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News August 10, 2015 Issue

Supreme Court May Again Provide the Final Word on Insider Trading

The insider trading decision from last December’s ruling by a panel of the U.S. Court of Appeals for the Second Circuit must be sticking in the craw of U.S. attorney for the Southern District of New York Preet Bharara. The Department of Justice is asking the Supreme Court to reverse it.

Solicitor General Donald Verrilli, Jr. on July 30 filed an appeal with the Supreme Court, asking it to reverse the Second Circuit panel’s December 2014 decision that itself reversed a lower court’s verdict against hedge fund managers Todd Newman and Anthony Chiasson. In its ruling reversing their convictions, the Second Circuit also redefined what constitutes insider trading, something that has made prosecutions more difficult.

This will be Bharara’s second and, it would appear, final bite at the apple in terms of seeking a judicial reversal of the appellate panel’s decision. A petition to the full Second Circuit court to review the panel’s decision was denied without explanation by the court on April 10.

"This type of request from the Department of Justice is highly unusual and signals the department’s strong adverse reaction to the appellate court’s ruling," said Zaccaro Morgan partner Nicolas Morgan. "Because investment advisers often encounter information from sources that may be uncertain (and may be tempted to act on that knowledge for the benefit of their clients), the appeal and any Supreme Court ruling that may come out of it will have a direct impact on the risk of liability in this area. Given the importance of the issue, the Supreme Court is likely to grant review and provide much needed clarity to insider trading law."

"If the Supreme Court decides to hear the case, it is very likely they will reverse," said University of North Carolina School of Law professor Thomas Lee Hazen. While the Court could decide not to hear the case, the likelihood is that it will, as the conservative justices will want to preserve the precedents involving insider trading that the Second Circuit panel overturned, he said.

"The government wants to have more flexibility to use its own subjective judgment about whether a tip was made for a bad purpose, thereby reserving for itself the decision as to whether the tipper and/or the trader committed a crime," said Brown Rudnick partner Alex Lipman. "The Second Circuit ruling in Newman was an attempt to limit the government’s discretion by articulating an objective, judicially imposed test for separating instances where information was passed for a benign purpose from instances of deliberate fraud. The Second Circuit got it right. Prosecutors should have the ability to exercise prosecutorial discretion, but market participants need clarity about what conduct will or will not get them in trouble."

The Justice Department’s argument

Much of the central controversy stemming from the Second Circuit panel’s ruling, and the basis behind much of the Justice Department’s appeal, derives from the interpretation of a landmark 1983 Supreme Court case, Dirks v. SEC, which has been the guidepost  for many insider trading decisions to date. In its ruling overturning the Newman and Chiasson verdicts, the Second Circuit panel offered a different interpretation of Dirks than had been previously used by prosecutors.

The Second Circuit panel said, in effect, that a benefit received by a tipper would need to be quite tangible – more than simply friendship – for it to be considered a benefit given in return for material, non-public information. That interpretation is at the heart of the Justice Department’s appeal to the Supreme Court.

"The question presented is whether the Court of Appeals erroneously departed from this Court’s decision in Dirks by holding that liability under a gifting theory requires ‘proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential and represents at least a valuable gain of a pecuniary or similarly valuable nature,’" the Justice Department said in its appeal.

The Court of Appeals broke with the Supreme Court’s decision in Dirks, the Justice Department argued. The position taken by the appellate panel that insider trading requires an exchange that is of a more tangible nature than friendship "cannot be reconciled with Dirks, which did not require an ‘exchange’ and did not impose amorphous standards for the relationships that can support liability," it said. "The effect of the new rule will be to hurt market participants, disadvantage scrupulous market analysts, and impair the government’s ability to protect the fairness and integrity of the securities markets."

The Appeals Court’s exchange formulation "erases a form of personal benefit that the [Supreme] Court has specifically identified," the Justice Department continued in its writ. "Under Dirks, an inference of a personal benefit to the insider arises in two situations: when the insider expects something in return for the disclosure of the confidential information, or [emphasis Justice Department] when the insider freely gives a gift of  information to a trading friend or relative without an
expectation of receiving money or valuables as a result."

"If the personal-benefit test cannot be met by a gift-giver unless an ‘exchange’ takes place, then Dirks’ two categories of personal benefit are collapsed into one – and the entire ‘gift’ discussion in Dirks becomes superfluous," the Justice Department said.

What’s at stake

"The Justice Department is betting that the Supreme Court will see the rather plain inconsistencies between how the Second Circuit read the Dirks case in Newman and how Dirks actually reads," said Georgetown University law professor Donald Langevoort. "The risk is that the Court will be less bothered by that than by the inevitable speculation required of a jury, particularly in a criminal case, about what benefit the tipper was seeking and what the tippee knew or not, and find the Second Circuit’s modification of Dirks appealing. The extra risk is that the Court might go even further than the Second Circuit in refining the Dirks test, whether in criminal cases or all insider trading cases."

Hazen found merit in the Justice Department’s argument regarding an exchange. "The Second Circuit was clearly wrong when it said there had to be some personal benefit and that friendship was not enough," he said. "Dirks said that explicitly."

"Unless the Supreme Court says that ‘we were wrong in Dirks and we are going to change our minds here,’ a motivation of giving information as a gift is going to be sufficient," he said.

Morgan noted that "for cautious members of the investment adviser community, the practical effect may be minimal. Even if the Supreme Court clarifies that the Department of Justice must prove that a ‘remote tippee’ had knowledge of a personal, pecuniary benefit to the tipper in addition to knowledge that the trading was based on material, non-public information, very few fund portfolio managers are going to want to risk coming anywhere near that line."

"This Court’s intervention is warranted now," the Justice Department argued in its writ. "If allowed to stand, the Court of Appeals’ novel personal benefit standard will restrict enforcement of Section 10(b)’s ban on insider trading, create uncertainty in the financial community about the boundaries of legitimate conduct, and produce disparate results in different circuits in the application of the federal securities laws."