Last week, a federal appeals court reversed two key insider trading convictions, in a decision which made it clear the government did not prove that a crime was committed. More importantly, the court’s decision could have major implications on prosecutors’ ability to win insider trading cases in the future.
Background of Case
This case arises from the Government’s investigation over the past few years into suspected insider trading activity at hedge funds. At the initial trial in 2012, the Government presented evidence that a group of buy-side analysts exchanged material non-public information they had obtained from company insiders.
The Government alleged that these analysts received information from corporate insiders at Dell and NVIDIA disclosing those companies’ quarterly earnings before they were publicly released at various times in 2008. These analysts passed the inside information to their portfolio managers, including Todd Newman of hedge fund Diamondback Capital Management and Anthony Chiasson of Level Global Advisors. These managers in turn, executed trades in Dell and NVIDIA stock, earning approximately $4 million and $68 million, respectively, in profits for their respective funds.
In December 2012, Chiasson and Newman were found guilty of insider trading. Subsequently, in May 2013, U.S. District Judge Richard Sullivan sentenced Newman to 54 months in prison and Chiasson received 78 months for their roles in what the prosecutor called a “criminal club” that netted them more than $70 million in illegal profits.
Appeals Court Decision
In its stunning 28 page decision, United States Court of Appeals for the Second Circuit in Manhattan overturned two of the government’s insider trading convictions, against hedge fund managers Todd Newman and Anthony Chiasson.
The unanimous decision by a three-judge panel was the first time that United States attorney in Manhattan, Preet Bharara, had one of his insider trading convictions overturned. The appeal court’s rationale for this decision was based on two factors — an error by the trial judge in his jury instruction and insufficient evidence on the part of the government.
“We agree that the jury instruction was erroneous because we conclude that, in order to sustain a conviction for insider trading, the Government must prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit. Moreover, we hold that the evidence was insufficient to sustain a guilty verdict against Newman and Chiasson for two reasons. First, the Government’s evidence of any personal benefit received by the alleged insiders was insufficient to establish the tipper liability from which defendants’ purported tippee liability would derive. Second, even assuming that the scant evidence offered on the issue of personal benefit was sufficient, which we conclude it was not, the Government presented no evidence that Newman and Chiasson knew that they were trading on information obtained from insiders in violation of those insiders’ fiduciary duties.”
In its ruling, the appeals court consistently cited its reading of the US Supreme Court case Dirks vs. the SEC which has long been used in understanding the courts’ view of insider trading. However, the appeals court went farther in its ruling to create a more defined line when assessing insider trading liability.
“In sum, we hold that to sustain an insider trading conviction against a tippee, the Government must prove each of the following elements beyond a reasonable doubt: that (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 divulged for personal benefit; and (4) the tippee still used that information to trade in a security or tip another individual for personal benefit.”
The appeals court felt the government failed to prove all of these facts beyond a reasonable doubt. Consequently, the three judge panel not only reversed the convictions, but they threw out the cases altogether.
In addition, the Second Circuit Court of Appeals attacked the Government’s contention that simply obtaining and trading on material nonpublic information was in itself enough to constitute a crime.
“Although the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets. The Supreme Court explicitly repudiated this premise not only in Dirks, but in a predecessor case, Chiarella v. United States. In Chiarella, the Supreme Court rejected this Circuit’s conclusion that ‘the federal securities laws have created a system providing equal access to information necessary for reasoned and intelligent investment decisions . . . . because [material non‐public] information gives certain buyers or sellers an unfair advantage over less informed buyers and sellers.’ 445 U.S. at 232. The Supreme Court emphasized that ‘[t]his reasoning suffers from [a] defect. . . . [because] not every instance of financial unfairness constitutes fraudulent activity under § 10(b).’”
Potential Impact of the Decision
The response to this decision has been extreme from both prosecutors and defense attorneys. On the one hand, prosecutors feel the appeal court’s decision will make it extremely difficult to prove insider trading cases – particularly when tippees are far removed from tippers as it will be difficult to prove that the tippees knew what benefits the tippers received to provide material nonpublic information.
In a public statement, US attorney Preet Bharara said that the appeal court’s ruling “interprets the securities laws in a way that will limit the ability to prosecute people who trade on leaked inside information.” Mr. Bharara said he was still evaluating the ruling and was considering appealing it to the Supreme Court.
Defense attorneys, however cheer the clarity that the appeals court provided in its decision regarding what the government must prove to win an insider trading case.
Some also suggest that the appeals court ruling could be extremely good news for other insider trading cases awaiting appeal. Michael Steinberg, of SAC Capital Advisors was also convicted of insider trading last year, and the judge who provided “erroneous instructions” to the jurors in Newman’s and Chiasson’s trial was the same who presided over Steinberg’s case — Judge Richard J. Sullivan. In that case, Steinberg was also far removed from the sources of the material nonpublic information.
The dismissal of the case against Mr. Chiasson and Mr. Newman could also lead to other dismissals — particularly those of cooperating witnesses who pleaded guilty to trading on the same material nonpublic information obtained from Dell and Nvidia insiders. The reason these reversals might occur is because the appeals court concluded that not only were Mr. Chiasson and Mr. Newman unaware that insiders had received a benefit, but that no such benefit had ever existed. This means that no insider trading took place.
It is important to note that there is no actual legislative statute which specifically addresses insider trading or makes it illegal. Rather, courts have interpreted the general law against securities fraud and have applied it to prohibit “insider trading”. Unfortunately, over the years the courts have not made it clear exactly what it takes for a tippee to be found guilty of insider trading.
The appeals court’s reversal of Mr. Chiasson and Mr. Newman’s insider trading convictions are important as this decision makes it clearer when a tippee is liable. This decision is also likely to have a significant impact on the government’s ability to prove insider trading cases when the purported tippee is not directly connected with the tipper because it will be harder to prove that a tippee knows that the tipper breached his/her fiduciary duty by receiving a benefit to provide this inside information.
In addition, the appeal’s court made it clear that the Government could not rely on the argument sometimes used that a “benefit” is being bestowed merely as a result of the tipper and tippee being friends. The appeals court clearly highlighted that a fraudulent breach of fiduciary duty could not be proven unless the personal benefit received by the tipper in exchange for the confidential information is of “some consequence”.
Ultimately, we feel that if the appeals court decision stands, prosecutors will be limited in their ability to win insider trading cases unless the tipper and tippee directly interact, or unless the tippee is clearly aware that the tipper breached his/her fiduciary duty by receiving a meaningful benefit, and despite knowing this the tippee still traded on the inside information.
We also see this case as important as it clearly outlines that a tippee IS NOT guilty of insider trading even if he/she obtains material nonpublic information AND ALSO trades on it. Merely profiting from an informational advantage IS NOT the basis for criminal action. Instead, a tippee is only guilty of insider trading if he/she provides a substantial benefit to the tipper to encourage him/her to breach their fiduciary duty by providing this inside information to the tippee, and then the tippee trades on this information.
Despite what many people beleive (including numerous regulators and journalists), hedge fund investors can still discover and profit from informational advantages without fear of being charged with a criminal activity.