If someone had asked me back in the mid-1980s whether an insider trading case required proof that the tippee was aware that the tipper was acting for personal gain, I would have said yes without much hesitation, because that’s what the Supreme Court had said in Dirks. To be sure, awareness has a great deal of elasticity, because Dirks used the phrase “knows or should know,” and personal benefit can come in a variety of soft forms. But one big implication from this common understanding was that selective disclosure to investment analysts would ordinarily not constitute insider tipping, because disloyal motivation can be hard to find in such cases. That’s, of course, why the SEC later on adopted Reg FD, a non-insider trading response to the selective disclosure dilemma.

From that historical vantage point, the Newman case should come as no great surprise, on its law or its facts. In the end, it was about mid-level people at Dell and NVIDIA giving out earnings-related information to analysts who were taking advantage of their relationships but not offering the insiders much in return. The defendants were three or four steps removed from these tips, with very little specific knowledge about the sources. If we take both personal benefit and “beyond a reasonable doubt” seriously—which is the main thrust of the opinion—criminal guilt does seem doubtful.

Starting in the mid-80s, however, courts—mainly in the Second Circuit—began a long, strange trip to redraw the map of tipper-tippee liability. This started with the possibility (which the SEC was pushing) that the Dirks test doesn’t apply under the widely-used misappropriation theory, and a few district courts quickly agreed. The Second Circuit’s Libera decision encouraged this, suggesting that the prosecution didn’t even need a classic “tip” in order to establish liability. The law was moving toward treating inside information as “stolen goods,” not to be touched if it doesn’t belong to you. When Dirks was applied, the personal benefit standard (especially the “gift-giving” prong) morphed into the idea that if there was no solid business reason for passing the information on, it was self-serving by inference—it was “not for nothing,” after all. So when the Second Circuit got around to summarizing the circuit’s tipper-tippee law a couple of years ago in SEC v. Obus, the synthesis was distinctly friendly to enforcers. Though holding that Dirks does indeed apply under the misappropriation theory, the court said that tips can be reckless rather than deliberate, that personal benefit is a stand-alone element disconnected from either the tipper’s motivation or the tippee’s state of mind, and that “should know” rather than actual knowledge or reckless disregard is the right focus with respect to the crucial aspects of tippee scienter. These ideas were all artifacts from the meandering twenty-five year journey, a Dirks 2.0.

Newman became an important case largely because Judge Sullivan, the trial judge, read Obus faithfully, even as applied to a criminal prosecution. Some benefit to the tipper was necessary, he ruled, but the tippee need not know of that benefit so long as there was sufficient awareness that the tip was a breach of duty. A jury thus had considerable freedom to draw that inference from the lack of legitimate business justification for passing the information on to a casual acquaintance with ties to Wall Street, and how the information was interpreted and processed at the other end of the pipeline, inside the hedge fund.

That’s what the panel in Newman rejected. The benefit has to be pecuniary-like, at least, and knowledge means just that. The pushback reminds me a bit of the original panel decision in the Chestman case in the 1990s (which was soon vacated and overturned en banc). In an effort to rein in an unruly line of district court cases construing fiduciary duty, that panel overcorrected and produced some unfortunate dicta as a result. So, too, in Newman. Particularly troubling, obviously, is Newman’s fixation on the tippee’s knowledge of the breach and personal benefit, given that Dirks so clearly adds “or should know.” No doubt the judges from the Obus panel would like an opportunity to respond to the not-so-subtle trashing of their elaborate (if somewhat “Delphic”) work product.

That assumes, however, that these issues will not soon make their way up to the Supreme Court for revision. There is an echo here of how the Court dealt a few years ago in the Skilling case with “honest services” for mail and wire fraud (which, after all, is where the misappropriation theory came from), narrowing what constitutes the necessary form of deception in relational settings in order to avoid due process and vagueness concerns. It didn’t like the soft edges in the case law there, and insider trading potentially has just as many, if not more. So maybe the Court will weigh in again soon, perhaps in the form of a case—which Justices Scalia and Thomas seem to want badly—where enforcement is bolstered by SEC’s rulemaking under 10b5-1 or 10b5-2. Precisely because Newman does send a message that the lower courts get the need for some restraint with respect to a very open-ended prohibition, this might help in opposing certiorari in other cases.

Two final thoughts about personal benefit and selective disclosure. As Adam Pritchard showed after digging carefully through Justice Powell’s files,[1] personal benefit was an afterthought in Dirks—Powell’s first cut focused on good faith purpose, candidly acknowledging that such an expansive standard had its risks. Justice O’Connor wanted something more objective and less focused on the insider’s motivation, based on her experience with such issues as a trial judge. The compromise (like so many edits, awkwardly expressed in the text of the opinion) was the personal benefit test. Powell was especially anxious to protect communications with investment analysts, egged on by a law clerk who was very much enamored with the efficient markets-based criticism of insider trading regulation, and the personal benefit standard meshed with that. From his notes, Powell seems to be a downright enthusiast for selective disclosure, fully understanding that the effect favors the big money managers over the average investor.

But that was then. The efficient markets view of insider trading still has its adherents, of course, and the securities industry regularly attacks the romanticism of “parity of information,” albeit probably for reasons having little to do with financial economics. However, investment analysts aren’t today quite the white-horse heroes they once were. The sell-side famously got their comeuppance for investment banking-driven bias, and we came to realize that selective disclosure was often a way insiders could influence analyst recommendations, making access conditional on a positive attitude toward the company. We have ample evidence of sleazy tactics on the part of buy-side analysts in pursuit of a momentary edge, whether it involves pay-offs or just using naïve mid-level corporate insiders who shouldn’t be talking to anyone about sensitive company information.

To me, the most bothersome aspect of Newman is its indifference to this potential, reading almost as a roadmap for selective disclosure. The court takes as exculpatory how willing senior types at Dell and NVIDIA were to leak earnings information, without mentioning that (if the information was material) that conduct was a gross violation of Reg FD. (If I were at the SEC I might have a few questions for company officials there, but that’s beside the point.)

So I come away from the case with mixed feelings. I don’t like selective disclosure, and have long wondered why it is that we assume that corporations themselves cannot take advantage of material nonpublic information when doing a stock buyback yet are free under Dirks, through their agents, to selectively make a gift of that same information to analysts of their choice. Were a magically responsible Congress to want to take up codification I’d hope it would abandon both fiduciary duty and personal benefit in favor of a prohibition based on wrongful possession or misuse.

That said, I do think the criminalization of insider trading (sentencing in particular) has gotten a bit out of hand, and Newman shows some apt sensitivity to the dangers of a crusade. Nor is its holding on tippee scienter all that disabling. We’ve seen from recent cases (like Whitman) that criminal convictions, sustained on appeal, are still quite possible even with a tighter knowledge of personal benefit standard. More challenging remote tippee cases probably should be left to the SEC. Notwithstanding everything defense counsel will do with what must seem like a godsend of dicta, Newman’s holding addresses little or nothing (certainly compared to Obus) about the SEC’s ability to get to the jury in civil cases.

So all in all, even though we could surely do better with sound legislative codification, I expect that the courts in the Second Circuit will—as they have long done—cobble together an insider trading prohibition fit for attacking Wall Street’s abuses, even if the journey sometimes looks like a judicial random walk with unexpectedly sharp turns. The best bet is usually reversion to mean, not sea change.

ENDNOTES

[1] A.C. Pritchard, Justice Lewis F. Powell, Jr., and the Counterrevolution in the Federal Securities Laws, 52 Duke L.J. 841, 937-42 (2003).

The preceding post comes to us from Donald C. Langevoort, the Thomas Aquinas Reynolds Professor of Law at Georgetown Law.