Since the Manhattan prosecutor’s office began an aggressive campaign to prosecute Wall Street insiders, they have secured 85 convictions on what has been described as “clear cut evidence of insider trading.” But last week’s ruling by the Second Circuit could put an end to prosecutor’s success on Wall Street and sets forth a playbook for lawyers defending insider trading cases in the future.
In a unanimous decision, the United States Court of Appeals for the Second Circuit overturned the convictions of two former hedge fund traders, Tom Newman and Anthony Chaisson. At their original trial, prosecutor’s introduced evidence that a group of financial analysts exchanged information they obtained directly but more often indirectly, from corporate insiders. The government alleged that the individuals involved received Dell and NVIDIA’s May and August 2008 earnings information from insiders before they were released publically. The analysts passed the information to their portfolio managers, including Newman and Chaisson, who traded on the information earning approximately $4 million and $68 million in profits for their funds. Even though Newman and Chiasson were several levels removed from the inside tippers, the government claimed they were criminally liable for insider trading, because as sophisticated traders, they must have known the information was disclosed by insiders in breach of a fiduciary duty.
The Second Circuit, relying on the Supreme Court’s holding in Dirks v. SEC, not only overturned the convictions based on faulty jury instructions, but dismissed the case altogether. The Government argued Dirks only required that the “tippee know that the tipper disclosed information in breach of a duty” and did not require the tippee to know the corporate insider disclosed the confidential information for their own personal benefit. The Court rejected the Government’s argument and laid out the three requirements necessary to prove an insider trading case. First, the tipper must have disclosed (not traded on) material, non public information. Second, the corporate insider must receive a personal benefit in exchange for the disclosure. Finally, a tippee must have known of the breach of duty owed by the tipper. Thus, the government must show the tippee knows of the personal benefit received by the insider in exchange for the information. It is not enough to simply show the insider disclosed confidential information. Newman and Chiasson were too far down the chain of disclosures to have known that the tipper disclosed information in breach of their fiduciary duty or that the tipper received a personal benefit from the disclosure.
The decision is a blow to prosecutors who have found unprecedented success in prosecuting insider trading cases. For years, prosecutors have been relying on the more expansive reading of Dirks to obtain convictions. In fact, the United States Attorney in Manhattan has a nearly undefeated record at trial. Prosecutor’s voiced concerns over not only the ability to prosecute future cases but the far reaching consequences the ruling may have on Wall Street insiders. They worry the ruling will simply encourage high level insiders to distance themselves from the leaks while still gaining big profits from the tips.
Defense attorneys welcome the ruling citing the vagueness of the law as written and the low standard often applied by judges to the “personal benefit” requirement. Before the ruling, the government could meet its burden by showing the people involved were friends, or, as was the case here, career advice being given from the Dell Insider. After the Second Circuit’s ruling, the government must be able to present evidence that points to a tangible benefit the tipper received or expected to receive by leaking the information. The tangible benefit must be of some consequence but does not necessarily have to be a pecuniary benefit.
Most of the convictions secured will likely stand, but there are a few high profile defendants who may benefit from the ruling. Michael Steinberg, of SAC Capital Advisors, was indicted last year. His trial was presided over by the same judge who handled Newman and Chiasson’s trial. In a foot note, the appellate court suggested prosecutors had tried to bring the case before the judge hoping for the same flawed jury instructions given at Newman and Chiasson’s trial. Raj Rajartnum, co-founder of Galleon Group LLC, may also benefit from the court’s ruling. Rajartnum was convicted of insider trading after unsuccessfully arguing his trades were based on a “mosaic” of publically available information he obtained from a variety of sources. The Court’s ruling suggests that this “mosaic theory” is a valid defense, and it gives credence to the theory that “downstream tippees” are not liable for trading on information.
While the ruling may signal the end of the glory days for prosecutors in inside trading cases, the Court’s ruling has given defense attorneys a playbook for defending insider trading cases in the future.