United States. v. Newman[1] represents the most serious defeat for the DOJ and the SEC in their campaign against insider trading since Dirks v. SEC[2] in 1983. In both cases, mistakes were made, and the Government did not at the time appreciate the difficulty of its position. Indeed, in Dirks, the SEC sued the hero of the Equity Funding scandal (Ray Dirks), not the villain. In Newman, the U.S. Attorney was prosecuting far more remote tippees than those in any other Second Circuit case. If the Government were to seek certiorari and take this case to the Supreme Court, it would be courting disaster. To go before the Supreme Court on these facts at a time when Justices Scalia and Thomas are demanding that insider trading law be rethought would be to blunder into a trap.[3] In Yogi Berra’s phrase, this would be “Déjà Vu, All Over Again”—the same hubris would be present here as led the SEC in Dirks to misunderstand how weak were the cards that it was holding.

But this is not to deny that (i) the decision will cripple regulators in many cases involving remote tippees, or (ii) defendants Newman and Chiasson were clearly exploiting information that any fool could have recognized was material and nonpublic. They are clearly neither heroes nor victims of governmental oppression (indeed, Chiasson made $68 million on his trades).[4]

The Government’s defeat should not be understated. Realistically, Newman means “ignorance is bliss.” Traders at hedge funds and elsewhere, counseled by lawyers who will stop just short of aiding and abetting fraud, will be advised that they can trade on material, nonpublic information that comes from a source within the issuer, provided that they do not learn that the original tipper received any “personal benefit” from the original tippee. This will quickly lead to an operative rule of “Don’t Ask; Don’t Tell.” That is, all but the dumbest of traders (and the dumbest belong in prison for their stupidity alone) will thank their tipper for his information, but never inquire how he learned his critical tip. To be sure, the original tippee who paid the benefit can still be convicted (as can his tipper), but tippees may learn to promise only a vague future benefit. Information will be exchanged under a loose (but hard-to-prove) norm of reciprocity: “You give me a tip, and I will owe you a tip.” The institution of the “favor bank”—and the norm that one should keep deposits to, and withdrawals from, it in balance—will be understood and respected among traders.

Was Newman an inevitable decision that finally told the Government that it extended the rubber band of insider trading law to the point at which it had to snap? Newman presents itself that way, criticizing the “doctrinal novelty” of recent insider trading prosecutions.[5] But this is unfair. If insider trading law was uncertain, the Second Circuit largely made it that way. In a series of decisions, other Second Circuit panels had seemed to relax, or even eliminate, the personal benefit requirement.[6] In particular, in 2012, in SEC v. Obus,[7] the Second Circuit set forth the requirements for tippee liability without any reference to a “personal benefit.”[8] Given these judicial hints, it was little wonder that prosecutors pushed the envelope.

Indeed, in view of decisions like Obus, it is a legitimate issue which decision controls. If the SEC were to sue in the future on facts resembling those in Obus, should a future panel follow Obus or Newman, as neither panel is entitled to overrule the other?

Newman also seems an overwritten decision, which reaches out to make law and prescribe a detailed set of rules that it was not required to specify. That is, Newman expressly finds:

“The Government presented absolutely no testimony or any other evidence that Newman and Chiasson knew that they were trading on information obtained from insiders…”[9]

At that point, the game was over; the convictions had to be reversed; and there was no need to discuss what defendants knew about the “personal benefits” paid to insiders if they did not even know the information came from insiders. Strictly speaking, everything else was dicta—but the decision is so strongly worded that no district court will dare consider it only dicta.

Newman’s greatest failure is that it ignores and fails to analyze an alterative grounds for liability that was expressly discussed and upheld in Dirks: namely, the “gift” of information from tipper to tippee. Dirks says that such “gifts” should be treated as if the tipper traded and made a gift of his profits to the tippee.[10] Although on the facts of Newman, it is doubtful that the Government could succeed in claiming that the original tipper made a gift to the original tippee, Newman nonetheless codifies the standards for insider trading liability without any reference to this express alternative theory. Other Circuits have found that the jury could find that the benefit lay in the expectation that the tip would be reciprocated by the recipient because they were involved in a continuing business relationship and/or friendship.[11]

So what should the Government do? The following options –some good, some bad—are open to it:

1. In future cases, it could seek to resurrect the “gift” theory in Dirks, treating Newman’s inattention to it as a mere oversight because the theory was not available on the facts of that case;
2. Alternatively, in future cases, it could seek to rely on the mail and wire fraud statutes and the theory of liability expressly accepted by the Supreme Court in the Carpenter case;[12]
3. In a few cases, it could assert “conscious avoidance” or “willful ignorance” theories where the facts suggest that the remote tippee went out of his way to avoid learning the details about how the information was acquired; Remember that the Government can use wire taps and cooperating witnesses, and they could set up the remote tippee in an incriminating conversation if the Government can flip the original tippee;
4. It could seek to instead rely on misappropriation theory and assert that Dirk’s “personal benefit” requirement does not apply in this context. A recent New York Times article suggests that the Government is seriously considering this theory;[13]
5. It could seek certiorari to the Supreme Court;
6. It could seek an en banc rehearing;
7. It could rely more heavily on existing Regulation FD, which was, of course, crafted to deal with the shortfall in the scope of insider trading law; or
8. It could look to the SEC to adopt new rules filling the new loopholes.

After this column was initially written, the S.D.N.Y. (presumably with the concurrence of the Solicitor General) decided to seek en banc review in Newman. That was a good decision, as seeking certiorari might have produced a self-inflicted wound. But what should it argue (if it gets a rare en banc review)? Unfortunately, the claim that the “personal benefit” element does not apply to misappropriation cases is a pipe dream, already rejected in Obus by the Second Circuit and even more emphatically by the Eleventh Circuit.[14] The language of Section 10(b) simply cannot support very different theories of liability with different requirements being derived from the same statutory text.

Instead, the tension between Newman and other recent Second Circuit decisions should be placed at center stage. In all likelihood, Newman will not be reversed (given its dispositive finding that defendants were not even shown to have been aware that the information came from insiders), but the overbreadth of its language could be curbed. What should a revised decision say? It should recognize that: (1) in some cases, an expectation of reciprocity can supply the necessary personal benefit (that is, an implied promise to return the favor can be a “personal benefit”); and (2) “gifts” of information can support liability where the parties are longtime friends or business associates.[15] To be sure, the remote tippee would have to know that such an improper gift to the initial tippee was made, but this is marginally better than having always to prove a financial benefit to the tipper. Legislative reform is also possible, but seems unlikely in the context of the current Congress. Regulation FD will have to be relied on in some cases, but it provides little deterrent for the tippee (although the tippee could sometimes be sued by the SEC as an aider and abetter). Thus, at the end of the day, the best option may be new SEC rules, paralleling the SEC’s earlier efforts to reverse a bad decision with SEC Rules 10b5-1 and 10b5-2. For example, the SEC could adopt a new Rule 10b5-3 that defined “personal benefit” expansively,[16] as suggested above. But this brings us back full circle to Justice Scalia’s unwillingness to confer Chevron deference on SEC rules in criminal cases. There is more to be written here.

Endnotes

[1] 2014 U.S. App. LEXIS 23190 (2d Cir. December 10, 2014).

[2] 463 U.S. 646 (1983).

[3] When the Court denied certiorari in United States v. Whitman, 135 S. Ct. 352 (2014), the two Justices filed a statement expressing doubt that “a court owes deference to an executive agency’s interpretation of a law that contemplates both criminal and administrative enforcement.” Id. at 353. The target of this criticism would seem to be SEC Rules 10b5-1 and 10b5-2, which do greatly simplify life for prosecutors and regulators—and implicated in that case.

[4] United States v. Newman, supra note 1, at *6

[5] Id. at * 18 (noting the “doctrinal novelty of…recent insider trading prosecutions”).

[6] In addition to SEC v. Obus (discussed below), see United States v. Libera, 989 F. 2d 596 (2d Cir. 1993). In Libera, the defendants obtained advance copies of Business Week, which had a market-moving stock column. On some occasions, they paid $20 for the magazine’s delivery to them, but at the outset no payments were made.

[7] 693 F. 3d 276 (2d Cir. 2012).

[8] Id at 289. In successive sentences, the panel set for the elements of tipper and tippee liability, expressly listing “personal benefit” in the requirements for tipper liability, but not in its requirements for tippee liability.

[9] 2014 U.S. App. LEXIS 23190 at * 32.

[10] 463 U.S. 646, at 664.

[11] See SEC v. Yun, 327 F. 3d 1263 (11^th Cir. 2003). The decision finds that the complaint adequately alleged that the tipper divulged material information to the tippee “for her direct, and/or indirect benefit because of her business relationship and friendship with the tippee.” Id. at 1274. The two individuals were real estate brokers who frequently acted for the same client and shared commissions.

[12] See Carpenter v. United States, 484 U.S. 19 (1987).

[13] See Peter J. Henning, “Fallout from Insider Trading Ruling,” New York Times Blogs (Dealbook), January 20, 2015.

[14] See SEC v. Yun, supra note 11 (requiring a personal benefit in a misappropriation case).

[15] This is the underlying fact pattern in SEC v. Obus, supra note 7.

[16] For a fuller consideration of possible SEC rules defining insider trading, see Coffee, Mapping the Future of Insider Trading Law: Of Boundaries, Gaps and Strategies, 2013 Columbia Business Law Review 281 (2013).

The preceding post comes to us from John. C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.