In its December 2014 decision in U.S. v. Newman, the United States Court of Appeals for the Second Circuit dealt a significant blow to federal prosecutors’ recent efforts to crack down on insider trading when it vacated the convictions of two hedge fund managers convicted of trading on nonpublic information leaked by employees of the computing companies Dell and NVIDIA. Specifically, the Second Circuit held that when the government prosecutes an outside investor (a tippee) for trading on nonpublic information provided by a corporate insider (a tipper), it must prove that the tipper provided the information in exchange for a personal benefit “of some consequence,” and that the tippee knew of that personal benefit.
The government has recently sought Supreme Court review of the Second Circuit’s Newman decision, and we should know whether or not the Supreme Court will consider the case by early this fall. Finance and legal professionals are anxiously awaiting the Justices’ decision, as the outcome will drastically impact insider trading law for the foreseeable future.
Newman makes it more difficult for the government to establish “tippee” liability.
In Chiarella v. United States, 445 U.S. 222 (1980), the Supreme Court held that there is no “general duty between all participants in market transactions to forgo actions based on material, nonpublic information.” Rather, under the “classical theory” of insider trading, corporate insiders who trade on material, nonpublic information may be held liable because they are deemed to have a “relationship of trust and confidence” with other shareholders that prohibits them from taking unfair advantage of their less informed counterparts.
Beyond taking advantage of nonpublic information to trade for his own account, a corporate insider (a tipper) may also face liability when, in breach of his fiduciary duties, he passes nonpublic information on to an outsider (a tippee) who then trades on that information before it becomes publicly available. In Dirks v. SEC, the 1983 decision that the Second Circuit addressed extensively in Newman, the Supreme Court held that an insider-tipper only breaches his fiduciary duty if he provides the tip for his own personal gain. To establish tippee liability, the Dirks Court held that the government must prove that the tipper “breached his fiduciary duty … and the tippee knows or should know that there has been a breach.”
In Newman, the defendant-portfolio managers received inside information not directly from Dell and NVIDIA insiders, but through multiple external analysts. The government argued that the defendants were liable under Dirks because, as “sophisticated traders,” the defendants knew or should have known that the Dell and NVIDIA employees had disclosed inside information in breach of their fiduciary duties. The defendants argued that they were not liable under Dirks because the government had not proven either that the Dell and NVIDIA employees received any personal benefits in exchange for disclosing inside information, or, even if they had, that the defendants knew of those personal benefits.
The Second Circuit agreed with the Newman defendants, holding that the government must prove both tipper benefit and tippee knowledge of that benefit. Furthermore, the Court held that the government must prove that the benefit to the tipper is “of some consequence,” and that intangible benefits such as “career advice,” which the government advocated in this case, do not suffice. The Second Circuit reversed the defendants’ convictions on the grounds that the District Court’s jury instructions were faulty and that there was insufficient evidence to convict under this more rigorous standard.
The government asks the Supreme Court to review Newman.
On July 30, the government sought Supreme Court review of the Newman decision, which the defendants opposed. The Court is expected to announce whether or not it will hear the case by early this fall. But, for now at least, Newman is the law and its impact has already been felt.
In the months immediately following the Second Circuit’s decision, federal courts across the country were inundated with petitions, of varying merit, to vacate pre-Newman convictions. More recently, Newman has impacted both judicial and administrative proceedings. For example, on September 11, U.S. District Judge Jed S. Rakoff adjourned the upcoming trial of two former brokers accused of improperly trading IBM stock until after the Supreme Court decides whether or not it will review the Second Circuit’s decision, noting that the case is a “much closer call in light of … Newman.” On September 14, an SEC administrative judge dismissed claims against a former Wells Fargo trader, holding, in part, that the SEC did not meet its burden of establishing that the trader’s tipper provided information in exchange for a personal benefit under Newman.
In recent years, government prosecutors have ramped up their efforts to crack down on insider trading, particularly in the Southern District of New York. In its Newman opinion, the Second Circuit criticized the government’s “recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders.” In its brief to the Supreme Court, the government criticized the Second Circuit’s decision as sending a message “that an insider may bestow secret corporate information on her friends and relations so long as she does not accept anything consequential in exchange.” These are both valid countervailing considerations for the Supreme Court, and perhaps Congress, to weigh.
If Newman stands, the DOJ and SEC may be expected to allocate fewer of their overstretched resources to prosecuting outsider-investors absent solid evidence of a close link between the investor and a corporate insider. If it falls, government prosecutors will likely resume their aggressive campaign against insider trading.
Additionally, a number of lawmakers have already responded harshly to Newman, proposing bills that would effectively overturn the Second Circuit’s decision and even expand insider trading law to impose a general duty on all market participants to forgo trading on nonpublic information. Thus, regardless of the Supreme Court’s decision, the debate over the appropriate contours of insider trading law will likely persist, and investors should tread with caution.
Mishcon de Reya New York is following these developments closely and is well-versed in insider-trading law and enforcement activities. Our lawyers have successfully represented clients in enforcement proceedings and investigations focused on insider-trading issues.