Second Circuit Narrows the Government’s Ability to Prosecute Insider Trading

December 10, 2014

On December 10, 2014, in United States v. Newman, the Second Circuit reversed the insider trading convictions of defendants Todd Newman and Anthony Chiasson. Overturning a 2012 jury trial conviction in the United States District Court for the Southern District of New York, the Second Circuit held that an individual may be found liable for trading on inside information only when he knows that the insider supplying the information to him or her is receiving a benefit for the disclosure.

Newman, a portfolio manager at Diamondback Capital Management, LLC, and Chiasson, a portfolio manager at Level Global Investors, L.P., were prosecuted for allegedly trading Dell and NVIDIA stock based on inside information regarding the companies' earnings before they were publicly reported. As a result of these trades, Newman and Chiasson made profits of approximately $4 million and $68 million, respectively.

Although Newman and Chiasson were several steps removed from the original source of the inside information, the Government contended that they were liable for insider trading because they were sophisticated traders and, therefore, they must have known that the inside sources who leaked the information were breaching a fiduciary duty to their respective corporations.

Prior to deliberation, the court instructed the jury that they must "consider whether the [G]overnment has proven beyond a reasonable doubt that [the insiders] intentionally breached that duty of trust and confidence by disclosing material[,] nonpublic information for their own benefit" and that the defendants "knew that the material, nonpublic information had been disclosed by the insider in breach of a duty of trust and confidence."

On December 17, 2012, after a six-week trial, the jury found that Newman and Chiasson were guilty of conspiracy to commit insider trading and insider trading. Subsequently, the court sentenced Newman to 54 months' imprisonment and Chiasson to 78 months' imprisonment. Both individuals were also given hefty fines.

Second Circuit Decision
On appeal, the Second Circuit held that "the jury instructions were erroneous and that there was insufficient evidence to support the convictions." Accordingly, the Court overturned Newman's and Chiasson's convictions.

In explaining its reasoning, the Court first articulated the standard from the United States Supreme Court decision, Dirks v. SEC, that applies to "tipping liability": "The test for determining whether the corporate insider has breached his fiduciary duty 'is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty . . . .'" Moreover, the Court explained that one who receives inside information, the tippee, may only be found liable when the "insider has breached his fiduciary duty . . . and the tippee knows or should know that there has been a breach."

Based on the well-settled law in Dirks, the Court found that Newman and Chiasson could not be found liable because they did not have knowledge of personal benefit to the inside sources at Dell and NVIDIA, even if knew that the sources were breaching a fiduciary duty.

In reaching its conclusion, the Court held that "a tippee's knowledge of the insider's breach necessarily requires knowledge that the insider disclosed confidential information in exchange for personal benefit." Because the district court did not instruct the jury that they could convict the defendants of insider trading only if they found the defendants must have known that the sources received a personal benefit, the erroneous jury instruction tainted the jury's decision. The Court concluded that "the Government has not cited, nor have we found, a single case in which tippees as remote as Newman and Chiasson have been held criminally liable for insider trading."

Finally, the Court pointed out that the Government presented a dearth of evidence to suggest that the corporate sources of information, the tippers, received a personal benefit in exchange for their disclosure. In past cases the Government often argued that mere "friendship" between the tipper and tippee is enough to satisfy the requirement that the tipper received a benefit but today the Court found that "the personal benefit received in exchange for confidential information must be of some consequence." The Court further noted, that even if evidence exists that the tipper received a personal benefit, the Government failed to introduce any evidence whatsoever that Newman or Chiasson were aware that the insiders received any benefit in exchange for the confidential information.

In conclusion, the Court found that "the bare facts in support of the Government's theory of the case are as consistent with an inference of innocence as one of guilt," and therefore, the prosecution failed to prove its case beyond a reasonable doubt.

A Significant Limitation on the Government's Ability to Prosecute Insider Trading
This ruling represents a significant blow to the Government's recent attempts to expand insider trading liability. The decision will make it much harder for prosecutors to prove that a tipper received a personal benefit for passing along insider information. The decision will also shield remote tippees from criminal liability for trading on information later determined to be inside information.

The Securities, Futures and Derivatives Litigation Group at Herrick, Feinstein LLP is here to advise you on the implications of critical legal decisions as they enter the regulatory landscape. For more information on the issues in this alert, please contact:

Arthur G. Jakoby at +1 212 592 1438 or [email protected]

© 2014 Herrick, Feinstein LLP. This alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.