In United States v. Newman, the U.S. Court of Appeals for the Second Circuit dealt a substantial blow to federal prosecutors’ epic crackdown on insider trading by raising the bar for the government’s burden of proof in “remote tippee” cases that have plagued the financial industry in recent years. Many people are wondering if the government might let the decision lie, rather than pursuing an en banc hearing—or an appeal to the Supreme Court, which could risk Newman becoming the law of the land and not just in the Second Circuit. Assuming Newman stands, the case also has important implications for civil enforcement of insider trading by the Securities and Exchange Commission (SEC). This update explores some considerations for navigating SEC insider trading investigations in the post-Newman era.
In Dirks v. SEC, the Supreme Court addressed tippee liability in insider trading cases, holding that a corporate insider is guilty of insider trading only if he disclosed confidential information to an outsider for a personal benefit. As the Court explained, a tippee’s duty not to trade on confidential information is derivative of the insider’s breach; thus, a tippee assumes the fiduciary duty not to trade on material nonpublic information only when the tipper has breached his duty and the tippee knows or should know that there has been a breach. However, the knowledge prong of the Court’s decision has been applied more recently in a somewhat inconsistent manner, as courts have tried to reconcile the Dirks tipper/tippee “co-venture” concept with enforcement cases based upon an increasingly remote chain of information.
Such was the case in Newman, where the defendants—hedge fund managers who placed the allegedly infringing trades—were several layers removed from the corporate insiders who had first disclosed the material nonpublic information. Vacating the defendants’ criminal convictions, a unanimous Second Circuit panel held that to be guilty of insider trading, a remote tippee must not only have knowledge that a corporate insider breached his fiduciary duty not to disclose confidential information, but also know that the corporate insider did so in exchange for a personal benefit. This decision resolves the ambiguity that the government had sought to capitalize on in Newman: whether the tipper’s derivation of a personal benefit is what actually creates the breach of duty. The government argued that personal benefit is a separate element of the tipper’s insider trading offense, and thus it could prove that the tippee knew of the insider’s breach without necessarily establishing that the tippee knew the insider did so in exchange for a personal benefit.
In rejecting the government’s argument, the Newman court held that under Dirks and its progeny, “the exchange of confidential information for personal benefit is not separate from an insider’s fiduciary breach; it is the fiduciary breach that triggers liability for securities fraud.” Thus, the government cannot establish that the tippee knew of the insider’s breach without also showing that the tippee knew about the personal benefit received by the insider.
Moreover, the Second Circuit rejected the government’s contention that given the detailed nature and accuracy of the information obtained by the defendants, they must have known (or deliberately avoided learning) that the information came from corporate insiders, and that the insiders must have disclosed the information in exchange for a personal benefit. Rather, the court explained that the evidence failed to support such a conclusion and noted that a government witness testified at trial that in the absence of any inside information, financial analysts had already run models that approximated the same information leaked by the corporate insider.
Regarding the personal benefit itself, the court found that the circumstantial evidence was too thin to even warrant an inference that the corporate insiders received a personal benefit in exchange for disclosing confidential information. The government tried to suggest there was friendship between the insiders and the individuals they initially leaked the information to, but the court countered that if that was the “benefit,” then “practically anything would qualify.”
Instead, the Second Circuit held that the alleged personal benefit must entail at least the potential of pecuniary or a similarly valuable gain—or, as it had noted previously in United States v. Jiau, a relationship between the insider and the recipient that suggests a “quid pro quo.” As a result, the Second Circuit took the extraordinary step of vacating the convictions and remanding to the district court to dismiss the indictment with prejudice, thereby ending the case.
In sum, Newman sets forth a new framework for insider trading cases, requiring prosecutors to prove each of the following beyond a reasonable doubt to establish tippee liability:
- A fiduciary duty on the part of a corporate insider;
- A breach of the fiduciary duty by the corporate insider by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit;
- The tippee knew of the tipper’s breach; that is, he knew the information was confidential and divulged for personal benefit; and
- The tippee still used that information to trade in a security or tip another individual for personal benefit.
Potential Impact on SEC Enforcement Actions
While Newman is a landmark decision in the criminal context, it also has important implications for civil actions brought by the SEC. The SEC has previously maintained that tippee liability requires the government to prove only that the tippee knew the tipper provided material non-public information in breach of a duty, and not that the tippee knew the tipper received a benefit for doing so. The agency has also lobbied for a more liberal view of what exactly constitutes a “personal benefit” than has been adopted by the Newman decision. It comes as no surprise then that SEC Chair Mary Jo White voiced concern shortly after Newman that the court had taken an “overly narrow” view on what constitutes illegal insider trading by tippees.
The Limits of Newman in Civil Proceedings
In its civil arena, the SEC will likely have more room to maneuver around the requirements in Newman, especially as they relate to the tippee’s knowledge of the insider’s breach. Specifically, in Newman, the court devoted much attention to criminal mens rea requirements—i.e., a “willful” violation of securities laws—which the court defined as “a realization on the defendant’s part that he was doing a wrongful act . . . under securities laws.” The court later used this high threshold to overcome the government’s arguments that given their “sophistication,” the defendant-tippees must have known, or deliberately avoided knowing, that the tips they traded on originated with corporate insiders and were disclosed for a personal benefit. On the other hand, since the SEC’s burden is much lower in a civil setting, the evidence constituting scienter, which is akin to mens rea, has been interpreted by courts to include both intentional and reckless conduct. This variation in burden might tip the scales in the SEC’s favor, especially in remote tippee cases, where much of the evidence is circumstantial.
A Second Option—Filing Insider Trading Cases as Administrative Proceedings
While it has been rare for the SEC to bring insider trading cases through administrative proceedings (APs), that track record has changed. Back in mid-June 2014, Andrew Ceresney, director of the SEC’s Division of Enforcement, announced that the agency would adjudicate more insider trading cases in SEC APs, as opposed to litigating them in federal court. A few months later, on September 30, 2014, the SEC instituted cease and desist proceedings against research analyst Jordan Peixoto, which was the SEC’s first AP alleging insider trading in three years. While Peixoto and several other respondents involved in SEC APs alleging insider trading have challenged the constitutionality of such proceedings, those arguments have been largely unsuccessful.
What remains is an enforcement framework that offers the SEC potential advantages for satisfying even the heightened knowledge requirements imposed by Newman. First, APs are governed by the SEC’s Rules of Practice, which do not adopt the Federal Rules of Evidence and eliminate traditional discovery tools, such as interrogatories, requests for admission and depositions. This could allow the SEC to build evidence of the tippee’s scienter through hearsay evidence, for example, while limiting the defense’s ability to discredit SEC witnesses through pre-trial depositions. Second, APs are presided over by administrative law judges, who are employed by the SEC, and operate in an environment where deference to the agency’s interpretations is arguably at its highest. Finally, the expedited nature of APs is generally viewed as a factor favoring the SEC, as the defense is forced to “catch-up” to an SEC investigation that may already be years old.
Thus, while the SEC cannot avoid addressing the implications of Newman in an AP—an appeal of most APs can ultimately be heard by the U.S. Courts of Appeals in the circuit where the defendant resides—it can utilize this more favorable forum to meet Newman’s exacting standards. The agency has made no secret of its intent to bring more insider trading cases through APs, and Newman might just create additional impetus for the SEC to keep going down that road.
 See, e.g., SEC v. Maxwell, 341 F.Supp. 941 (S.D. Ohio 2004) (“The Commission contends that ‘[a] mere allegation that the insider has disclosed material[,] non-public information is sufficient to create a legal inference that the insider intended to provide a gift to the recipient of the information, thereby establishing the personal benefit requirement.’”); SEC v. Thrasher, 152 F.Supp.2d 291, 304 (S.D.N.Y. 2001) (same).
 See, SEC v. Maio, 51 F.3d 623, 633 (7thCir. 1994) (unless there is some legitimate reason for disclosure, inference that tip was improper gift is “unassailable.”).
 Evelyn Cheng, SEC’s White: Insider trading ruling ‘a concern,’ at http://www.cnbc.com/id/102260212 (Dec. 11, 2014).
 Sarah Lynch, US SEC to File Some Insider-Trading Cases in its In-House Court, Reuters, at http://www.reuters.com/article/2014/06/11/sec-insidertrading-idUSL2N0OS1AT20140611 (June 11, 2014).
 See Order Instituting Public Administrative Cease-And-Desist Proceedings, Exch. Act Rel. No. 73263, Admin. Proc. File No. 3-16184 (Sept. 20, 2014).
 Max Stendahl, Judge OK’s SEC Admin Case Against “Big Short” Manager, Law360 (Dec. 12, 2014).
© 2014 Perkins Coie LLP