corporate
insider) tipper obtained a personal benefit, and (ii) that the
evidence was insufficient to establish that any personal benefit
existed, much less that it was known to the tippees.
In Newman, the Court of Appeals reviewed the insider
trading convictions of Todd Newman and Anthony Chiasson, portfolio
managers at two different hedge funds. The government
maintained that insiders at publicly traded technology companies
shared material non-public information with analysts at various
investment firms and hedge funds who shared the information among
themselves and ultimately passed the information to the portfolio
managers at their firms, including Newman and Chiasson, who then
allegedly traded based on it. In other words, Newman and
Chiasson were alleged recipients of material non-public information
("tippees" in the parlance of insider trading law) three
or four levels removed from the sources of the information, and
there was no evidence that they were aware of those
sources. The issue presented on appeal was the degree of
knowledge required by remote tippees like Newman and Chiasson in
order to hold them liable for insider trading.
Below, we review the legal landscape leading up to the court's
decision in Newman and analyze it in light of US Supreme
Court and Second Circuit precedent. We then conclude with some
practical considerations.
Background Case Law
The seminal decision regarding insider trading liability for
tippers and tippees is Dirks v. SEC.2 In Dirks, the Supreme Court
announced several principles of insider trading law relevant to
defendants such as Newman and Chiasson. First, the Court made
clear that the liability, if any, of a tippee is derivative of that
of the tipper.3 Second,
a tipper is liable for insider trading only if he or she disclosed
information in breach of a fiduciary duty.4 The Dirks Court made clear that
a breach of a fiduciary duty is proven only if information was
disclosed in breach of a duty of confidentiality
and for the personal benefit of the
tipper.5 In other words, the
personal benefit requirement is not a separate element of an
insider trading offense, but rather a showing required to establish
the breach of the fiduciary duty element. Third, the Supreme
Court provided examples of the requisite personal benefit. As
the Court explained, personal benefit to the tipper can be shown
where the tipper has a sufficiently close personal relationship
with the tippee such that the tip could be viewed as the functional
equivalent of a monetary gift to a friend,
or where the tip was part of a quid pro
quo in which the tipper provided the information in return for
something of value.6 Fourth, the Supreme Court appeared to
suggest that something short of actual knowledge by the tippee
concerning the tipper's breach of fiduciary duty would be
sufficient to establish liability on the part of the tippee.
Specifically, the Court stated that a tippee would be liable if he
or she "knew or should know" of the tipper's breach
of fiduciary duty.7
Two years ago, the Second Circuit issued a decision in SEC v.
Obus,8 in which the
court examined, among other things, the degree of knowledge
required on the part of a tippee in order to give rise to insider
trading liability. In Obus, the SEC charged a
corporate executive with insider trading based on allegations that
he tipped a friend from college who was a hedge fund analyst
regarding a financing transaction on which the corporate executive
was working. The hedge fund analyst then relayed the
information to his boss, who allegedly traded based on the
information. The district court granted summary judgment in
favor of the defendants, holding that the corporate executive had
not breached any duty to his employer, and thus neither the hedge
fund analyst nor his boss could be derivatively liable. What
is more, the district court ruled that the SEC failed to present
any evidence that the hedge fund analyst's boss
"subjectively believed that the information he received was
obtained in breach of a fiduciary duty."9
The SEC appealed the grant of summary judgment to the Second
Circuit, which reversed. Critically, the Obus court
defined insider trading liability for tippers by dividing the
breach of fiduciary element into two separate elements, holding
that the SEC must prove that the tipper "(1) tip[ped] (2)
material non-public information (3) in breach of a fiduciary duty
of confidentiality owed to shareholders (classical theory) or the
source of the information (misappropriation theory) (4) for the
personal benefit of the tipper."10 With regard to the personal benefit
requirement, the Obus court stated—consistent with
Dirks—that it could be proven with evidence
"not only of 'pecuniary gain,' such as a cut of the
take or a gratuity from the tippee, but also a 'reputational
benefit' or the benefit one would obtain from simply
'mak[ing] a gift of confidential information to a trading
relative or friend.'"11 The court ruled that the tipper and tippee
being "friends from college" was sufficient to send the
personal benefit question to the jury.12
With regard to tippee liability, the Obus court went on to
state that the SEC must prove, as Dirks held, that the
tippee "knew or should have known" that the tipper had
breached "a fiduciary duty" by relaying the
information.13 Elsewhere, the court stated that the
SEC must prove that "the tippee knew or had reason to know
that the tipper improperly obtained the information."14 The court held that there
was evidence from which a jury could infer that the hedge fund
analyst's boss knew or should have known that the corporate
executive had "breached a duty" in disclosing the
information at issue to the hedge fund analyst.15 But because the Obus court
had treated the personal benefit requirement as distinct from the
breach of fiduciary duty element, it is not clear that the court
considered whether there was evidence from which the jury also
could infer that the hedge fund analyst's boss knew that the
corporate executive had received a personal benefit in exchange for
his tip.16 One reading of
Obus is that the court held that the SEC must prove that
the tippee knew of the personal benefit when it stated that the
tippee must know that tipper "improperly obtained the
information." But the issue was arguably left open in
Obus.17
Newman Decision
In Newman, the district court squarely addressed the issue
of whether the government must prove that the defendant knew that
the tipper received some personal benefit from his or her
disclosure. The district court instructed the jury that it
need only find that the disclosure was in violation of a duty of
confidentiality; the instruction made no mention of a requirement
that the tippee knew (or even should have known) that the tipper
would receive some personal benefit for his disclosure. After
being convicted at trial, defendants Newman and Chiasson appealed,
challenging the jury instructions and also arguing that there was
insufficient evidence of their knowledge of any personal benefit
flowing to the original tipper, who was several steps removed from
them. The Court of Appeals reversed the convictions, holding
both that (i) the district court erred in
failing to instruct the jury that, in order to return a guilty
verdict, it must find that the defendant-tippees knew of the
original tippers' receipt of a personal benefit
and (ii) the evidence was insufficient
not only as to the defendants' knowledge of any personal
benefit but also on the question of whether the tippers even
received a personal benefit.
With regard to the knowledge element, the Court of Appeals noted
that Dirks had conditioned tippee liability on knowledge
that there had been a breach of a fiduciary duty.18 The Second Circuit then went on to
explain that Dirks counsels us that the exchange of
confidential information for personal benefit is not separate from
an insider's fiduciary breach; it is the fiduciary breach that
triggers liability for securities fraud under Rule 10b-5. For
purposes of insider trading liability, the insider's disclosure
of confidential information, standing alone, is not a breach. Thus,
without establishing that the tippee knows of the personal benefit
received by the insider in exchange for the disclosure, the
Government cannot meet its burden of showing that the tippee knew
of a breach.19
In other words, while the Obus decision had separated the
personal benefit requirement from the breach of fiduciary duty
element, the Newman court recognized that they were one
and the same under Dirks. Accordingly,
Dirks' requirement that a tippee have knowledge of the
breach of fiduciary duty in order to be liable necessarily meant
that the tippee must be aware not only of the disclosure of
confidential information but also that such disclosure was made for
the personal benefit of the tipper. The question was one of
first impression for the Second Circuit, but the court's
holding is not surprising in and of itself.
The Second Circuit, however, did not simply reverse and remand for
a retrial based on the flaw in the district court's jury
instruction on the knowledge element. Instead, the court then
considered whether the evidence was sufficient to establish such
knowledge. Rather than rule only that the evidence of the
tippee's knowledge was insufficient, the court went further
still and ruled that the evidence at trial was insufficient to
establish the existence of any personal benefit to the tipper at
the top of the tipping chain. It is here that the
Court of Appeals' ruling is of significant
consequence. In particular, the court held that the
government may not "prove the receipt of a personal benefit by
the mere fact of a friendship, particularly of a casual or social
nature."20 The
court went on to explain that if "the Government was allowed
to meet its burden by proving that two individuals were alumni of
the same school or attended the same church, the personal benefit
requirement would be a nullity."21 Rather, the Second Circuit explained,
an inference of personal benefit is "impermissible in the
absence of proof of a meaningfully close personal relationship that
generates an exchange that is objective, consequential,
andrepresents at least a potential
gain of a pecuniary or similarly valuable nature."22 The court continued, stating
that "[w]hile our case law at times emphasizes language from
Dirks indicating that the tipper's gain need not be
immediately pecuniary, it does not erode the fundamental insight
that, in order to form the basis for a fraudulent breach, the
personal benefit received in exchange for the confidential
information must be of some consequence."23 Taken literally, the Newman
decision would seem to require that, in order to prove the
requisite personal benefit, the government must show that the
tipper received (or had the potential to receive), directly or
indirectly, some financial or similarly consequential benefit in
exchange for the tip.
Practical Considerations Going Forward
There is little doubt that the Newman decision is of great
consequence in the development of the law of insider
trading. We discuss below several practical considerations
that firms should consider in light of the Newman
opinion:
First, the Newman decision provides defendants in
insider trading cases with a significant weapon to use against
attenuated personal benefit theories advanced by the SEC and DOJ in
insider trading prosecutions. At a minimum, the decision makes
clear that casual relationships amounting to little more than
acquaintances will not suffice to establish the type of close
personal relationship that the Dirks court
envisioned.
Second, at least in the Second Circuit, it is likely that
the knowledge requirement announced in Newman will be
binding in civil SEC cases as well. The court's holding
turned on its reading of the Section 10(b) scienter element as
articulated in Dirks (which was itself an SEC case), not on the
willfulness element of a criminal prosecution. Because the
scienter element also applies in an SEC case, there is no reason to
think that the knowledge of personal benefit requirement would not
also apply in a civil case brought by the SEC. It should be
noted, however, that the SEC (at least in the Second Circuit) can
establish scienter by showing reckless disregard for the
truth,24 which is
something short of actual knowledge.
Third, the Newman holding regarding the required
knowledge on the part of tippees should be read cautiously given
the willful blindness doctrine. The Dirks opinion
states that tippees are liable to the extent they know or
"should know" of the breach of fiduciary duty (including
the receipt of a personal benefit) by the tipper. While the
"should know" language arguably is dicta, the DOJ or SEC
could argue that the knowledge requirement has been met where even
a remote tippee turns a blind eye to the personal benefit received
by the tipper.
Fourth, because the Newman decision is only
binding law in the Second Circuit, there is a risk that either the
DOJ or, more likely, the SEC will pursue cases in other circuits on
the theory that the knowledge requirement announced in Newman is an
incorrect interpretation of Dirks. In particular, the SEC
has greater flexibility than the US Attorney's Offices in New
York to file its cases in any district with venue and in which the
Newman decision would not be binding precedent. While
the Newman decision would be persuasive precedent in
defending against an insider trading case brought in another
district, it would not be binding. Thus, we think that, for
now, it would be unwise to rely on the knowledge requirement for
tippee liability as announced in Newman as a basis for
trading in securities when the trader knows there has been a breach
of duty but does not have detailed information about the
tipper's motive, at least until additional courts have spoken
on this issue.
1 --- F.3d at ---, 2014 WL 6911278 (2d Cir. Dec. 10, 2014).
2 463 U.S. 646 (1983).
3Id. at 659 ("Thus, the tippee's duty to disclose or abstain is derivative from that of the insider's duty.").
4Id. at 660 (holding that "a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee").
5Id. at 661-62 ("All disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders....Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure. This standard was identified by the SEC itself in Cady, Roberts: a purpose of the securities laws was to eliminate the use of inside information for personal advantage. Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach." (internal quotation marks and citations omitted)).
6Id. at 664 ("For example, there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient. The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.").
7Id. at 660 (Thus, a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.).
8 693 F.3d 276 (2d Cir. 2012).
9Id. at 284 (internal quotation marks omitted).
10Id. at 286.
11Id. at 285 (quoting Dirks, 463 U.S. at 663-64).
12Id. at 291 ("Here, the undisputed fact that Strickland and Black were friends from college is sufficient to send to the jury the question of whether Strickland received a benefit from tipping Black.").
13Id. at 292.
14Id. at 289.
15Id. at 293.
16 See id. at 292-93.
17 On remand, the three defendants were found not liable of insider trading after a jury trial.
18Newman, --- F.3d ---, 2014 WL 6911278, at *6.
19Id.
20Id. at *10.
21Id.
22Id. (emphasis added).
23Id. (emphasis in original).
24Obus, 693 F.3d at 286.
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