Among several independent holdings stated by the court on its way to reversing the convictions of Todd Newman and Anthony Chiasson, the Newman court declared that: “in order to sustain a conviction for insider trading [against a remote tippee], the Government must prove beyond a reasonable doubt that [the remote] tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.”^[1] My musings leave aside whether from a doctrinal standpoint, this statement is incorrect, within a range of holdings that the court could have come to, or simply necessitated by the authorities the court had to work with. Rather, I want to explore the queasy feeling the decision leaves so many with. That queasy feeling is traceable to how the decision squares with assumptions regarding what it means to play fairly in the securities markets.^[2] The decision blesses making money not through the study of issuers, industry trends or general market dynamics but through the courting of issuers’ disloyal agents. Although the decision does not prevent the SEC from continuing to prosecute initial tippers and their tippees, it hinders the SEC from pursuing those that actually make money due to insider disloyalty. In so doing, the Newman decision deregulates demand for insider information. This may lead to cultivation of tips from corporate insiders as well as shut off a source of compensation to security holders who are harmed when they trade against better, and improperly, informed remote tippees. If doctrinally these results are right, then it may be time to reassess the doctrine.

Requiring that a remote tippee know of the benefit that was exchanged between the corporate insider and his initial tippee creates a hard to surmount obstacle for prosecutions in this context. Why would the reseller of stolen goods discuss the price he initially paid to the thief? Where an insider leaks confidential information in exchange for a benefit, how likely is it that the initial tippee will then explain the benefit he gave to the insider when divulging that information to a subsequent tippee? Such disclosure would not only generally be irrelevant to the remote tippee, but would also give the remote tippee information that could be used to convict the initial tippee of insider trading. Although appearing on the page as a doctrinal nuance, the burden Newman places on the prosecution in a remote tippee scenario will in many if not all circumstances be paralyzing. Notably, the Newman court did not delve into a theory of liability based on constructive knowledge (see Professor Langevoort’s apt comments on the odd absence of inquiry into whether Newman and Chiasson should have known that something was amiss when they received earnings information about public companies before such information was disclosed publicly by the relevant issuers).

The inability to pursue remote tippees may have real and serious consequences for the great majority of U.S. investors. Newman confirms there is no law protecting them from traders using improperly disclosed insider information. This creates a distributional effect between two communities. The winners are traders—professional or otherwise—who share corporate gossip with professional pals, golfing buddies, drinking mates, etc. and on occasion come across material non-public information that at its source was leaked by an insider. The losers are all other investors, whom the former are trading against. This indeed was the situation in Newman, where the government alleges “a cohort of analysts at various hedge funds and investment firms obtained material, nonpublic information from employees of publicly traded technology companies, shared it amongst each other, and subsequently passed it on to portfolio managers at their respective companies” including Newman and Chiasson.^[3] The Newman decision does not refute this allegation, as it is immaterial to its reasoning. Let that sink in.^[4]

As recent tippee liability cases show, the stakes are not small. Gains made by Newman and Chiasson totaled $4 million and $68 million, respectively (Newman’s penalty was approximately $1.73 million, and Chiasson’s penalty was approximately $7 million).^[5] These gains (or in cases where the tip consists of negative information about the issuer, avoided losses) represent a transfer to the tippee from other market participants. This transfer is likely to be regressive, as networks of folks that have insights into confidential corporate goings-on are likely to predominantly draw their membership from the upper range of the income spectrum. This transfer is also not “earned” in any way, and acts to erode trust in the impartiality of our securities markets.^[6]

Newman significantly dulls prosecutorial tools to deter and recoup these transfers. As a result, traders are free to trade on material non-public information so long as they can find an eager-to-please stooge or another in-between with corporate connections to relay information. It is likely that the decision will encourage the cultivation of such in-betweens, and with them, the rise of agency costs as the intermediaries will themselves succeed by cultivating disloyalty among corporate insiders. In other words, the Newman court has largely deregulated the demand for confidential issuer information. This will increase supply, to the detriment of issuers that will be losing information to the leaks. This will also increase the incidence of trading on insider information, and that will hurt those that tend to be without it (i.e., the great majority of us). Significantly, trading profits resulting from the trades on insider information will not be available to compensate either the issuer or the innocent counterparties. Thus an important source of compensation has disappeared from the insider trading ecosystem; particularly where the trading gains (losses), as in Newman, are large enough for the insider and immediate tippee to be relatively judgment proof. Although the specific figures in Newman are small relative to the volume of securities trading in any normal day, we do not know how much such trading goes on and how much more will when traders like Chiasson and Newman are no longer subject to the threat of prosecution. Are these the results we intend for our insider trading laws to have?

ENDNOTES

^[1] United States v. Newman, 2014 U.S. App. LEXIS 23190, 3-4 (2nd Cir. 2014).

^[2] See S.E.C. v. Obus, 693 F.3d 276, 285 (2nd Cir. 2012) (“The ‘abstain or disclose’ rule was developed under the classical theory [of insider trading liability] to prevent insiders from using their position of trust and confidence to gain a trading advantage over shareholders.”).

^[3] Newman at 3. See id. at 5 (“at trial, the Government presented evidence that a group of financial analysts exchanged information they obtained from company insiders, both directly and more often indirectly . . . receiv[ing] information from insiders at Dell and NVIDIA disclosing those companies’ earnings numbers before they were publicly released . . .”)

^[4] In other words, it does not matter to Newman’s conclusion whether there was a scheme among professionals to elicit confidential material information from publicly traded companies and pass that information on to their institutions for purposes of trading, so long as those actually engaging in the trading did not know of the benefit that passed between the relevant corporate insiders and the initial tippees.

^[5] Newman at 6, 10.

^[6] See Securities Act Release No. 33-7881 (Aug. 15, 2000) (“We believe that the practice of selective disclosure leads to a loss of investor confidence in the integrity of our capital markets.”).

This post comes to us from Ilya Beylin, Editor-at-Large of Columbia Law School’s Blue Sky Blog and a Post-Doctoral Research Scholar for Professor John C. Coffee, Jr.