In a ground-breaking decision, the Second Circuit dealt a substantial blow to federal prosecutors’ epic crackdown on insider trading by raising the bar for the government’s burden of proof in “remote tippee” cases that have plagued the financial industry in recent years.
The decision in United States v. Newman (available here) places significant restrictions on the ability of prosecutors to impose liability on so-called remote tippees, or individuals who trade on inside information, but have at least one layer between them and the corporate insider who initially disclosed the tip. Such was the case in Newman, where the defendants—hedge fund managers who placed the allegedly infringing trades—were several layers removed from the corporate insiders who had first disclosed the material nonpublic information. At the district court level, the government obtained convictions of the defendants based in part on jury instructions requiring the jury to find that (1) corporate insiders breached their fiduciary duties by disclosing material non-public information for their own benefit; and (2) that the defendants knew that confidential information had been disclosed in breach of this duty. On appeal, the defendants asserted that the jury instructions were wrong, in that they should have required a finding that defendants also knew that a personal benefit had been obtained by the corporate insiders in exchange for releasing the confidential information.
On Wednesday, a unanimous Second Circuit panel agreed with the defendants, holding that to be guilty of insider trading, a remote tippee must not only have knowledge that a corporate insider breached his fiduciary duty not to disclose confidential information, but also have knowledge that the corporate insider did so in exchange for a personal benefit. This decision resolves a previous ambiguity that the government had sought to capitalize on in Newman: whether the tipper’s derivation of a personal benefit is what actually creates the breach of duty. The government argued that personal benefit is a separate element of the tipper’s insider trading offense, and thus it could establish that the tippee knew of the insider’s breach, without necessarily establishing that the tippee knew the insider did so in exchange for a personal benefit.
In rejecting the government’s stance on this question, the Newman court held that under a long line of precedential insider trading cases, “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.” Thus, the government cannot establish that the tippee knew of the insider’s breach without showing that the tippee knew about the personal benefit received by the insider.
Moreover, the Second Circuit rejected the government’s contention that given the detailed nature and accuracy of the information obtained by the defendants, they must have known (or deliberately avoided learning) that the information came from corporate insiders, and that the insiders must have disclosed the information in exchange for a personal benefit. Rather, the court explained that the evidence failed to support such a conclusion, and noted that a government witness testified that in the absence of any inside information, financial analysts had already run models that approximated the same information that was leaked by the corporate insider.
Regarding the personal benefit itself, the court found that the circumstantial evidence was too thin to even warrant an inference that the corporate insiders received a personal benefit in exchange for disclosing confidential information. The government’s evidence suggested friendships between the insiders and the individuals they initially leaked the information to, but the court rebuked that if that was the “benefit,” then “practically anything would qualify.” Instead, the court stated that the alleged personal benefit must entail at least the potential of pecuniary or a similarly valuable gain—or, as the Second Circuit noted in United States v. Jiau, a relationship between the insider and the recipient that suggests a “quid pro quo.”
New Standard for Tippee Liability under Newman
In sum, Newman sets forth a new framework for establishing insider trading cases, as it hold that prosecutors must prove each of the following elements beyond a reasonable doubt to establish tippee liability:
- A fiduciary duty on the part of a corporate insider;
- A breach of the fiduciary duty by the corporate insider by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit;
- The tippee knew of the tipper’s breach; that is, he knew the information was confidential and divulged for personal benefit; and
- The tippee still used that information to trade in a security or tip another individual for personal benefit.
The implications of the Newman decision are wide-reaching, and most imminently may impact the recent conviction of SAC Capital portfolio manager Michael Steinberg. Steinberg was convicted of securities fraud in December 2013 based on his trades in the same stocks as the Newman defendants, also based on information that he received through the same tipping chain at issue in Newman. In a post-trial motion for acquittal, the Steinberg district court largely rejected the defendant’s argument that the government must establish that the tippee knew of a personal benefit to the insider who initially disclosed the information.
Going forward, courts and juries in remote tippee cases may also have to grapple with questions about the level of knowledge a tippee must have about the personal benefit; what evidence will be sufficient to demonstrate such knowledge; and what will be the outer bounds on circumstantial evidence used by the government to establish the tippee’s knowledge of the personal benefit.