Friends With Benefits: Second Circuit Overturns Newman And Chiasson Convictions And Raises The Government’s Burden In Insider Trading Cases Against Tippees

In a blow to insider trading prosecutions against downstream recipients of inside information, on Dec. 10 the U.S. Court of Appeals for the Second Circuit overturned the May 2013 convictions of Todd Newman and Anthony Chiasson (see related story, page 1711). In its watershed opinion, the court ruled that ''in order to sustain a conviction for insider trading, the Government must prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information in exchange for a personal benefit.'' Importantly, the court chided the government for the ''doctrinal novelty of its recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders.''

As a result of the ruling, both the Department of Justice and the Securities and Exchange Commission are likely to face significant hurdles to successfully prosecuting insider trading cases where the tippee is several degrees removed from the insider. These challenges could force the government to reconsider its aggressive approach toward downstream tippees.

Previously Muddled Standards for Establishing Tippee Liability

It is well-established that trading based upon material nonpublic information only violates Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10-b5 when that information was obtained in violation of a duty of trust and confidence owed to another party. See, e.g., Dirks v. SEC, 463 U.S. 646, 654-49 (1983). However, the standards for determining when a breach has occurred and when the tippee has knowledge of the breach have been unclear.

The genesis of the issue in United States v. Newman can be traced back to Dirks,1 which introduced a new analysis for determining when a breach of duty had occurred. Dirks was an officer of a broker-dealer who learned about fraud within a life insurance company, Equity Funding, from a former officer of the insurance company. Dirks alerted his clients to the fraud, and those clients sold their interests in Equity Funding. The court explained that whether an insider's disclosure of material nonpublic information constituted a breach of duty depends upon ''whether the insider will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. Absent a breach by the insider, there is no derivative breach.''2

Some commentators and litigants have read Dirks as reasoning that if one does not know of the tipper's personal gain, then one could not know of the tipper's breach. Thus, in their view, Dirks arguably requires that the government prove a tippee's knowledge of a benefit to the tipper who violated a fiduciary duty. Others, however, view Dirks as requiring the government to prove that the tipper received some benefit, but not prove that the tippee knew of that benefit. Lower courts have been inconsistent in their interpretations of Dirks, so it was unclear whether the government was required to prove a tippee's knowledge of the tipper's benefit when the tippee was several degrees removed from the tipper. In some cases within the Second Circuit, the court has required the government to demonstrate that a tippee knew of the benefit to the tipper.3 However, in other cases in the Second Circuit, courts did not mention that requirement.4

In 2012, the Second Circuit decided SEC v. Obus, a significant insider trading case, but did not explicitly address whether the government...