Todd Newman, a former portfolio manager for Diamondback Capital Management LLC, left, and his attorneys Stephen Fishbein, center, and John A. Nathanson, right, arrive at federal court in New York on Nov. 13, 2012. Photographer: Peter Foley/Bloomberg

Appeals Court Not So Keen on Insider Trading Crackdown

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Todd Newman and Anthony Chiasson are two hedge fund managers convicted in U.S. Attorney Preet Bharara's big push to prosecute insider traders. They appealed their convictions to the U.S. Court of Appeals for the Second Circuit, and a lot of people expected the Second Circuit to reverse. There were some technical problems with the district judge's jury instructions. Plus, as I said, Newman and Chiasson didn't actually seem to be guilty. So those two things combined would probably be enough to get the convictions reversed. The way it works is, if the appeals court thinks you're innocent, then it finds a problem with the jury instructions and reverses the conviction. The appeals court doesn't just declare you innocent. That's too drastic.

Today the appeals court declared Newman and Chiasson innocent. You can read the opinion here, and it is just astounding. The jury instructions, sure, the jury instructions were wrong, whatever. The appeals court is not interested in jury instructions. It thinks that Bharara's entire insider trading crackdown is fundamentally misguided. I mean, this passage:

The Government’s overreliance on our prior dicta merely highlights the doctrinal novelty of its recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders. By contrast, our prior cases generally involved tippees who directly participated in the tipper’s breach (and therefore had knowledge of the tipper’s disclosure for personal benefit) or tippees who were explicitly apprised of the tipper’s gain by an intermediary tippee.

Notice "its recent insider trading prosecutions." Not "this one case." All of them. And this is only barely an exaggeration. Here is a Bloomberg News diagram showing nine people convicted of insider trading based on tips from Nvidia employee Chris Choi and/or Dell employee Rob Ray. Two of those people were Newman and Chiasson, who were convicted at trial and had their convictions reversed here. One was Michael Steinberg of SAC Capital, who was also convicted at a trial with the same judge and the same erroneous jury instruction, and who also appealed. Six pled guilty. All of them, according to the Second Circuit's reasoning, were innocent.

That's not about jury instructions. The law of insider trading is, basically, that you are guilty of insider trading if:

  1. someone has material nonpublic information,
  2. he gives it to you in breach of a duty of confidentiality,
  3. he gets some personal benefit for doing so,
  4. you know about it,
  5. and you trade on it.

The jury instruction dispute was over step 4: Did Chiasson and Newman have to know that Choi and Ray got a personal benefit for tipping the analysts who tipped the other analysts who tipped Newman and Chiasson? If they did, um, that would be hard to prove, because Chiasson and Newman had never heard of Choi or Ray, and certainly didn't know what benefits they got. So that would be a reason to reverse. And it was.

But the appeals court got stopped on step 3: Did Choi and Ray even get a personal benefit for disclosing nonpublic information to investment analysts? There's good reason to think that they didn't. Neither Choi nor Ray was ever charged with a crime, for one thing, though Choi settled with the Securities and Exchange Commission for a $30,000 fine. Also, Ray was an investor relations employee at Dell, meaning that his job was to talk to investors and analysts.

Also they just didn't get anything for their tips. That bar is pretty low, or so everyone always thought. The SEC will bring cases where the personal benefit is just the warm feeling you get from giving "a gift to a friend and/or reputational benefit." But here is the Second Circuit today (citations omitted):

This standard, although permissive, does not suggest that the Government may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature. If that were true, and the Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity. To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades “resemble trading by the insider himself followed by a gift of the profits to the recipient,” we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature. In other words, as Judge Walker noted in Jiau, this requires evidence of “a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the [latter].”

While our case law at times emphasizes language from Dirks indicating that the tipper’s gain need not be immediately pecuniary, it does not erode the fundamental insight that, in order to form the basis for a fraudulent breach, the personal benefit received in exchange for confidential information must be of some consequence.

Probably no one believed that "fundamental insight" before today, largely because no one got convictions reversed because the tipper didn't get a big enough benefit.

But now they have. The Second Circuit didn't just find that the jury should have considered whether Newman and Chiasson knew that the tippers received benefits in exchange for their tips. It didn't just find that Newman and Chiasson didn't know about those personal benefits, and so couldn't be guilty. It found that there were no such personal benefits, and so no one in the whole chain -- Newman, Chiasson, Steinberg, Ray, Choi or any of the six people who pled guilty -- could be guilty.

That's great for Steinberg, obviously. I don't know what it does for the six people who pled guilty. Probably nothing. But it's huge for insider trading law. Now, if you trade on a tip from a corporate insider, you're not guilty of insider trading unless the tipper actually got some personal benefit in exchange for the tip. That was always notionally the law, but now it's actually the law.

This renders a whole host of insider trading cases problematic. Even golf buddy cases. One of the Oakley Country Club cases featured a corporate executive who allegedly tipped his golf buddy with the goal of "currying favor" with him "and/or providing confidential information to a trading friend." Does that sound like the sort of personal benefit that the Second Circuit would find sufficient for criminal liability? It sounds to me more like "the mere fact of a friendship, particularly of a casual or social nature." And so it's not criminal insider trading.

But the Second Circuit is not really interested in golf buddy cases. It's interested in remote-hedge-fund-manager-network cases. And the even bigger result of this ruling is that, if you trade on a tip from a corporate insider, you're not guilty of insider trading unless you knew that the tipper actually got some personal benefit in exchange for the tip.

What that means is that, if you are far away from the original corporate insider in the chain of knowledge, you basically can't be guilty of insider trading. And that's clearly what the appeals court wants. After criticizing the "doctrinal novelty" of the recent prosecutions, the court today went on to say that its "prior cases generally involved tippees who directly participated in the tipper’s breach (and therefore had knowledge of the tipper’s disclosure for personal benefit) or tippees who were explicitly apprised of the tipper’s gain by an intermediary tippee":

We note that the Government has not cited, nor have we found, a single case in which tippees as remote as Newman and Chiasson have been held criminally liable for insider trading.

And now Newman and Chiasson won't be held criminally liable either. I think this is the right result in this case: As I've said before, it seems clear enough to me that Newman and Chiasson really didn't think they were trading on illegal inside information, so I'm glad that they won't go to prison.

But the breadth of the opinion is still surprising. What the Second Circuit is saying here is, basically, that Bharara's whole theory of insider trading prosecutions is wrong, that prosecutors and courts shouldn't be in the business of tracing inside information as it passes through the nodes of a hedge-fund network. Once it's gone through enough nodes, it's clean, or clean enough: The people further up the chain probably don't know whether or how the original insider was compensated, and so aren't guilty of insider trading even if they know that they're trading on information that came from an insider. If you don't know the insider, it's probably not insider trading.

That means that prosecutors should stick to, basically, golf-buddy cases. (I mean, the ones where the golf buddies are paid for information, anyway.) Classic, obvious shady insider trading, bags of cash passed in parking lots to corporate insiders, all that stuff is still fair game. But the theory that insider trading is pervasive in the hedge fund world, and that prosecutors should infiltrate that world to stamp it out -- that pretty much ends with this opinion. It may be true. But now it's not illegal.

  1. Technically, it found that the evidence against them was insufficient to convict them beyond a reasonable doubt. When we last discussed this case I said:

    "We're innocent" is not a valid basis for an appeal. "Insufficiency of the evidence" to convict is a valid basis, and Chiasson and Newman argue it here, but it's a bit disfavored. Judges don't like to say that no rational jury could have come to the conclusion that an actual jury actually came to. It doesn't make the system look good.

    So I assumed they'd reverse on the jury-charge stuff. But, nope: They ruled for Chiasson and Newman both on the jury charge and on the insufficiency of the evidence.

    Also, disclosure (?): Ralph Winter, one of the three judges on the panel, taught me Securities Regulation in law school.

  2. Plus two more people (and one SAC Capital) who've paid civil fines, which are not subject to quite the same standard.

  3. And four of them -- Steinberg and three of the guilty pleas -- were added to the caption of the case on appeal, at the direction of the Second Circuit. Which is ... weird? There's a partial explanation in footnote 5 of the opinion, which mentions that the government added Steinberg to the Newman/Chiasson indictment after Newman and Chiasson had already been tried, presumably so that the government could guarantee that Steinberg would be tried by Judge Sullivan, who gave the erroneous instruction here that the government likes. (And who is treated rather harshly in this opinion.) So the caption sort of calls out that Steinberg is part of this case. But I don't think it has any other legal effect.

  4. The Second Circuit says, erroneously, that "Ray and Choi have yet to be charged administratively, civilly, or criminally for insider trading or any other wrongdoing." Here is the SEC release announcing Choi's civil charges and settlement. (That SEC release came out April 23, the day after the Newman/Chiasson oral argument.)

  5. It did find that. See pages 18-20 of the opinion.

  6. It found that too. See pages 24-27. E.g.:

    Even assuming that the scant evidence described above was sufficient to permit the inference of a personal benefit, which we conclude it was not, the Government presented absolutely no testimony or any other evidence that Newman and Chiasson knew that they were trading on information obtained from insiders, or that those insiders received any benefit in exchange for such disclosures, or even that Newman and Chiasson consciously avoided learning of these facts. As discussed above, the Government is required to prove beyond a reasonable doubt that Newman and Chiasson knew that the insiders received a personal benefit in exchange for disclosing confidential information.

    It is largely uncontroverted that Chiasson and Newman, and even their analysts, who testified as cooperating witnesses for the Government, knew next to nothing about the insiders and nothing about what, if any, personal benefit had been provided to them.

    Also relevant (citation omitted):

    The Government now invites us to conclude that the jury could have found that the appellants knew the insiders disclosed the information “for some personal reason rather than for no reason at all.” But the Supreme Court affirmatively rejected the premise that a tipper who discloses confidential information necessarily does so to receive a personal benefit.
  7. Another long quote, page 23 (citations omitted):

    Here the “career advice” that Goyal gave Ray, the Dell tipper, was little more than the encouragement one would generally expect of a fellow alumnus or casual acquaintance. Crucially, Goyal testified that he would have given Ray advice without receiving information because he routinely did so for industry colleagues. Although the Government argues that the jury could have reasonably inferred from the evidence that Ray and Goyal swapped career advice for inside information, Ray himself disavowed that any such quid pro quo existed. Further, the evidence showed Goyal began giving Ray “career advice” over a year before Ray began providing any insider information. Thus, it would not be possible under the circumstances for a jury in a criminal trial to find beyond a reasonable doubt that Ray received a personal benefit in exchange for the disclosure of confidential information.

    The evidence of personal benefit was even more scant in the NVIDIA chain. Choi and Lim were merely casual acquaintances. The evidence did not establish a history of loans or personal favors between the two. During cross examination, Lim testified that he did not provide anything of value to Choi in exchange for the information. Lim further testified that Choi did not know that Lim was trading NVIDIA stock (and in fact for the relevant period Lim did not trade stock), thus undermining any inference that Choi intended to make a “gift” of the profits earned on any transaction based on confidential information.

    The next sentence begins "Even assuming that the scant evidence described above was sufficient to permit the inference of a personal benefit, which we conclude it was not."

  8. But see footnote 3 about the re-captioning of the case. I don't think that means much, though; there are no specific orders that I can find relating to the three people who pled guilty but nonetheless seem to have been added to this appeal.

  9. IMPORTANT:

    1. The Oakley Country Club is in the First Circuit, not the Second, so this case is not binding on its members.
    2. None of this -- none of this whole post -- is legal advice. If you go out and play golf and insider trade and get arrested and are like "Matt Levine told me it was fine," you are an idiot.
  10. The government makes an argument that Newman and Chiasson should have known that the information they had was from insiders, because it was so specific. The court disagreed. But more importantly, it said (page 27):

    Moreover, even if detail and specificity could support an inference as to the nature of the source, it cannot, without more, permit an inference as to that source’s improper motive for disclosure.

    That is: Even if you knew it was inside information, you still didn't know that the insider got a benefit for providing it. So you can't be guilty.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matthew S Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net