Second Circuit Raises the Bar in Insider Trading Cases
A federal appellate court in New York City has raised the bar on the Government’s burden of proof in criminal insider trading cases.
United States v. Newman and Chiasson, Nos. 13-1837-dr (L), 13-1917-cr (con), U.S.C.A., 2d Cir., December 10, 2014, held that the Government must prove that the Defendant had knowledge that the insider who disclosed the inside information was gaining a personal benefit from the disclosure.
The defendants, Todd Newman and Anthony Chiasson, were portfolio managers at hedge funds. They obtained early inside information regarding the quarterly earnings of Dell and NVIDIA, and traded profitably on that information in advance of public earning announcements. Their combined profit in Dell stock was roughly $4 million and in NVIDIA stock was roughly $68 million. Newman and Chiasson were convicted at a jury trial of criminal insider trading, in violation of SEC Rule 10b-5. That Rule prohibits the use of any fraudulent device or scheme in connection with the purchase or sale of securities.
Newman and Chiasson were each “remote tippees,” that is, the inside information they traded on was passed through a number of other persons in the securities industry before it reached them. The chain of who-told-whom for each corporation was the following:
Dell → Rob Ray → Sandy Goyal → Jesse Tortora → Newman → Spyridon Adondakis → Chiasson
NVIDIA → Chris Choi → Hyung Lim → Danny Kuo → Tortora and Adondakis → Newman and Chiasson
Newman and Chiasson had clearly traded on the inside information. The issue before the Second Circuit involved whether they had the essential mens rea to be guilty of a criminal violation of Rule 10b-5.
Rule 10b-5 analysis is complicated by the principle, stated in Dirks v. S.E.C., 463 U.S. 646 (1983), that not all trading on material inside information results in 10b-5 liability. Generally, a company employee has a fiduciary duty under Rule 10b-5 not to trade in the company’s securities based on material inside information, and a further duty not to disclose material information (that is, not to “tip”) another person who will trade in the company’s securities based on that information. In Dirks, however, a company insider wanted to expose fraud at his company, and told a securities analyst. The Supreme Court held that a Rule 10b-5 violation required the insider to benefit personally from the disclosure; in the absence of a personal benefit, the insider in Dirks could tip the securities analyst and the securities analyst could legally trade on that information.
In Newman, the Government had proven that the corporate insiders had in fact violated their duty of confidentiality. But what the Government had not proven was that the defendants, who were remote tippees of the insiders, knew that the tippers (the insiders) had received a personal benefit. The Second Circuit held that this absence defeated the Government’s case. According to the Second Circuit the elements of a criminal 10b 5 case are:
(1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade in a security or tip another individual for a personal benefit.
Newman, at *18. The Second Circuit stated that the “personal benefit” must be at least a potential gain of a pecuniary or similarly valuable nature, and the mere fact of a friendship will not be sufficient.
A remarkable difference in the Newman case from most insider trading cases is that the corporate insiders, the “tippers” who first breached confidentiality, told their friends (who were the next links in the chain) about the inside information without any pecuniary or other valuable benefit in return, but apparently just because they were friends.
The Second Circuit in Newman stressed repeatedly that the circumstances surrounding a stock tip can be sufficient to inform a trader that the stock tip came from an insider who breached a duty of confidentiality in return for a personal benefit. But the holding in Newman shows that this is not always the case. The Newman decision will make it more difficult for the Government to achieve criminal convictions at the outer reaches of multi-layer “tipping” schemes. It should be noted, however, that Newman did not address the elements of civil liability for insider trading, for which the considerations are different.
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