The Impact of Newman on SEC Enforcement: Part I
The Impact of Newman on SEC Enforcement: Part I
This is the first segment of a five part series discussing the impact of the Second Circuit’s ruling in Newman on SEC insider trading cases
In seeking rehearing and an en banc hearing before the Second Circuit Court of Appeals the Manhattan U.S. Attorney’s Office told the Court that the panel decision in U.S. v. Newman, Case Nos. 13-1837, 13-1917 (2nd Cir. December 10, 2014), would undermine the ability of law enforcement to effectively police the securities markets for insider trading. Petition of the United States of America for Rehearing and Rehearing En Banc, filed January 23, 2015 (“Petition for Rehearing”) at 22. The SEC, in an amicus brief, concurred. Brief for the Securities and Exchange Commission as Amicus Curiae Supporting the Petition of the United States for Rehearing or Rehearing En Banc, filed January 29, 2015 (“SEC Brief”) at 11. The Court denied the request for rehearing. Newman is the law, at least in the Second Circuit.
Unless Newman is overturned by the Supreme Court, the decision will remain the law in the Second Circuit and perhaps others in view of the Court’s influence in securities law. The impact of Newman thus becomes a critical issue for SEC enforcement. To assess the potential impact of Newman on SEC enforcement four key points should be considered: 1) the decision; 2) its impact on existing criminal and civil cases; 3) its impact on SEC cases; and 4) analysis.
The Decision in Newman
Todd Newman and Anthony Chiassons, remote tippees, three to four steps removed from the source of the inside information about pending earnings announcements for Dell, Inc. and NVIDIA, were convicted of insider trading. In reviewing their convictions the Second Circuit stated: “ We note that the Government has not cited, nor have we found, a single case in which tippees as remote as Newman and Chiasson have been held criminally liable for insider trading.” U.S. v. Newman, Nos. 13-1837-cr, 13-1917 (2nd Cir. Decided December 10, 2014). The Second Circuit drew a clear line regarding the requirements for tipper liability using the “personal benefit” test crafted for the protection of analysts by the Supreme Court in Dirks v. S.E.C., 463 U.S. 646 (1983). The convictions were reversed.
Todd Newman and Anthony Chaisson were portfolio managers at, respectively, Diamondback Capital Management, LLC and Level Global Investors, L.P. Both were convicted of insider trading in the shares of Dell and NVIDIA following a six week trial. Both were remote tippees. With regard to the trading in Dell, the inside information went down a chain: Company employee Rob Ray transmitted the earnings information to analyst Sandy Goyal, who in turn tipped Diamondback analyst Jesse Tortora who then told Mr. Newman and Global Level analyst Sam Adondukis who told Mr. Chaissom. Each portfolio manager traded.
The inside information regarding NVIDIA traveled a similar, lengthy path to the two portfolio managers. It began with company insider Hyung Lim who passed the information to Danny Kuno who furnished it to Messrs. Tortora and Adondukis who transmitted it to, respectively, Mr. Newman and Mr. Chaisson. Each portfolio manager traded in NVIDA shares.
At the close of the evidence each defendant made Rule 29 motions for acquittal, arguing that tippee liability derives from that of the tipper. Since here there was no evidence that the corporate insiders obtained a personal benefit the charges should be dismissed. The District Court reserved judgment and sent the case to the jury for consideration based on its instructions. The defendants argued that the jury charge on tippee liability should include the element of knowledge of a personal benefit received by the insider. The Court gave the jury an alternate instruction which stated in part that the Government had to prove that the insider “intentionally breached that duty of trust and confidence by disclosing material nonpublic information for their own benefit.” The instructions also stated that the defendant had to “know that it [the inside information] was originally disclosed by the insider in violation of a duty of confidentiality.” The jury found both defendants guilty of insider trading.
The Second Circuit disagreed. The Court held that the jury instructions were inadequate and that the evidence on tippee liability was insufficient. Accordingly, the convictions were reversed and the charges dismissed with prejudice.
The Court began its analysis by reviewing the basic tenants of the classical and misappropriation theories of insider trading. The elements of tipping liability are the same regardless of the theory utilized, according to the Court. Under Dirks the test for determining if there has been a breach of fiduciary duty is “’whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty . . .’” the Court stated, quoting Dirks. The tippee’s liability stems directly from that of the insider. Since the disclosure of inside information alone is not a breach, “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.”
In reaching its conclusion the Court held that “nothing in the law requires a symmetry of information in the nation’s securities markets.” That notion was repudiated years ago in Chiarella v. U.S., 445 U.S. 222 (1980). While efficient capital markets depend on the protection of property rights in information, they also “require that persons who acquire and act on information about companies be able to profit from the information they generate.” It is for this reason that both Chiarella and Dirks held that insider trading liability is based on breaches of fiduciary duty, not on “informational asymmetries.”
Based on these principles, the elements of tippee liability are: (1) the corporate insider had a fiduciary like 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. ..” Since the jury instructions did not incorporate these elements they were incorrect.
Finally, in reviewing the sufficiency of the evidence, the Court gave definition to the personal benefit test. That test is broadly defined to include pecuniary gain and also reputational benefit that will translate into future earnings and the benefit one would obtain from making a gift of confidential information to a relative or friend. While the test is broad it does not include, as the Government argued, “the mere fact of a friendship, particularly of a casual or social nature.” A personal benefit can be inferred from a personal relationship but “such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature. In other words . . . this requires 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.” (internal quotes omitted). Here the evidence is not sufficient to meet this test. The Second Circuit subsequently denied a motion for rehearing by the U.S. Attorney.