Proving Insider Trading Just Got Harder

Anthony Chiasson, the co-founder of Level Global Investors LP, and Todd Newman, a portfolio manager of Diamondback Capital LLC, were convicted of insider trading in December 2012. Their trial followed a federal probe of what the government alleged was a wide-ranging scheme involving a group of analysts and insiders who traded on illicit tips about Dell, Inc. and Nvidia Corporation. The reversal of the convictions on December 10, 20141 has reignited a debate about just what it means to be guilty of the crime of insider trading.

In both cases, the insider information passed through a chain of informers before it reached Chiasson and Newman. Here’s what happened in the case of the information about Dell. Rob Bray, in Dell’s Investors Relations Department, tipped information regarding the company’s upcoming earnings report to Sandeep Goyal, an analyst at Neuberger Berman, who in turn passed the information on to Jesse Tortora, an analyst at Diamondback. Tortora then relayed the information to Newman and a Level Global analyst, who tipped Chiasson.

Therefore, Newman and Chiasson were, respectively, three and four levels removed from the ultimate source of the information about Dell. The Nvidia tipping chain was similar. It was certainly apparent to Chiasson and Newman that the information was not publicly available. Having advance knowledge of Dell’s earnings proved profitable. Chiasson made $50 million on a single trade based on the Dell tip.

The trial court charged the jury that it could find Chiasson and Newman guilty if they were aware that the tippers had breached a fiduciary or other relationship of trust and confidence with their (the tippers’) employers by disclosing material non-public information for their own benefit and that that information had been disclosed to Chiasson and Newman in breach of that duty.

The jury returned a verdict of guilty. Chiasson was sentenced to 78 months imprisonment followed by one year of supervised release, and was fined $5,000,000 and ordered to forfeit an amount up to $2,000,000. Newman was sentenced to 54 months imprisonment followed by one year of supervised release, and ordered to pay a $1,000,000 fine and to forfeit $737,724.

There is no statute or regulation which expressly prohibits insider trading. The crime is predicated on the notion that insider trading is a kind of securities fraud in violation of Section 10(b) of the Securities Act of 1934, which prohibits the use of “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of securities, and Rule 10(b)-5.

The problem with using vague civil statutes, which are open to interpretation, as the basis for defining crimes nowhere mentioned in the statute books is that different prosecutors, and judges, are not going to view the same conduct as criminal. That’s what happened in the cases of Chiasson and Newman. Both the prosecutor and the Court of Appeals for the Second Circuit had plenty of precedent to rely on to come to opposed conclusions. Still, there are some principles, based on a number of theories, that govern insider trading cases.

Under the “classical” theory of insider trading, a corporate insider violates Section 10(b) and Rule 10(b)-5 by trading in the corporation’s securities based on material non-public information about the corporation. Corporate insiders are barred from trading upon such information because of their obligation to refrain from taking advantage of uninformed shareholders.

An alternative basis for insider trading liability, called the “misappropriation” theory, extends liability to “outsiders.” Tipping liability arises where the insider, or misappropriator, in possession of material non-public information does not trade on the information, but rather discloses it to an outsider (a “tippee”), who then trades on the basis of the information before it is publically disclosed.

The insiders are barred by their fiduciary relationship from personally using the undisclosed corporate information to their advantage and may not provide it to an outsider for the same purpose. The test for determining whether the insider has breached the fiduciary duty is whether the insider derives a benefit, direct or indirect, from the disclosure. Without such a benefit, there has been no breach of a duty and hence no insider trading.

A requirement common to all kinds of insider trading is “scienter,” which, simply put, is an intent to deceive, manipulate or defraud. Thus, in order to establish a criminal violation of the securities laws, the government must show that the defendants acted with the knowledge that they had violated the securities laws.

The Court of Appeals summarized the elements of the tippee’s liability: first, it must derive from the tipper’s breach of a fiduciary duty, not from trading on material non-public information; second, the tipper must receive a personal benefit in exchange for the disclosure; and third, the recipient of the tip, the “tippee,” is liable only if he knows, or should have known, of the breach and utilized the information either to trade the security or further tip the information.

The element missing in the cases against Chiasson and Newman, according to the Court of Appeals, was proof, beyond a reasonable doubt, that they knew the tippers had personally benefitted from the disclosure. In fact, there was no evidence that Chiasson and Newman even knew the identity of the ultimate sources of the non-public information (who have not been prosecuted), let alone that the sources derived a personal benefit.

While what it did was not without precedent, the Court of Appeals adopted as narrow a definition of insider trading as you will find anywhere. The court also suggested that perhaps it was too easy to convict traders and even that the government was getting a bit too aggressive in bringing insider trading cases. In other words, the Court of Appeals was concerned that the law does not require a “symmetry of information,” so that a prosecutor should not see a crime wherever there is unequal access to information.

Those are fair points, but the cases of Chiasson and Newman were not particularly good vehicles for making them. Both were evidently aware that they were trading on information unavailable to others, no matter how diligently the others worked to discover it. Both, and especially Chiasson, made substantial profits on their trades.

So what are the broader ramifications of the decision? For one thing, it will have no impact on prosecutions such as those of Raj Rajaratnam, co-founder of Galleon Group LLC, and Mathew Martoma of S.A.C. Capital Advisors L.P., which did not involve a long chain of tippers and in which the jurors were required to find that Rajaratnam and Martoma were aware that the tippers had gained a personal benefit.

Where the government will be hamstrung is in cases similar to Chiasson’s and Newman’s, in which the source of the information is remote from, or unknown to, the tippee who trades on it. Where there is a chain of sources, or a far flung network disseminating information, a conviction may be virtually impossible.

Is this good as a matter of policy? It really depends upon whether you think it is too easy for the government to obtain convictions in insider trading cases. After all, the Dell and Nvidia trades of Chiasson and Newman have the potential to undermine investor confidence in the markets just as much as the most aggravated examples of insider trading which led to long sentences for other traders. The average investor is unlikely to see the relevance of whether a trader knew that a remote source of information benefitted from the tip or indeed whether there even was a benefit to the source.

You can debate the wisdom of what the Court of Appeals did, but what you can’t debate is that we need a statute to put the matter to rest for the sake of the criminal justice system, the SEC and professionals who must evaluate the information they receive on a daily basis.

Endnotes

1 United States v. Newman, Docket Nos. 13-1837-cr and 13-1917-cr (2d Cir. Dec. 10, 2014).