Insider Trading: High Court's Refusal to Review Leaves Uncharted Path Forward
The U.S. Supreme Courtís refusal to review a lower court ruling that redefined insider trading creates an uncertain legal world. Defense attorneys and their clients may take comfort from the higher hurdles some prosecutors may now have to jump over to bring such cases, but all parties will need to get used to a new playing field as practice takes hold.
The Supreme Court on October 5 chose, without comment, not to review the December 2014 decision by the U.S. Court of Appeals for the Second Circuit that tossed out the insider trading convictions of two hedge fund managers, Todd Newman and Anthony Chiasson. The Department of Justice this past July had filed an appeal with the top court, asking that the lower court decision be reversed Ė but the Supreme Courtís refusal to take up the request means that Justice Department prosecutors will need to live within the confines of the Second Circuit ruling.
"My suspicion is that it will take a couple of years before we can say whether Newman will have had a profound impact of the law, or was instead just part of its ebb and flow," said Georgetown University law professor Donald Langevoort. Investment advisers, he suggested, "should by no means take this to suggest that inside edges can be extracted with impunity."
Nor is this necessarily the end of the road. "It may just be a refusal to review right now," said University of Michigan law professor Adam Pritchard. "There will be plenty of opportunities down the road, and the Court may want to see how things develop in those cases."
The Second Circuit ruling, in addition to overturning the convictions of Newman and Chiasson, changed the definition of what constitutes insider trading in two critical ways:
What constitutes a benefit. Under the Second Circuit ruling, a benefit received by a tipper would need to be quite tangible Ė more than simply friendship Ė for it to be considered a benefit given in return for†material, non-public information. Previously, based on the landmark 1983 Supreme Court case of Dirks v. SEC, an insider providing inside information to a trading friend or relative without an expectation of something tangible in return was nonetheless considered to be receiving a benefit. That interpretation was at the heart of the Justice Departmentís appeal to the Supreme Court.
What a tippee knows. The Second Circuit also ruled that there must be evidence to prove that a tippee knew he or she was trading on information obtained from an insider in violation of the insiderís fiduciary duty. The Department of Justice did not challenge this part of the ruling, however.
"Many things will now happen," Langevoort said. "Courts of appeal outside of the Second Circuit will continue to offer their own opinions about the meaning of personal benefit and the standard for tipper-tippee liability. Even inside the Second Circuit, courts will have to address whether the standards for liability vary when the case is brought as a civil action by the SEC rather than by criminal prosecutors."
Zaccaro Morgan partner Nicolas Morgan said there is some uncertainty as to whether the Newman standard applies in civil SEC cases. "One indication that Newman does apply in SEC cases came earlier this year from one of the SECís own administrative law judges when he concluded that the standard did apply," he said. "That said, the SEC Division of Enforcement has appealed that ALJís decision and may take the opposite view in cases filed in federal court, so the issue may remain unsettled for some time until courts bring greater clarity."
"The SEC and Department of Justice likely are going to try to narrow Newman as much as possible," said University of North Carolina School of Law professor Thomas Lee Hazen. "It is unclear whether the holding that friendship alone is not sufficient can be limited to criminal cases with the higher burden of proof. Also, even in criminal cases there may be an attempt to narrow Newman to its facts where there was a remote tippee and the friendship may not have been more†casual than close. Perhaps a showing of a closer personal friendship might have led to a different result."
The Supreme Courtís refusal to review must be particularly stinging to U.S. attorney for the Southern District of New York Preet Bharara, who has built his career as a prosecutor in part on pursuit of insider trading by hedge funds. The appeal to the Supreme Court was his second attempt at review. An April 2015 appeal for review to the full Second Circuit also went nowhere, when the Second Circuit, like the high court, chose not to review.
Attorneys defending against insider trading prosecution welcomed the Supreme Court development.
"By declining to consider the Second Circuitís well-reasoned decision, the Supreme Courtís action reinforces the clarity the Newman decision provides for insider trading cases and places appropriate checks on the prosecution of tenuous insider trading cases by zealous prosecutors," said Morgan.
Brown Rudnick partner Alex Lipman said that the primary result of the Supreme Courtís refusal to review is that prosecutors will need to "put on more evidence of bad intent" when bringing insider trading cases. Prior to the Second Circuit ruling, prosecutors routinely based their charging decisions on their subjective view of whether a set of facts constituted insider trading. "Now they will have to look primarily at the objective facts," he said. "The government will need to put on objective evidence to prove that the sharing of information was for a bad purpose."
As a result, "the government is going to have a harder time proving the cases on the margins," he said. But he also is of the opinion that this will not mean fewer insider trading cases, as both the Department of Justice and the SEC will simply focus on developing additional facts needed to meet the new standards.
Advisers take note
Should investment advisers be more lenient in terms of monitoring for insider trading in their firms as a result of the Supreme Court not reviewing the Second Circuit ruling? Better think twice before taking such a course.
"If an adviser is in possession of information that he or she knows is material, non-public information obtained directly or indirectly from an insider, itís hard to imagine a chief compliance officer advising anything other than extreme caution in trading on that information," said Morgan. "To conclude, based on Newman, that itís okay to trade because the person providing the information did not receive a pecuniary benefit would be very aggressive advice, to say the least. Just because a legal theory would make an excellent defense at trial, permitting conduct that comes anywhere close to an ill-defined legal line is not advisable."
Advisory firms "should not change a thing" in terms of how they monitor for and detect insider trading, Lipman said. "I wouldnít relax."