Author: Dan Stroh, Associate Member, University of Cincinnati Law Review
The phrase “insider trading” does not have a positive connotation. Despite the lack of an express provision prohibiting trading on insider information, insider trading has long been prosecuted under anti-fraud provisions found in securities law regulations.[1] A recent focus by the U.S. Attorney for the Southern District of New York, Preet Bharara, coupled with the conviction of a billionaire hedge fund manager, has brought renewed attention to this area of law.[2] Mr. Bharara’s presence in the press, combined with his record in policing insider trading, have so far been largely successful in policing conduct harmful to the general public.[3]
A recent ruling by the Second Circuit, however, threatens to undermine much of the work done by Mr. Bharara’s office. In United States v. Newman, a judge reversed the insider trading convictions of two traders with prejudice, declaring the guilty verdict unsupportable and barring the United States from retrying the defendants.[4] By departing from prior case law interpreting certain elements of fraudulent insider trading, the court put an abrupt stop to many of the prosecutions of insider trading, which has reverberated throughout the legal community. Because the decision affects not only the ability of the government to prosecute insider trading in the future but also threatens to undercut much of the work done by Mr. Bharara, whether this decision will stand as is or be reheard will have a significant impact on the landscape of securities law.[5]
Insider Trading as Securities Fraud: The Development of Insider Trading Prosecution
Despite not being explicitly addressed in securities law, insider trading has a long history of prosecution in the United States. Critics of insider trading claim that the practice harms the integrity of the marketplace for investors by offering significant advantages to those with non-public information about corporations.[6] This informational asymmetry creates an unfair advantage for the insiders. With the goal of much of securities law focused on full disclosure to ensure the same information is available to all investors, insider trading has long been seen as especially harmful to the efficient operation of capital markets.[7]
Prosecution of insider trading occurs under two separate provisions of securities law. Section 10(b) of the Securities Exchange Act of 1934 prohibits anyone involved in the sale or purchase of securities from using “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.”[8] SEC Rule 10b-5 proscribes investors from both “employ[ing] any device, scheme, or artifice to defraud” and “engag[ing] in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person . . . .”[9] As the rule is not explicit in its ban on insider trading, the law in this area has developed over time through judicial decisions rather than legislative changes.
The simplest and first-prosecuted form of insider trading involves a corporation’s directors, officers, or other employees making trades while in possession of information known only to insiders.[10] This knowledge and additional information gives insiders an upper hand when deciding when and how to invest, harming the public investor that the rules intend to protect by keeping all investors on a level informational playing field. In addition, an insider breaches fiduciary duties to the corporation by misusing information received only from their association with the corporation for their personal benefit. This is viewed as the “classical theory” of liability.[11]
The most common type of liability alleged in the cases prosecuted by Mr. Bharara is a derivative theory known as tipper liability. In this type of case, an insider (“the tipper”) passes the information obtained to an outsider (“the tippee”) in a breach of his duties to the corporation.[12] The tippee then uses this information to trade with an advantage. In SEC v. Dirks, the seminal case establishing tipping liability, the Supreme Court noted that there must be a personal benefit to the tipper in these situations to establish a breach.[13] Finally, to be liable for insider trading, the tippee receiving the information must know or should know that the information was obtained in a breach of fiduciary duty.[14] The Newman ruling most affected these last two elements as the court disagreed with the government on what qualifies as a personal benefit and what evidence is required to show that the information was received as a breach of an insider’s duty.
What Is a “Personal Benefit”?
The main question in many cases following Dirks has been what constitutes a personal benefit great enough to establish a breach. Obviously, in cases involving personal financial benefits for providing the tip, there is a breach. Personal benefits are not limited to immediate monetary gains. Cases since Dirks have clarified that on its own, simple intent by the tipper to benefit the tippee for the possibility of future profits—or many other types of value in the mind of the tipper—meets the personal benefit criterion.[15]
The decision in Newman significantly narrowed the scope of this reading of § 10(b) and Rule 10(b)-5. The court in Newman held, “the personal benefit received in exchange for confidential information must be of some consequence,” and therefore makes insider trading more difficult, if not impossible, to prove when there is little tangible benefit associated with the tip.[16] In Newman, the government alleged two different personal benefits were received in regard to two separate tips. In one situation, a tipper was alleged to have received career advice from a former business school colleague, with the tippee having received insider information.[17] The second tipper was only alleged to have a friendship with the tippee, with little else to support the personal benefit theory.[18] In dismissing these situations as conferring no personal benefit, the court placed limitations on the personal benefit theory of liability not present before this ruling.
However, these limitations are not supported by prior case law, as pointed out by the government in its petition for rehearing.[19] Specifically, the court in Newman misconstrued language in Dirks, the origin and authority for tipper-tippee liability.[20] In Dirks, the Supreme Court noted that a breach of fiduciary duty exists solely “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 profits to the recipient.”[21] By explicitly stating that the simple passing of information alone is enough to resemble direct insider trading, the Supreme Court clearly intended to allow the requirements for breach to be broadly construed. Despite not having a tangible benefit, a breach occurs solely through the tipper’s intent to pass the information.[22] By requiring that the breach involve a personal benefit of consequence, the Second Circuit has limited the liability of traders as tippees who do not pay or otherwise benefit a tipper despite still obtaining the informational advantage sought to be punished by insider trading. This break from the intent of the Supreme Court and the overall goal of preventing insider trading undermines prosecutors seeking to protect equal information in the markets.
Knowledge of the Breach: Can a Tippee Insulate Himself by Not Knowing a Direct Source?
In Newman, both insiders were several levels of tippers and tippees removed from the traders capitalizing on their inside information.[23] This distance meant that the defendants themselves did not personally know the identities of the tippers or of any personal benefits provided to the tippers.[24] This makes the prosecution’s ability to meet the final knowledge prong of liability difficult. Showing that the tippee knew of the insider’s breach of fiduciary duty requires that the tippee know both that an insider is disclosing the information and that the insider received a personal benefit. However, prior cases have not required the tippee to have actual knowledge of the insider-tipper’s breach of duty to be guilty of insider trading.[25] Instead, if evidence can show that tippees acting on insider knowledge should have known or consciously avoided knowing the source of insider information, they may still be convicted of insider trading.[26]
As a secondary result of the Newman court’s determination of the extent of “benefits,” the court ruled that there was no way the tippee could know of the benefits provided to the tipper. Even if the benefits met the higher standard determined in Newman, the multiple layers of tipper and tippees involved in this situation would make prosecution impossible because it would require the tippee’s actual knowledge of the benefits to tippers. Thus, the court reversed the conviction, deciding no reasonable jury could infer that the defendants knew or should have known of the breach.[27]
In Newman, the court placed an emphasis on the distance between the insider and the downstream tippee.[28] However, by emphasizing this fact, the court ignored other relevant facts from which a jury might have inferred that the defendants knew of a breach. In one instance, defendant Newman, the eventual tippee, funneled $175,000 to the wife of an analyst who received information in return for career advice to an insider, and passed that information to the defendant.[29] A different defendant and eventual tippee instructed an employee in touch with a tipper closer to the insider source to avoid having a paper trail and to create bogus trading reports specifically omitting the information obtained from the insider.[30] The court held that these facts did not establish any relevance to the eventual traders’ knowledge of a tipper giving the knowledge. While not conclusive, the dismissal entirely of the relevance of this exchange, despite past precedent allowing inferences to show knowledge, is improper because the appropriate focus should not be entirely on the original tipper’s benefits. The combination of the court’s reading of “personal benefits” to the insiders, along with the distance from insider to eventual tippee led the court to prohibit the government even from seeking a retrial under the newly created personal benefit test. While the main source of this problem is still the personal benefit test, this is an illustration of the difficulty that prosecutors will face if the standard introduced in Newman is upheld.
Rough Waters Ahead: The Difficulties of Righting the Ship
Prosecutors now face a more challenging road to convictions for insider trading under the tippee liability established in Dirks. Due to an improper understanding of the language of the Supreme Court’s decision in that case, the Second Circuit has placed a number of seemingly insurmountable hurdles in the path of prosecutors. Indeed, the U.S. Attorney’s office has already had to drop charges against four traders in a separate case because the evidence supporting those convictions will not meet the higher standard required by the Newman ruling.[31]
The higher standard of personal benefits requiring them to be of “some consequence” is not only unsupported by Dirks but actually is contrary to the language of the Supreme Court. In addition, by applying this standard and seemingly requiring actual knowledge, allowing the traders to distance themselves for plausible deniability, the court has gone too far in its reading of the elements of tippee liability. The court should grant a rehearing and revisit its reading of the prior case law. As the case is one of great importance to the future of insider trading liability, a greater clarification on why the court believes this is the proper reading is necessary at the least. If the reversal is upheld on rehearing, prosecutors should petition for certiorari from the Supreme Court to reinforce the standard that it set out in Dirks to allow for prosecutors to combat and convict insider traders preventing abuse unfair advantages in the marketplace.
[1] 4 Thomas Lee Hazen, Treatise on the Law of Securities Regulation, § 12.17 (2015). The antifraud provisions are found in the Securities Exchange Act § 10(b) and SEC Rule 10b-5. See 15 U.S.C.A. § 78j(b) and 17 C.F.R. § 240.10b–5.
[2] Benjamin Weiser and Peter Lattman, U.S. Attorney Sends Message to Wall Street, N.Y. Times DealBook, May 12, 2011 9:21 PM) http://dealbook.nytimes.com/2011/05/12/u-s-attorney-sends-a-message-to-wall-street/.
[3] Preet Bharara, Why Corporate Fraud Is So Rampant: Wall Street’s Cop, CNBC Business, (July 23, 2012 1:33 PM), http://www.cnbc.com/id/48286908; See also Matthew Goldsten and Ben Protess, U.S. Attorney Preet Bharara Challenges Insider Trading Ruling, NY Times Dealbook, (Jan. 23, 2015 5:45 PM). http://dealbook.nytimes.com/2015/01/23/u-s-attorney-preet-bharara-to-challenge-insider-trading-ruling/ (Stating Mr. Bharara’s prior insider trading prosecutions resulting in over 80 convictions).
[4] 773 F.3d 438 (2d Cir. N.Y. 2014), petition for reh’g and reh’g en banc filed Jan. 23, 2015.
[5] Peter J. Henning, Fallout Builds From Ruling on Insider Trading, N.Y. Times DealBook (Jan. 20, 2015 12:32 PM), http://dealbook.nytimes.com/2015/01/20/fallout-from-insider-trading-ruling/?_r=0.
[6] Hazen, supra note 1, at § 12.17[1] (2015).
[7] Id.
[8] 15 U.S.C. § 78j(b).
[9] 17 CFR § 240.10b-5.
[10] Hazen, supra note 1, at § 12.17[1] (2015).
[11] Id.
[12] Id.
[13] Dirks v. SEC, 463 U.S. 646, 662 (1983). The novel circumstances involved in Dirks deserve mentioning here as well. In Dirks an insider sought to expose fraud within his corporation and disclosed the inside information to reporters in an effort to be a whistleblower. The Supreme Court expressly stated that there was no monetary or personal benefit received and that he was motivated by a desire to expose the fraud. This appears to have played a role in the Supreme Court requiring that an individual accused of insider trading have some benefit for a breach of confidentiality.
[14] Dirks at 662.
[15] See United States v Jiau, 734 F.3d 147, 153 (2d Cir. 1998). (desire to avoid “relentless pestering,” the simple desire to solidify a friendship, and access gained to an investment club meet the personal benefit test.); SEC v Warde, 151 F.3d 42, 49 (2d Cir. 1998) (stating that gifts from the profits of the trade is a personal benefit).
[16] United States v. Newman, 773 F.3d 438, 438 (2d Cir. N.Y. 2014).
[17] Newman, 773 F.3d at 453.
[18] Id.
[19] Petition for Rehearing at 11, Newman, 773 F.3d 438 (2015) (No. 13-1837).
[20]See Hazen, supra note 1 at § 12.17[5] (2015).
[21] Dirks at 664.
[22] Dirks at 664.
[23] The Court notes that the defendants were three and four levels removed in the chain of tipping. Newman at 443.
[24] Newman, 773 F.3d at 453-454.
[25] Hazen, supra note 1, at § 12.17[5] (2015).
[26] Id.; Dirks at 660.
[27] Newman, 773 F.3d at 455.
[28] Newman, 773 F.3d at 454.
[29] Petition for Rehearing 20, Newman, 773 F.3d 438, (2015) (No. 13-1837). $175,000 was but a small portion of the $4,000,000 earned by that defendant.
[30] Id.
[31] Nate Raymond, U.S. Prosecutor to Drop Insider Trading Charges over IBM Deal, Reuters, http://www.reuters.com/article/2015/01/29/us-usa-insidertrading-ibm-idUSKBN0L21J420150129.
