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News January 26, 2015 Issue

Appeals Court Ruling on Insider Trading May Not Be the Final Word

It’s not over until it’s over – and that includes the staying power of last month’s landmark decision by the Second Circuit of the U.S. Court of Appeals that sharply narrowed the definition of what constitutes insider trading.

The December 10 decision by a three-judge panel of the Second Circuit in United States of America v. Todd Newman and Anthony Chiasson, which reversed the convictions and threw out the indictments of two hedge fund portfolio managers, rewriting insider trading case law in doing so, may be challenged in a number of ways. These include:

  • Reconsideration or appeal of the case. The U.S. Attorney’s Office for the Southern District of New York, which brought the prosecution of the two portfolio managers, as of January 23 was planning to file for a rehearing before the Second Circuit to reconsider the case, a spokesperson for the U.S. Attorney’s Office said. Prosecution of insider trading was overly aggressive prior to the ruling, said Georgetown University law professor Donald Langevoort, but the Second Circuit decision language was "unusually strong and may have gone too far in the eyes of some other judges on the court given language in prior opinions." As for an appeal to the U.S. Supreme Court, Langevoort said that the boldness of the ruling was the Second Circuit "sending a decision that ‘we’re in control of the process now, there is no need for the Supreme Court to get involved.’" From the Second Circuit’s point of view, the Supreme Court Justices have less experience on the topic of insider trading than the Second Circuit has.
  • Criminal, not civil. Given that the original case involved criminal, not civil, charges, the SEC may take the position that the decision primarily affects Justice Department or U.S. Attorney’s Offices, and not the many civil cases the Commission brings, said University of Michigan law professor Adam Pritchard. "It wouldn’t be surprising for U.S. attorneys to lay low for a bit while the SEC moved forward," he said. The Commission "is not going to abandon its court cases," and may try to "cabin" the ruling so it applies only to criminal cases.
  • Defense counsel arguments. The SEC is most likely "already getting requests from defense counsel" using the Second Circuit’s decision to challenge insider trading cases that have been brought or are about to be brought, Langevoort said. One argument likely to be raised by defense attorneys in challenging these cases, said Pritchard, is that the information shared by a tipper was "sufficiently distant" from the tippee, since the Second Circuit said that for insider trading to occur, tippees must know they are trading on information obtained from insiders in violation of those insiders’ fiduciary duties. DLA Piper partner Nicolas Morgan suggested that "cases to watch will be 1) criminal or civil cases with similar facts brought in courts outside the Second Circuit in which the SEC or U.S. Attorney’s Office argues that the Second Circuit got it wrong in Newman, 2) criminal cases within the Second Circuit with slightly different facts that try to distinguish them from Newman, and 3) SEC cases in the Second Circuit that try to argue Newman doesn’t apply to civil insider trading claims."
  • Rulemaking. The SEC could always choose to write a rule legally defining just what insider trading is and when it is prohibited, said Sidley Austin partner Nader Salehi, as it is not explicitly prohibited in a federal statute. Whether the SEC will choose to do so, however, given its current workload that includes enacting Dodd-Frank mandates, is another question.

The Appeals Court decision

The Second Circuit, in a unanimous 28-page decision from the three-judge panel, ruled in favor of defendants Newman and Chiasson, portfolio managers for, respectively, former hedge funds

Diamondback Capital Management and Level Global Investors, who were charged with insider trading and conspiracy to commit insider trading (ACA Insight, 12/15/14). In reversing the guilty verdicts from U.S. Attorney’s Office, the appellate court said that the district court judge had provided "erroneous jury instructions" and that "the evidence was insufficient to sustain a guilty verdict." The verdict not only relieved the defendants of the burden of pending jail terms and hefty fines, but set tight standards for just what will constitute insider trading in the future.

"Because the government failed to present sufficient evidence that the defendants willfully engaged in substantive insider trading or a conspiracy to commit insider trading in violation of the federal securities laws, we reverse Newman and Chiasson’s convictions and remand with instructions to dismiss the indictment as it pertains to them with prejudice," wrote judge

Barrington Parker, who authored the decision.

In siding with the defendants, the Second Circuit threw out the government’s premise that the mere receipt of material, non-public information is, in and of itself, insider trading. It instead substituted a tighter definition of insider trading that requires the following:

Evidence of personal benefits received by the insiders who passed on the information. Tippee liability derives from tipper liability, and without proof that the tipper personally benefitted, there is no tippee liability, according to the decision.

  • Evidence that the tippees knew they were trading on information obtained from insiders in violation of those insiders’ fiduciary duties. The government presented no evidence in this regard, according to the decision. In fact, in a detailed analysis of the chain of the information passage, the Second Circuit concluded that the portfolio managers were "three and four levels removed from the insider tipper" in one case and "four levels removed" in the other.


Knowledge and benefits

There are two lessons from the Newman case, said Langevoort, with one of them – that the tippee must have knowledge of a personal benefit received by the tipper – understood by most parties. "That was not a surprise, as many lower court judges anticipated there would be a ruling like this," he said, adding that, as a result, not that many cases will be affected, since the judges likely would have wanted to see evidence of a personal benefit in any event.

The other lesson, what Langevoort referred to as the "wild card," is the question of what constitutes a benefit. The Second Circuit relied on what Langevoort believes is an excessively narrow reading of part of the 1983 U.S. Supreme Court case, Dirks v. the SEC

, considered to be a benchmark for insider trading cases. The Second Circuit ruling said, in effect, that a benefit received by a tipper would have to be "so strong that it has to be almost like money" for it to be considered a benefit given in return for material, non-public information.

For instance, consider this language from the Second Circuit decision:

"To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades ‘resemble trading by the insider himself followed by a gift of the profits to the recipient’ [quoting from case law], we hold that such an inference is impermissible in the absence of proof of 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."

However, according to Langevoort, this is not the usual reading of Dirks, which he said actually "leaves more leeway as to when a gift counts as a benefit." In addition, Dirks uses the words "know or should know" in terms of a tippee’s recognition of confidential information when he or she receives it, something that also provides a wider net for prosecutors. "The SEC has plenty of arguments it can make," he said.