In its recent decision in United States v. Newman, the United States Court of Appeals for the Second Circuit provided important guidance on the scope of insider trading liability. The case concerned the liability of two hedge fund managers, Anthony Chiasson and Todd Newman, who were alleged to be members of a group of financial analysts who shared information about various publicly-traded companies. Chiasson and Newman were so-called “remote tippees” in that they were each multiple levels removed from the sources of the information – insiders at Dell and Nvidia. Neither defendant was alleged to have had direct contact with the insiders and, according to the court, there was no evidence that either was aware of the source of the information on which they traded.
The government’s theory at trial, was that, “as sophisticated traders, [the defendants] must have been aware that the information upon which they traded was disclosed by insiders in breach of a fiduciary duty.” In overturning the defendants’ conviction by a jury of criminal insider trading, the Second Circuit rejected this theory, concluding that it was inconsistent with the scope of insider trading liability set out in Dirks v. SEC. In Dirks, the Supreme Court held that tippee liability requires both a breach of fiduciary duty by the source of the inside information and knowledge by the tippee of the breach. Moreover, Dirks held that a corporate insider does not breach his or her fiduciary duty unless the insider receives a personal benefit in exchange for the information.
The Newman court reasoned that, as a result, the requirement that a tippee know of the personal benefit received by the insider “follows naturally from Dirks.” Because according to the court, there was insufficient evidence even that the insiders had received a personal benefit, and “absolutely no evidence” that the defendants had any knowledge about a personal benefit, the court reversed their convictions.
Extending its analysis more generally, the court appeared critical of the government’s practice of prosecuting insider trading cases against remote tippees. The court characterized the practice as one of “doctrinal novelty” and distinguished such cases from those involving tippees who directly participated in the insider’s breach or were explicitly informed of the breach. As a result, the court’s decision should be understood not merely as an evaluation of the case-specific evidence, but a broader reflection on the government’s prosecution policy. Newman fairly raises the question of how much responsibility investors should have for verifying the source of information before trading. It goes on to answer that question by limiting that responsibility in cases in which the trader does not play a role in generating the tip.
In my view, that aspect of Newman is consistent not just with the letter of the Dirks decision but with the policy considerations that motivated the Supreme Court’s analysis. The Dirks Court was cognizant of the complex information environment on Wall Street in which investors move millions of dollars or more in and out of investment options based on hunches, rumors and information fragments. Whether the trading activities of hedge funds, high frequency traders, activists and the like are socially desirable is a complex policy question, but expansive criminal prosecutions based on a general prohibition against fraud are ill-suited for addressing those concerns. Rather, existing insider trading liability should focus on the information asymmetries that result from an insider’s breach of trust and should extend to those who play a role in creating that breach.
In particular, the Newman prosecution illustrates a problematic theme in the recent government policy of pursuing the end users of inside information rather than the source. As the Newman court itself observed, as of the date of its decision, neither corporate insider had been criminally charged. In a similar vein, another hedge fund manager, Mathew Martoma, was sentenced to nine years in prison for trading on nonpublic information about the results of FDA drug trials. His source, Dr. Sid Gilman, who betrayed his obligation to keep those results confidential, was not prosecuted. The explanation for this theme is simple – the hedge fund end users of inside information generate enormous profits. The trades for which Newman and Chiasson were prosecuted generated profits of $4 million and $68 million respectively. Martoma’s trades generated profits for his hedge fund of more than $200 million. What the government appears to overlook, however, is that these profits were the result of an insider’s willingness to betray a position of trust. Recent prosecutions do not appear to focus on holding these insiders sufficiently accountable.
The SEC’s adoption, in 2000, of Regulation Fair Disclosure or Reg FD, 17 C.F.R. § 243.100, reflects a greater focus on the source of inside information. Reg FD attempts to prevent information asymmetries by prohibiting corporations and corporate officials from selectively communicating material nonpublic information to investors. In so doing, Reg FD does not limit its reach to fraudulent activity – corporate insiders are liable for violating the rule regardless of whether they receive a personal benefit.
The SEC’s enforcement efforts under Reg FD have been limited, largely in response to a defeat in an early case against Siebel Systems. Nonetheless, as I have written elsewhere, Reg FD has had a powerful effect, causing issuers to develop compliance and education systems for their employees and leading to a reduction in information asymmetries.
The Newman decision, like Dirks, reasons that, at its heart, insider trading liability is premised on misconduct by those who are entrusted to keep nonpublic corporate information confidential. Ultimately it is the breach of trust by these insiders that renders the resulting trading fraudulent. In reminding us of the appropriate limits of insider trading enforcement, Newman also demonstrates the valuable check that the federal courts provide on government policy. We should be wary of regulator efforts to evade that oversight, such as the Securities & Exchange Commission’s increased use of administrative proceedings instead of federal court litigation.
 2014 U.S. App. LEXIS 23190 (2d Cir. 2014).
 463 U.S. 646 (1983).
 See United States v. Martoma, 2014 U.S. Dist. LEXIS 123785 (S.D.N.Y. 2014) (denying motion for judgment of acquittal and recapping evidence at trial).
 SEC v. Siebel Systems, Inc., 384 F.Supp.2d 694 (S.D.N.Y. 2005).
 See Jill E. Fisch, Regulation FD: An Alternative Approach to Addressing Information Asymmetry in RESEARCH HANDBOOK ON INSIDER TRADING (Elgar, Stephen Bainbridge, ed. 2013).
 See Jenna Greene, The SEC’s On a Long Winning Streak, Nat. L.J., Jan. 19, 2015
The preceding post comes to us from Professor Jill E. Fisch, the Perry Golkin Professor of Law and Co-Director, Institute for Law and Economics at the University of Pennsylvania Law School.