Personal Benefit Test Does Not Apply To Misappropriation Theory of Insider Trading — USAO
In U.S. v. Newman, Nos. 13-1837-cr, 13-1917, 2014 WL 6911278 (2nd Cir. Decided Dec. 10, 2014) the Second Circuit handed prosecutors perhaps the only defeat they have suffered in recent years in an insider trading cases. After noting that not a single criminal prosecution of tippees as remote as third and fourth tier tippees Todd Newman and Anthony Chiassons could be found, the Court reversed and dismissed their convictions. The predicate was the long established, but all but disappeared, personal benefit test of Dirks v. S.E.C., 463 U.S. 636 (1983).
Following Dirks, and distinguishing earlier Second Circuit cases which might appear to the contrary, the Court held that the elements of tippee liability are: “(1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his 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 . . .” That personal benefit, while broadly defined, must be more than “the mere fact of a friendship, particularly of a casual or social nature.” Rather, it is defined to include pecuniary gain and also reputational benefit that will translate into future earnings. This will require “evidence of a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the latter.”
There is no doubt that Newman may have a significant impact not just on criminal insider trading actions but also those of the SEC. The Manhattan U.S. Attorney’s Office, unaccustomed to losing insider trading cases, now claims, however, that Newman is limited to actions based on the classic theory of insider trading cases. Under this approach insider trading cases based on the misappropriation theory adopted in U.S. v. O’Hagan, 521 U.S. 642 (1997) would not be impacted by Newman.
The Government’s theory is being advanced in actions centered on the acquisition by IBM of SPSS, Inc., announced in July 2009. The Government’s Memorandum of Law In Support of The Sufficiency of the Defendants’ Guilty Pleas, dated Jan. 12, 2015, filed in U.S. v. Durant, Case No. 1:12-cr-00887 (S.D.N.Y.). Prior to that announcement Daryl Payton, Benjamin Durant, David Weishaus and Thomas Conradt were all stockbrokers employed in the Manhattan office of a Connecticut based securities trading firm. The information they obtained about the deal and used to trade traced to an attorney working on the acquisition. Collectively the defendants made over $1 million from trading in advance of the deal. Four of the five defendants pleaded guilty while one is awaiting trial. In pleading guilty each admitted to trading in SPSS securities based on inside information, stated that he understood the information traced to a breach of duty and that his actions were done knowingly and were wrong or illegal.
On a motion to vacate the guilty pleas based on Newman, the Government now argues that the Second Circuit’s decision is not applicable to misappropriation cases. This contention is based on what the Government claims is a distinction in the type of duty on which the classic and misappropriation theories of insider trading are based.
The classic theory of insider trading is based on “a relationship of trust and confidence between an insider and shareholders that gives rise to a duty to disclose or to abstain because of the necessity of preventing a corporate insider from taking unfair advantage of uninformed shareholders.” (internal quotations and citations omitted). Accordingly, Dirks requires that in order for an insider to have improperly disclosed the information he must do so based on a breach of that duty and for personal benefit. Under this approach the question of whether the insider obtained a benefit is part of the duty analysis, not because a benefit in and of itself is required. Rather, the benefit “evidences the improper motive necessary to give rise to liability for insider trading . . .” under the classic theory, according to the Government.
This contrasts with the duty on which the misappropriation theory is based. O’Hagan, which crafted the misappropriation theory, drew the duty from the Restatement (Second) of Agency. Under agency principles a “fiduciary breaches the duty not to misappropriate a principal’s confidential information whenever the fiduciary disclosed that information in competition with or to the injury of the principal.” (internal quotations omitted). This is because the fiduciary “has a duty not to use the information acquired for any purpose likely to cause the principal harm or to interfere with his or her business. This duty is distinct from that on which the classic theory is based since it is grounded in the protection of property rights in information and potential harm to the principal rather than self-dealing. Accordingly, the duty on which the misappropriation theory is based does not require proof of a personal benefit. This is consistent with decisions such as U.S. v Libera, 989 F. 2d 596 (2nd Cir. 1993) which held that the misappropriation theory protects property rights and SEC v. Materia, 745 F. 2d 197 (2nd Cir. 1984) which is similar, the Government argues.
The difficulty with this theory is not just Newman but also the Second Circuit’s decision in S.E.C. v. Obus, 693 F. 3d 276 (2nd Cir. 2012). The former specifically states that “the elements of tipping liability are the same, regardless of whether the tipper’s duty arises under the classic or the misappropriation theory.” Newman, 2014 WL 6911278, *4. Obus, which unlike Newman was based on the misappropriation theory, held that the elements of tippee liability include the personal benefit test, citing Obus. The statement in Newman is not controlling, according to the Government because “[i]t would be incorrect to read more into this one sentence than it can logically bear . . . it is also surely dicta . . .”
Obus lists a personal benefit as part of the elements of tippee liability. The Government, however, drew a distinction as to remote tippees: “Obus also makes plain that a downstream tippee need not know of any benefit to the tipper in order to have knowledge of the tippe’s breach . . . tippee liability is established if a tippee ‘knew . . that confidential information was initially obtained and transmitted improperly (and thus through deception), and if the tippee intentionally . . . traded while in knowing possession of that information.” The distinct duties on which the classic and misappropriation theories are based dictates a difference in tippee liability, according to the Government. The motions to vacate are pending.