On December 10, 2014, the Second Circuit issued an important decision (U.S. v. Newman, No. 13-1837, 2014 WL 6911278 (2d Cir. Dec. 10, 2014)) that will make it more difficult in that Circuit for prosecutors, and most likely the SEC, to prevail on a “tippee” theory of insider trading liability. Characterizing the government’s recent tippee insider trading prosecutions as “novel” in targeting “remote tippees many levels removed from corporate insiders,” the court reversed the convictions of two investment fund managers upon concluding that the lower court gave erroneous jury instructions and finding insufficient evidence to sustain the convictions. The court held, contrary to the government’s position, that tippee liability requires that the tippee trade on information he or she knows to have been disclosed by the tipper: (i) in violation of a fiduciary duty, and (ii) in exchange for a meaningful personal benefit. Absent such knowledge, the tippee is not liable for trading on the information.

Tippee liability differs from “classical” or “misappropriation” theories of insider trading, where the person trading on inside information is a corporate insider or one who misappropriates non-public information from a company. A tippee’s liability, in contrast, “derives only” from the insider’s fiduciary duty and not from trading on inside information. As articulated in 1983 by the Supreme Court in Dirks v. SEC, 463 U.S. 646, 647 (1983), tippee liability requires that: (i) the tipper “has breached his fiduciary duty to the shareholders by disclosing the [material nonpublic] information to the tippee”; (ii) the tippee “knows or should know that there has been a breach”; (iii) the tippee trades on the basis of the transaction; and (iv) the tipper receives some personal benefit in return for the disclosure.

Newman arose out of the U.S. Attorney’s Office for the Southern District of New York’s high-profile probe into suspected insider trading at hedge funds. In January 2012, that Office brought insider trading and conspiracy charges against Todd Newman and Anthony Chiasson, portfolio managers at two hedge funds, Diamondback Capital Management and Level Global Investors. According to the government, lower-level financial analysts at Diamondback and Level Global received nonpublic earnings information from insiders at two public technology companies, and passed this information on to their portfolio managers (including Newman and Chiasson), who then executed trades on the basis of this information. The prosecution of Newman and Chiasson was noteworthy given the remoteness of the defendants from the corporate insiders: the earnings information was passed through several third-party analysts before it came to anyone at Diamondback or Level Global, meaning that Newman and Chiasson were three or four levels removed from the inside tippers.

At trial, the defendants moved for a judgment of acquittal, arguing that the government had offered no evidence that the corporate insiders provided the information “in exchange for a personal benefit,” and even if they had, there was no evidence that Newman or Chiasson knew about it. Alternatively, defendants requested a jury instruction that, to prevail, the government must have proved that Newman and Chiasson knew that the tipper disclosed confidential information “for personal benefit.” The district court (Judge Richard Sullivan, S.D.N.Y.) denied the motion for a judgment of acquittal, and rejected defendants’ requested instruction. Instead, the court instructed the jury that, in order to obtain a conviction, the prosecution must only prove that defendants knew the information was disclosed “in violation of a duty of confidentiality.” The jury returned a verdict of guilty on all counts, and in May of last year, the court sentenced Newman and Chiasson to prison for more than four and six years, respectively, and imposed multi-million dollar fines and forfeitures. The defendants appealed.

In its opinion, the Second Circuit vacated Newman and Chiasson’s convictions. First, the appellate court found that an insider breaches a fiduciary duty only when he or she discloses inside information in exchange for a personal benefit. In other words, the exchange of confidential information for personal benefit is not separate from the breach, but instead “is the fiduciary breach.” As a result, the rule articulated in Dirks—that tippees (here, Newman and Chiasson) may be liable only when the tippee knows of the insider’s breach—necessarily means that tippee liability requires knowledge that the insider disclosed information in exchange for personal benefit. The district court erred by not instructing the jury that “the government had to prove beyond a reasonable doubt that Newman and Chiasson knew that the tippers received a personal benefit for their disclosure.”

Second, the appellate court found insufficient evidence for the jury to find that the corporate insiders received a benefit or that the tippees knew of such a benefit. The court observed that while the benefits need not be “immediately pecuniary,” they must be “of some consequence.” Here, the government’s evidence of personal benefits amounted to no more than “career advice” and friendship, and all parties denied that any quid pro quo existed. The court, citing Dirks, also rejected the premise that an insider who discloses confidential information necessarily does so for personal benefit. Finally, the court rejected the government’s argument that the timing and specificity of the information provided to the tippees supported an inference that the tippees had the requisite knowledge. For instance, the defendants presented evidence showing that their internal financial models run prior to receiving any inside information produced results that were “very close” to the company’s actual reported earnings. This and other evidence undermined any suggested inference of guilt on the part of the tippees.

Reactions to the decision were swift and numerous. Lawyers for the defendants described the ruling as a “resounding victory for the rule of law” and “vindication” of their clients. On the other hand, the U.S. Attorney, Preet Bharara, condemned the court’s “narrow” decision, stating that it will “limit the ability to prosecute people who trade on leaked inside information.” SEC Chair Mary Jo White echoed that assessment, indicating her concern that the Second Circuit took “an overly narrow view of the insider trading law.”

The U.S. Attorney’s office in the Southern District of New York has made insider trading prosecutions, and in particular prosecutions of tippees, a centerpiece of its enforcement strategy. Wednesday’s ruling dealt that strategy a substantial blow. Several high profile cases currently pending at the trial or appellate level raise similar issues and may result in vacated convictions or acquittals. For example, the conviction of Michael Steinberg, formerly of SAC Capital Advisors, earlier this year on similar charges is now decidedly in doubt. The Newman decision also reduces risk to individuals who trade on inside information in certain circumstances. Even if an outsider knows that information they receive is “inside” information, he or she does not face liability unless the outsider knows that the information was disclosed by the insider in exchange for personal benefit.