On December 10, 2014, the United States Court of Appeals for the Second Circuit reversed the convictions of two hedge fund managers for insider trading and conspiracy to commit insider trading. The Second Circuit’s opinion in U.S. v. Newman significantly narrowed the definition of insider trading and made it more difficult for prosecutors to pursue remote tippees in a “chain” of tippees.
The Court in its opinion restated its view of the standards for a tippee insider trading criminal case: “(1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and disclosed for personal benefit; and (4) the tippee still used the information to trade in a security or tip another individual for personal benefit.”
The central issues on appeal were whether the personal benefits to the corporate insiders were legally sufficient and whether a jury was required to find that the tippees had knowledge that the original tippers had received personal benefits in exchange for the information they disclosed.
The Court’s Decision
On the first question, the Court found that the circumstantial evidence in this case was too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips, and noted that the “mere fact of a friendship, particularly of a casual or social nature” is insufficient to draw this inference. The Court held that, in order to demonstrate the requisite personal benefit (where there is no obvious quid pro quo between the tipper and tippee), the Government must adduce 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.” This clarification of the benefit standard likely will affect cases involving both direct as well as remote tippees.
As to the second question, the Court held that the Government was required to prove that the defendants knew that the insider-tippers received a personal benefit. The Court explained that without establishing that the tippee knew of the personal benefit, the Government cannot meet its burden of showing that the tippee knew of the breach of fiduciary duty (a required element of insider trading claims), which is important because the receipt of a personal benefit is the fiduciary breach that triggers liability for insider trading. Thus, under the Newman case, absent a tippee-defendant’s knowledge of the personal benefit to the tipper – or her “conscious avoidance” of learning of the personal benefit – there is no liability for insider trading, at least in the criminal context.
The Second Circuit’s decision regarding the significance of the “personal benefit” standard may make it more difficult for the Government to bring insider trading cases based on tipping. The Government may now be more wary about bringing insider trading cases (even for direct as opposed to remote tippees) if it cannot allege a concrete quid pro quo involving a personal benefit to the tipper.
Similarly, by requiring that the tippee have knowledge of the personal benefit to the tipper, the Second Circuit now has made it significantly more difficult for the Government to bring insider trading cases against tippees and, in particular, against remote tippees. In fact, on December 15, 2014, the Securities and Exchange Commission moved to dismiss civil insider trading claims previously filed against tippee Jordan Peixoto, accused of receiving confidential information from the tipper-roommate of an analyst at Pershing Square Capital Management LP in advance of the investment firm’s public presentation about Herbalife Ltd. While the Securities and Exchange Commission has stated that it moved to dismiss the charges because two witnesses will not be available to testify at the March 2015 trial, it is very possible that the Newman decision played a significant role in the decision to drop the action against Peixoto.
A Final Note
The impact of the Second Circuit’s decision is limited in several ways. Newman is a criminal case, and the standard there is more exacting than in a civil action, where the plaintiff need not prove liability “beyond a reasonable doubt” and need show only that the defendant knew or should have known of the personal benefit to the original tipper. In addition, the opinion has precedential effect in only the Second Circuit, which includes New York, Connecticut and Vermont. This fact means that prosecutors bringing cases in other U.S. jurisdictions may not be required to prove that the tipper received a consequential benefit of a quid pro quo nature or that the tippee knew of the benefit. We expect that the contours of the new status quo in insider trading law will become clearer as district courts begin applying the Second Circuit’s analysis and other judicial circuits respond to the decision in the months and years to come.