United States: A Step Too Far: U.S. Appeals Court Throttles Back "Tippee" Insider Trading Prosecutions

Last Updated: February 5 2015
Article by Robert N. Rapp

On December 10, 2014, a three-judge panel of the United States Court of Appeals for the Second Circuit concluded that federal prosecutors and a lower court had gone too far in the imposition of criminal liability for insider trading violations of the federal securities laws on two individuals who were "tippees" of inside information. In U.S. v. Newman, et al., the Court of Appeals reversed criminal convictions, and went further to direct the dismissal of indictments against them with prejudice, of two hedge fund portfolio managers - - Todd Newman and Anthony Chiasson -- who had been found guilty and sentenced to prison terms in a Manhattan federal district court on charges of insider trading. The two were remote tippees of material non-public information about two publicly traded technology companies that they used to make profitable trades for their respective hedge funds. Although they were in possession of material non-public information when directing these profitable trades, Newman and Chiasson were several steps removed from the corporate insiders who originally divulged the information that ultimately came into their possession, and indeed, there was no evidence that either was even aware of the source of the inside information, much less any circumstances in which the information had been disclosed.

The Court of Appeals concluded that Newman and Chiasson had been convicted on a prosecution theory, on which the lower court instructed the jury, that ignored a fundamental basis for insider trading liability of a tippee, namely, that the tippee have actual knowledge that the information was originally disclosed by an insider in breach of a fiduciary-based duty of confidentiality, in exchange for some personal benefit in doing so. A tippee who is merely in possession of material non-public information, and who trades advantageously on the basis of it, does not violate any prohibition on insider trading unless that tippee has actual knowledge that the insider source of the information disclosed it in exchange for some personal benefit. Newman and Chiasson were convicted on an erroneous standard advanced by the Government and embraced by the lower court that required only that the Government prove that they "must have known" that material non-public information was originally disclosed by the corporate insider in violation of a duty of confidentiality. But for purposes of imposing insider trading liability on a tippee, a corporate insider's disclosure of confidential information, standing alone, is not the breach of a duty on which liability of a tippee of the information may be premised. The breach of duty by the corporate insider comes with receipt of a personal benefit. Without actual knowledge of the personal benefit received by the insider, a tippee is not liable for insider trading when he or she trades advantageously using it, as was the case with Newman and Chiasson trading for their respective hedge funds.

Although the decision in U.S. v. Newman has been widely seen as repudiating unbridled prosecutions for insider trading orchestrated by Preet Bharara, U.S. Attorney for the Southern District of New York in recent years, it is much more importantly an exclamation point as a matter of law, and a statement of the fundamental principle of actual culpable misconduct that underlies the broad notion of "insider trading" in U.S. securities markets. Some commentators have suggested that the decision in Newman will make prosecutions for insider trading more difficult; with others suggesting that the Court of Appeals has "raised the bar" for these prosecutions, both views implying that the case alters an applicable legal standard. It does not. As discussed below, the decision in Newman is solidly anchored in a legal standard that has been in place for decades, and the court has firmly stated that "although the Government might like the law to be different," insider trading liability is a function of much more than one simply being knowingly in possession of material non-public information.

"Tippee" Liability For Insider Trading

Insider trading is most often considered in the context of trading by one who has possession of material non-public information by virtue of a position, and who is disabled from using that information by reason of an extant duty associated with his or her position. A traditional corporate insider, for example, is barred by the long established legal principle of "disclose or abstain" from trading in the stock of her corporation based on material non-public information obtained in that insider capacity. Traditional corporate insiders owe a fiduciary duty to shareholders of the company to protect the confidentiality of information to which they have access by virtue of their position, and which is intended to be used only for corporate purposes and not for personal gain. Others who are not corporate insiders may also be positioned or become positioned to have or take on the same duty as a traditional corporate insider regarding company information entrusted to them or to which they have been provided access as, for example, attorneys and accountants. Likewise, persons who are "outsiders" will be guilty of insider trading when they trade advantageously on the basis of material non-public information "misappropriated" from the owner in violation of a duty owed to the owner. The key consideration for establishing insider trading liability in all of these circumstances is the breach of a duty owed by the person who actually trades on the basis of the material non-public information.

Liability of a "tippee" for insider trading has an entirely different premise. Tippee liability is based on a breach of duty by someone else: the "tipper," or source, of the inside information. A tippee does not occupy any position in relation to the source, or owner, of material non-public information that would necessarily prevent him or her from trading on the basis of the information. The critical consideration for insider trading liability of a tippee is whether the tipper - - the source of the inside information -- violates a duty in divulging it, and whether the tippee recipient knows of that breach of duty. Most importantly, the breach of duty by the source of the information is not simply divulging the information to another, but rather doing so for some direct or indirect personal benefit. Absent some personal gain, there is no breach of duty by the person divulging the inside information. And absent a breach of duty, a tippee does not violate any prohibition on insider trading when he or she trades advantageously on the basis of it. Moreover, even if there is a breach of an extant duty by the original tipper who may, for example, be a traditional corporate insider who divulges the information, the Court of Appeals in U.S. v. Newman explained that in order for a tippee to be held liable, he or she must have actual knowledge that the original tipper/insider received a personal benefit. In the case of "remote" tippees like Newman and Chiasson, who have little or no knowledge regarding the original disclosure of the information, proving actual knowledge of a personal benefit received by the original tipper/insider is problematic.

The Court of Appeals did not create this standard for tippee insider trading liability in U.S. v. Newman. It is rather a standard established by the United States Supreme Court in 1983. The Government's prosecution of Newman and Chiasson, and their convictions for insider trading, were premised on a view of insider trading liability that disregarded the long-established requirement for tippee liability that the defendant have actual knowledge that the original tipper had received a personal benefit, thus establishing a breach of duty by the original tipper. The jury was not instructed that to convict Newman and Chiasson the Government must prove beyond a reasonable doubt that each of them actually knew that the insiders who originally divulged the material non-public information that made its way to them through a chain of analysts to whom the original disclosures had been made, received a personal benefit. The lower court, consistent with the prosecution theory, only instructed the jury that Newman and Chiasson could be found guilty of insider trading if the Government proved that each of them "must have known" that the information was originally disclosed by insiders in violation of a "duty of confidentiality." Aside from the fact that "must have known" is obviously different from actual knowledge, the jurors were not instructed on the meaning of the applicable duty, which can be based only on the tipper/insiders having received some personal benefit from disclosing the information.

The Faulty Premise: The Step Too Far

"Insider trading" is not defined by one being in possession of material non-public information and trading advantageously on the basis of it. In U.S. v. Newman, the Court of Appeals made the simple observation that nothing in the law requires a "symmetry of information" in securities markets. There will in fact be information asymmetries; some market participants will always have, and make investment decisions on the basis of, more or better information than others. That is how price discovery and asset valuation in securities markets works. Insider trading liability is not based on informational asymmetries. It is rather defined by one being in possession of material non-public information and who, in violation of an extant duty, trades advantageously on the basis of it or tips it to another who does.

The United States Attorney who prosecuted Newman and Chiasson had compiled an enviable, if not amazing, record of success in criminal insider trading cases. This case, however, went a step too far in seeking to convict two remote tippees simply for being in possession of material nonpublic information that they "must have known" had originally been divulged in violation of a duty that could only be defined in terms of a personal benefit of which Newman and Chiasson had to have actual knowledge if they were to be convicted as tippees. To underscore the point that the Government and the lower court simply ignored what the law required, and to drive home the point by dismissing the Newman and Chiasson indictments with prejudice, the Court of Appeals went on to consider the evidence that showed not only that the two knew "next to nothing" about the original insider/tippers, but also that there was no sufficient evidence that the insider/tippers had ever received any benefit of which Newman and Chiasson could have had knowledge in the first place.

Will the decision in U.S. v. Newman make prosecutions for insider trading more difficult? The answer is obviously no. The case quite boldly reaffirms the basis for tippee insider trading liability, of which prosecutors had apparently lost sight in seeking to continue their successful run. Rather than inhibiting prosecutions for insider trading, the decision in Newman simply makes clear what is the wrong case to pursue.

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