The Gray Area between Friend and Fiduciary
In a landmark decision, the United States Court of Appeals for the Second Circuit, an influential court in securities litigation, provided clarity on the elements required to hold a tippee liable for insider trading. The decision by the Second Circuit on December 10, 2014 to reverse the charges, with prejudice, in United States v. Todd Newman, Anthony Chiasson sets a new definition for who can be held liable for insider trading. Before Newman,, insider trading was broadly defined. This decision narrows the scope. The Government now must tangibly prove whether an investment professional knew that information had been disclosed in breach of a fiduciary duty in exchange for a personal benefit. The Government’s impending efforts to combat and thwart those tippees who are alleged to be involved in insider trading activities now must first determine, and later prove, whether the material nonpublic information was obtained from a friend with benefits.
Todd Newman and Anthony Chiasson, hedge-fund portfolio managers, were accused of involvement in the exchange and disclosure of material non-public information. The Government in the 2012 six-week trial presented evidence that company insiders at Dell and NVIDIA had disclosed non-public earnings numbers with a group of financial analysts, who then allegedly passed the inside information on to their portfolio managers, which included Todd Newman and Anthony Chaisson. Those portfolio managers subsequently executed equity trades in Dell and NVIDIA, earning millions of dollars in profits. As a result of these trades, Todd Newman and Anthony Chiasson were convicted on December 17, 2012 of securities fraud in violation of sections 10(b) and 32 of the Securities Exchange Act of 1934, Securities and Exchange Commission (SEC) Rules 10(b)(5) and 10(b)(5)(2), and conspiracy to commit securities fraud in violation of 18 U.S.C. § 371.
The Second Circuit, however, overturned the convictions on December 10, 2014. The Court ruled that in order to convict these portfolio managers, or tippees, there had to be proof beyond a reasonable doubt that an insider breached his or her fiduciary duty to shareholders by disclosing material nonpublic information in exchange for a “personal benefit.” Providing further clarification, the Court stated that “personal benefit” must be “objective, consequential, and represent[ing] at least a potential gain of pecuniary or similarly valuable nature” eliminating the mere “fact of a friendship, particularly of a casual or social nature.” Specifically, the Court of Appeals held that the government must prove each of the following elements beyond a reasonable doubt to convict a tippee of insider trading: “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.”
Newman and Chiasson, as it stood, were several steps removed from the corporate insiders who initially disclosed the information. Thus, the Government failed to present evidence that either defendant was aware of the source of the inside information or that they received a personal benefit, as defined by the Second Circuit.
Prior Rulings and Historical Background
Three Supreme Court decisions, as well as recent SEC rules, precisely influenced and shaped insider trading law and the Newman decision. The first was Chiarella v. United States, which gave the “classical theory” of insider trading liability, limiting the scope of liability to corporate insiders or those who work directly for a company, such as its lawyers and investment bankers. Defendants only violate that law if they violate their duty of trust and confidence to the company whose shares were traded by misusing information material non-public information. Expanding the definitions of liability and giving us the “misappropriation theory,” the Court in United States v. O’Hagan ruled anyone who obtains information from their employer and trades the information in any stock, can be found guilty of insider trading, so long as they have been entrusted with the information in confidence. Finally, the Supreme Court affirmed in its ruling in Dirks v. Securities Exchange Commission that a tippee holds a fiduciary duty to the shareholders. That duty arises “when a insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know there has been a breach.” Dirks, 463 U.S. at 660. The Courts are left with the discretion to determine whether the tipper received a personal benefit to determine if the tipper breached a fiduciary duty, and if the tippee knew of this breach of fiduciary duty.
The SEC also adopted three new rules in October of 2000: 1.) Regulation Fair Disclosure addressing the selective disclosure by issuers of material nonpublic information; 2.) Rule 10(b)(5)(1) regarding when insider trading liability arises in connection with a trader’s “use” or “knowing possession” of material nonpublic information; and most importantly in Newman, 3.) Rule 10(b)(5)(2), when the breach of a family or other non-business relationship may give rise to liability under the misappropriation theory of insider trading. These were important in the effort to help set the standard for those who could be found guilty of illegal insider trading.
The Court ruled in United States v. Todd Newman, Anthony Chiasson, based on the holding in Dirks, 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 10(b)(5). For purposes of insider trading liability, the insider’s disclosure of confidential information, standing alone, is not a breach.”
This redefining of what terms the Government can hold tippees liable for illegal insider trading will have a vast impact on many of the recent prosecutions which have been brought against investment professions removed from the source of the information. Though only time will tell the magnitude this decision will have on prosecuting those involved in securities fraud, the decision could have an immediate impact on both the Department of Justice and the Securities and Exchange Commission (SEC). Last month in California, however, a federal judge denied a motion to dismiss insider trading charges based on Newman. James Mazzo, the CEO and Chairman of the Board of a medical device company, was accused of having provided material non-public information about potential mergers to a friend, former Baltimore Orioles player Doug DeCinces, who traded on the information. Central District Court Judge Andrew Guilford denied the motion to dismiss.
On the other hand, following Newman, four guilty pleas in the Southern District of New York were vacated in United States v. Durant. In that case, the judge ruled that the Newman decision and its heightened standard for tippee liability applies to insider trading cases based on misappropriation cases in addition to cases based on the classical theory of insider trading. Because the defendants, in their guilty pleas, had not admitted to knowledge that the tipper received a personal benefit, the court vacated the pleas.
We will likely continue to see in the near future the Courts with pending litigation involving illegal insider trading reevaluate whether an investment professional knew that information had been disclosed in breach of a fiduciary duty in exchange for a personal benefit, and of course, prosecutors reconsider whether to bring charges against certain tippees.
Though only time can fully reveal the impacts the Newman holding will have on the securities trade industry, the grounds are already shifting. Most likely in future litigation, the Government will have more difficultly convicting those removed from the source of the information unless there is proof of knowledge of a specific personal benefit to the tipper. If the tippees, those individuals such as Todd Newman and Anthony Chiasson, had no prior knowledge of the personal benefit gained from the leaked information, then similarly situated tippees should not be held to a standard to act solely in the shareholder’s interest. Newman narrowed the scope of liability for those who can be held accountable for insider trading, making it more difficult to convict those without proof that the tippee was involved in a situation of friends with benefits.