On December 10, the US Court of Appeals for the Second Circuit issued an opinion in United States v. Newman1 that could be the most consequential insider trading decision in a generation, but for reasons that virtually no one anticipated. In short, the Newman decision held (i) that a tippee can be liable for insider trading only if he or she has knowledge that the (corporate insider) tipper obtained a personal benefit, and (ii) that the evidence was insufficient to establish that any personal benefit existed, much less that it was known to the tippees.
In Newman, the Court of Appeals reviewed the insider trading convictions of Todd Newman and Anthony Chiasson, portfolio managers at two different hedge funds. The government maintained that insiders at publicly traded technology companies shared material non-public information with analysts at various investment firms and hedge funds who shared the information among themselves and ultimately passed the information to the portfolio managers at their firms, including Newman and Chiasson, who then allegedly traded based on it. In other words, Newman and Chiasson were alleged recipients of material non-public information ("tippees" in the parlance of insider trading law) three or four levels removed from the sources of the information, and there was no evidence that they were aware of those sources. The issue presented on appeal was the degree of knowledge required by remote tippees like Newman and Chiasson in order to hold them liable for insider trading.
Below, we review the legal landscape leading up to the court's decision in Newman and analyze it in light of US Supreme Court and Second Circuit precedent. We then conclude with some practical considerations.
Background Case Law
The seminal decision regarding insider trading liability for tippers and tippees is Dirks v. SEC.2 In Dirks, the Supreme Court announced several principles of insider trading law relevant to defendants such as Newman and Chiasson. First, the Court made clear that the liability, if any, of a tippee is derivative of that of the tipper.3 Second, a tipper is liable for insider trading only if he or she disclosed information in breach of a fiduciary duty.4 The Dirks Court made clear that a breach of a fiduciary duty is proven only if information was disclosed in breach of a duty of confidentiality and for the personal benefit of the tipper.5 In other words, the personal benefit requirement is not a separate element of an insider trading offense, but rather a showing required to establish the breach of the fiduciary duty element. Third, the Supreme Court provided examples of the requisite personal benefit. As the Court explained, personal benefit to the tipper can be shown where the tipper has a sufficiently close personal relationship with the tippee such that the tip could be viewed as the functional equivalent of a monetary gift to a friend, or where the tip was part of a quid pro quo in which the tipper provided the information in return for something of value.6 Fourth, the Supreme Court appeared to suggest that something short of actual knowledge by the tippee concerning the tipper's breach of fiduciary duty would be sufficient to establish liability on the part of the tippee. Specifically, the Court stated that a tippee would be liable if he or she "knew or should know" of the tipper's breach of fiduciary duty.7
Two years ago, the Second Circuit issued a decision in SEC v. Obus,8 in which the court examined, among other things, the degree of knowledge required on the part of a tippee in order to give rise to insider trading liability. In Obus, the SEC charged a corporate executive with insider trading based on allegations that he tipped a friend from college who was a hedge fund analyst regarding a financing transaction on which the corporate executive was working. The hedge fund analyst then relayed the information to his boss, who allegedly traded based on the information. The district court granted summary judgment in favor of the defendants, holding that the corporate executive had not breached any duty to his employer, and thus neither the hedge fund analyst nor his boss could be derivatively liable. What is more, the district court ruled that the SEC failed to present any evidence that the hedge fund analyst's boss "subjectively believed that the information he received was obtained in breach of a fiduciary duty."9
The SEC appealed the grant of summary judgment to the Second Circuit, which reversed. Critically, the Obus court defined insider trading liability for tippers by dividing the breach of fiduciary element into two separate elements, holding that the SEC must prove that the tipper "(1) tip[ped] (2) material non-public information (3) in breach of a fiduciary duty of confidentiality owed to shareholders (classical theory) or the source of the information (misappropriation theory) (4) for the personal benefit of the tipper."10 With regard to the personal benefit requirement, the Obus court stated—consistent with Dirks—that it could be proven with evidence "not only of 'pecuniary gain,' such as a cut of the take or a gratuity from the tippee, but also a 'reputational benefit' or the benefit one would obtain from simply 'mak[ing] a gift of confidential information to a trading relative or friend.'"11 The court ruled that the tipper and tippee being "friends from college" was sufficient to send the personal benefit question to the jury.12
With regard to tippee liability, the Obus court went on to state that the SEC must prove, as Dirks held, that the tippee "knew or should have known" that the tipper had breached "a fiduciary duty" by relaying the information.13 Elsewhere, the court stated that the SEC must prove that "the tippee knew or had reason to know that the tipper improperly obtained the information."14 The court held that there was evidence from which a jury could infer that the hedge fund analyst's boss knew or should have known that the corporate executive had "breached a duty" in disclosing the information at issue to the hedge fund analyst.15 But because the Obus court had treated the personal benefit requirement as distinct from the breach of fiduciary duty element, it is not clear that the court considered whether there was evidence from which the jury also could infer that the hedge fund analyst's boss knew that the corporate executive had received a personal benefit in exchange for his tip.16 One reading of Obus is that the court held that the SEC must prove that the tippee knew of the personal benefit when it stated that the tippee must know that tipper "improperly obtained the information." But the issue was arguably left open in Obus.17
In Newman, the district court squarely addressed the issue of whether the government must prove that the defendant knew that the tipper received some personal benefit from his or her disclosure. The district court instructed the jury that it need only find that the disclosure was in violation of a duty of confidentiality; the instruction made no mention of a requirement that the tippee knew (or even should have known) that the tipper would receive some personal benefit for his disclosure. After being convicted at trial, defendants Newman and Chiasson appealed, challenging the jury instructions and also arguing that there was insufficient evidence of their knowledge of any personal benefit flowing to the original tipper, who was several steps removed from them. The Court of Appeals reversed the convictions, holding both that (i) the district court erred in failing to instruct the jury that, in order to return a guilty verdict, it must find that the defendant-tippees knew of the original tippers' receipt of a personal benefit and (ii) the evidence was insufficient not only as to the defendants' knowledge of any personal benefit but also on the question of whether the tippers even received a personal benefit.
With regard to the knowledge element, the Court of Appeals noted that Dirks had conditioned tippee liability on knowledge that there had been a breach of a fiduciary duty.18 The Second Circuit then went on to explain that Dirks counsels us that the exchange of confidential information for personal benefit is not separate from an insider's fiduciary breach; it is the fiduciary breach that triggers liability for securities fraud under Rule 10b-5. For purposes of insider trading liability, the insider's disclosure of confidential information, standing alone, is not a breach. Thus, without establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the Government cannot meet its burden of showing that the tippee knew of a breach.19
In other words, while the Obus decision had separated the personal benefit requirement from the breach of fiduciary duty element, the Newman court recognized that they were one and the same under Dirks. Accordingly, Dirks' requirement that a tippee have knowledge of the breach of fiduciary duty in order to be liable necessarily meant that the tippee must be aware not only of the disclosure of confidential information but also that such disclosure was made for the personal benefit of the tipper. The question was one of first impression for the Second Circuit, but the court's holding is not surprising in and of itself.
The Second Circuit, however, did not simply reverse and remand for a retrial based on the flaw in the district court's jury instruction on the knowledge element. Instead, the court then considered whether the evidence was sufficient to establish such knowledge. Rather than rule only that the evidence of the tippee's knowledge was insufficient, the court went further still and ruled that the evidence at trial was insufficient to establish the existence of any personal benefit to the tipper at the top of the tipping chain. It is here that the Court of Appeals' ruling is of significant consequence. In particular, the court held that the government may not "prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature."20 The court went on to explain that if "the Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity."21 Rather, the Second Circuit explained, an inference of personal benefit is "impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, andrepresents at least a potential gain of a pecuniary or similarly valuable nature."22 The court continued, stating that "[w]hile our case law at times emphasizes language from Dirks indicating that the tipper's gain need not be immediately pecuniary, it does not erode the fundamental insight that, in order to form the basis for a fraudulent breach, the personal benefit received in exchange for the confidential information must be of some consequence."23 Taken literally, the Newman decision would seem to require that, in order to prove the requisite personal benefit, the government must show that the tipper received (or had the potential to receive), directly or indirectly, some financial or similarly consequential benefit in exchange for the tip.
Practical Considerations Going Forward
There is little doubt that the Newman decision is of great consequence in the development of the law of insider trading. We discuss below several practical considerations that firms should consider in light of the Newman opinion:
First, the Newman decision provides defendants in insider trading cases with a significant weapon to use against attenuated personal benefit theories advanced by the SEC and DOJ in insider trading prosecutions. At a minimum, the decision makes clear that casual relationships amounting to little more than acquaintances will not suffice to establish the type of close personal relationship that the Dirks court envisioned.
Second, at least in the Second Circuit, it is likely that the knowledge requirement announced in Newman will be binding in civil SEC cases as well. The court's holding turned on its reading of the Section 10(b) scienter element as articulated in Dirks (which was itself an SEC case), not on the willfulness element of a criminal prosecution. Because the scienter element also applies in an SEC case, there is no reason to think that the knowledge of personal benefit requirement would not also apply in a civil case brought by the SEC. It should be noted, however, that the SEC (at least in the Second Circuit) can establish scienter by showing reckless disregard for the truth,24 which is something short of actual knowledge.
Third, the Newman holding regarding the required knowledge on the part of tippees should be read cautiously given the willful blindness doctrine. The Dirks opinion states that tippees are liable to the extent they know or "should know" of the breach of fiduciary duty (including the receipt of a personal benefit) by the tipper. While the "should know" language arguably is dicta, the DOJ or SEC could argue that the knowledge requirement has been met where even a remote tippee turns a blind eye to the personal benefit received by the tipper.
Fourth, because the Newman decision is only binding law in the Second Circuit, there is a risk that either the DOJ or, more likely, the SEC will pursue cases in other circuits on the theory that the knowledge requirement announced in Newman is an incorrect interpretation of Dirks. In particular, the SEC has greater flexibility than the US Attorney's Offices in New York to file its cases in any district with venue and in which the Newman decision would not be binding precedent. While the Newman decision would be persuasive precedent in defending against an insider trading case brought in another district, it would not be binding. Thus, we think that, for now, it would be unwise to rely on the knowledge requirement for tippee liability as announced in Newman as a basis for trading in securities when the trader knows there has been a breach of duty but does not have detailed information about the tipper's motive, at least until additional courts have spoken on this issue.
1 --- F.3d at ---, 2014 WL 6911278 (2d Cir. Dec. 10, 2014).
2 463 U.S. 646 (1983).
3Id. at 659 ("Thus, the tippee's duty to disclose or abstain is derivative from that of the insider's duty.").
4Id. at 660 (holding that "a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee").
5Id. at 661-62 ("All disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders….Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure. This standard was identified by the SEC itself in Cady, Roberts: a purpose of the securities laws was to eliminate the use of inside information for personal advantage. Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach." (internal quotation marks and citations omitted)).
6Id. at 664 ("For example, there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient. The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.").
7Id. at 660 (Thus, a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.).
8 693 F.3d 276 (2d Cir. 2012).
9Id. at 284 (internal quotation marks omitted).
10Id. at 286.
11Id. at 285 (quoting Dirks, 463 U.S. at 663-64).
12Id. at 291 ("Here, the undisputed fact that Strickland and Black were friends from college is sufficient to send to the jury the question of whether Strickland received a benefit from tipping Black.").
13Id. at 292.
14Id. at 289.
15Id. at 293.
16 See id. at 292-93.
17 On remand, the three defendants were found not liable of insider trading after a jury trial.
18Newman, --- F.3d ---, 2014 WL 6911278, at *6.
20Id. at *10.
22Id. (emphasis added).
23Id. (emphasis in original).
24Obus, 693 F.3d at 286.