The Continuing Fall-Out from the Second Circuit’s Insider Trading Decision in Newman

Wall Street

Last week, a New York federal judge struck another blow to prosecutorial efforts to secure insider trading convictions in tipper-tippee cases. As discussed in detail here, the U.S. Attorney’s Office for the Southern District of New York suffered a high-profile defeat in an insider trading case last month, when the Second Circuit issued its decision in U.S. v. Newman, No. 13-1837, 2014 WL 6911278 (2d Cir. Dec. 10, 2014). In Newman, the Second Circuit found that prosecutors in tipper-tippee cases must prove both that the tipper (the individual disclosing inside information in breach of a duty) received a personal benefit in exchange for the disclosure, and that the tippee (the individual receiving and trading on the information) knew about the tipper’s receipt of that benefit. In the wake of Newman, U.S. Attorney Preet Bharara and others expressed concerns that the decision could limit future insider trading prosecutions.

It is now clear that those concerns were warranted. Last month, Judge Andrew Carter of the Southern District of New York indicated that, based on Newman, he intended to vacate the recent guilty pleas of four insider trading defendants in U.S. v. Durant, et al., No. 12-cr-887 (S.D.N.Y.). The government requested an opportunity to submit briefing demonstrating both that Newman does not control the outcome in Durant and that the pleas were legally sufficient. The government’s brief was filed on January 12.

The government argued in its brief that, while both are tipper-tippee cases, Newman and Durant concern different underlying theories of insider trading. Newman involved the “classical” theory, meaning that the tipper was a corporate insider who obtained material, nonpublic information by virtue of his position within his company, and in disclosing that information, he breached fiduciary duties to the company and its shareholders. Durant, however, was prosecuted under the “misappropriation” theory of insider trading. This theory applies where the tipper is not a corporate insider, but lawfully comes to possess material, nonpublic information, and in disclosing the information, breaches a duty of trust or confidence to the source of the information.

By way of background, in Durant, the defendants purchased stock in and call options on a company that was in the process of being acquired. One of the defendants allegedly received nonpublic information about the acquisition from a friend, a lawyer working on the transaction. Because the tipper (i.e., the lawyer) was not a corporate insider, disclosure of the information was considered “misappropriation,” meaning that the lawyer as a corporate outsider breached a duty of trust and confidence to his client in disclosing the information to his friend.

The government argued that there is no requirement to prove a personal benefit in a misappropriation case because the “breach . . . occurs upon the theft of confidential information.” In other words, the lawyer breached a duty to his client the moment he disclosed sensitive information to an outside party whether or not he received a benefit in exchange for the disclosure. According to the government, this stands in contrast with classical insider trading cases, where proof of a personal benefit has long been required to show that the insider breached fiduciary duties upon disclosure to the tippee. (In Newman, the court found that to be liable, the tippee must know the tipper received a benefit and that the benefit be “of some consequence.”) The government also cited Second Circuit precedent in support of its argument that proof of a personal benefit is not required in misappropriation prosecutions. See U.S. v. Libera, 989 F.2d 596 (2d Cir. 1993) and U.S. v. Falcone, 257 F.3d 226 (2d Cir. 2001). While acknowledging that Newman had stated that the elements for tipping liability were the same under both the classical and misappropriation theories, the government argued that this statement was dicta, and should not be read to overturn what it claims is Second Circuit precedent.

Judge Carter was not persuaded by the government’s arguments. On January 22, the court applied Newman and held that the “elements of tipping liability are the same, regardless of whether the tipper’s duty arises under the ‘classical’ or the ‘misappropriation’ theory.” Judge Carter rejected the government’s efforts to synthesize Newman with prior misappropriation precedent, finding that Newman provided an “unequivocal statement,” and was “part of a meticulous and conscientious effort by the Second Circuit to clarify the state of insider-trading law in this Circuit.” Finally, Judge Carter found that even if the cited language in Newman was dicta (as the government claimed), it was “emphatic dicta,” which meant that it “must be given the utmost consideration.” The court vacated the guilty pleas of all four defendants because there was no longer a sufficient factual basis for concluding that they could be guilty of insider trading.

On January 23, the day after Judge Carter issued his order, the government filed a petition with the Second Circuit requesting a panel rehearing and a rehearing en banc of Newman. Indeed, since Newman, numerous insider trading defendants in the Southern District of New York have sought to have the charges against them dismissed. Among the most high-profile is Michael Steinberg, formerly of SAC Capital Advisors, who was convicted earlier this year on similar charges involving a classical theory of tippee liability. The government’s odds of success appear slim. Since 2012, the Second Circuit has granted en banc consideration only once. Given that there is currently no clear split among the Circuits on this issue, Supreme Court review also is by no means likely, although it remains a possibility.