A Legal Heads-Up on Insider Trading Prosecutions

Finally, there's a little relief for attorneys like me who routinely defend insider trading cases in federal courts here in MA, throughout NE, in NY and elsewhere! The Second Circuit Court of Appeals, which was once described as the "Mother Court" for securities law by late Supreme Court (SCOTUS) Justice Harry Blackmun, recently decided a case which will have the effect of limiting the Department of Justice's ability to bring criminal actions against so-called "insider traders." In U.S. v. Newman, No. 13-1837, two defendants appealed their convictions of conspiracy to commit insider trading in violation of 18 U.S.C. § 371 (the general federal conspiracy statute, alternatively referred to as "Klein Conspiracy"), sections 10(b) and 32 of the Securities Exchange Act of 1934, and SEC Rules 10b-5 and 10b5-2. (As a practice tip, most insider trading cases are charged as Securities Fraud under 18 USC § 1348). The defendants, who were portfolio managers for certain hedge funds, were alleged to have received information from financial analysts who worked at their respective hedge funds about the earnings of two tech companies (Dell and NVIDIA) prior to the release of the tech companies' earnings to the public. The evidence suggested these financial analysts received this "insider information" from persons working within Dell and NVIDIA.

In "classic" insider trading cases, allegations tend to involve persons who work within a corporation/company who receive material nonpublic information about that corporation and then perform trades, i.e. on the stock market, based on that nonpublic information. This is considered illegal because, for the most part, those persons working within a corporation who obtain/act on insider information about that corporation owe a duty of "trust and confidence" to the shareholders of the corporation. This duty of trust and confidence is deemed violated because the insider is viewed as unfairly taking advantage of his position within the corporation. Despite this general application, it's important for any lawyer who defends insider trading cases to be aware that SCOTUS has already rejected the broad idea there is "a general duty between all participants in market transactions to forgo actions based on material, nonpublic information." Instead, what is essential to the "classic" insider trading case is the existence of a "relationship of trust and confidence" between the insider and the shareholders of the corporation. See Dirks v. SEC, 463 U.S. 646 (1983).

A slightly modified version of the "classic" insider trading case occurs when the insider does not, himself or herself, trade on the inside information, but instead gives that information to an outsider (a "tippee") who then trades on the basis of the insider information before that information is publicly disclosed. In these situations, the insider, or "tipper," can be liable if he or she "personally will benefit, directly or indirectly, from his disclosure" of the insider information. The tippee can likewise be liable if he traded on the insider information, if the following two conditions are met: (1) the tipper is liable; and (2) the tippee "knew or should have known" the tipper was breaching his fiduciary duty to the shareholders of the corporation.

All of which brings us back to the Newman case. There, the defendants who had their convictions overturned, were alleged "tippees" (i.e. persons who received a "tip" from an insider), and the persons within Dell and NVIDIA from whom they received this information were the alleged "tippers." The question for the Second Circuit in Newman was whether the defendant/tippees had to know the insider/tipper received a personal benefit from disclosure of the inside information. In its decision, the Second Circuit held they, in fact, do have to have such knowledge, which both effectively adds another element of proof and substantially enhances the evidentiary burden placed on the government when prosecuting such cases.

After deciding this central question, the Second Circuit went three steps further. First, they clarified what type of evidence is required to establish the "personal benefit" received by the tipper. When the government attempted to argue that the "personal benefit" received by the tippers amounted to a "reputational benefit" because the tippers either went to the same school, were friends with, or went to the same church as some of the tippees, the Court ruled this kind of evidence to be insufficient; instead, there must be a "meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature." Second, the Court affirmatively imposed the additional requirement that the government prove the tippee knew or should have known that the information the defendants received came from an insider. (In Newman the "insider information" was "of a nature regularly and accurately predicted by analyst modeling" (i.e. projected earnings for certain months of Dell and NVIDIA). Accordingly, it was not "sufficiently detailed and proprietary to permit an inference that the tippee knew that the information came from an inside source.) Third, the Court required the government to have concrete evidence the tippee they are prosecuting actually knew about the personal benefit received by the tipper upon giving the tip. (Importantly, the tippees in Newman were "three or four levels removed from the inside tipper" – the tipper gave the information to an analyst, who in turn gave it to another person within the defendant's hedge fund, who in turn gave it to the defendants.) In response to the defendant's position (which the Second Circuit adopted in its opinion) that the government was required to prove that the defendants actually knew about the personal benefit received by the tipper, the government argued the evidence it presented at trial was sufficient to establish that the tippees should have known the tippers were receiving a personal benefit in light of the nature of the tip. The Second Circuit disagreed and said the government's evidence fell well short as nothing more than "bare facts."

In sum, the Second Circuit's decision in Newman did four important things that make it substantially more difficult for the government to both charge and prove insider trading criminal cases: first, it added an additional element to prove "tippee" liability which now requires the government to prove actual knowledge by the tippee of the tipper's personal benefit for giving a tip; second, it required the government to prove more than a mere friendship between the tippee and tipper to establish a "reputational benefit" which can be used to satisfy the "personal benefit" element of tipper liability; third it required the government to prove that the tippee actually knew the information received was "insider information" if the information received is "regularly and accurately predicted" by analysts; and fourth Newman signaled to prosecutors they have to have some form of concrete evidence to establish the tippee's knowledge of the tipper's personal benefit for giving the tip.

While still possibly subject to further challenge, Newman potentially changes the landscape around how insider trading cases premised on tippee liability must now be prosecuted. At a minimum, the decision will prompt the government to think twice before it seeks to criminally charge those who may or may not have been involved in insider trading. At its maximum, it may also spare innocent or unwitting information sharers, or "water-cooler gossipers," from the heartbreak, indignity, and/or calamity of unjust prosecutions.

Finally, if the Second Circuit is indeed "the Mother Court" for Insider Trading cases, Preet Bharara, the U.S. Attorney for the Southern District of NY (where most of these cases are prosecuted—and where I am also licensed to practice), can properly be called the "Father of Insider Trading Prosecutions"). In the Bailey household the standing maxim is "Mom rules." My prediction is SCOTUS will feel the same way about Newman.