Insider Trading is Not Always Illegal

In “Game-Changer” Decision, Second Circuit Reminds the Government That Not All Insider Trading is Illegal

By James M. Mulcahy on February 25, 2015

Insider trading always has been a dramatic and highly controversial issue in the law. Historically, the Government has chosen to prosecute only tippees who directly participated in the insider-tipper’s breach of her fiduciary duty, or tippees who were explicitly aware of the insider-tipper’s “personal benefit” or gain.

Most recently, however, in what has been described as “doctrinal novelty,” the Government has “increasingly targeted at remote tippees many levels removed from corporate insiders.”[1] But, on December 10, 2014, in United States v. Newman, the Second Circuit handed down a “game-changer” decision. And, after 31 years, the Government again has been reminded that “nothing in the law requires a symmetry of information in the nation’s securities markets.”[2] In other words, insider trading is not always illegal.

Insider Trading in the 1980s

During the 1980s, the war against insider trading became a top priority of the Securities and Exchange Commission (“SEC”) and its ally, the U.S. Attorney’s Office for the Southern District of New York. According to the Los Angeles Times, the then-U.S. Attorney (Rudolph Giuliani) brought five times as many insider-trading cases as had ever been brought before in his district.

From its inception, the war against “illegal” insider trading has been fraught with legal and conceptual problems. During the 1980s, the Government never developed a theory of why insider trading was harmful or a rationale for deciding whom and when to prosecute. Nevertheless, the prevailing view during the 1980s – which continues through today – has been that insider trading must be stopped in order to restore “public confidence” in the securities markets throughout the country. Unfortunately, the line between normal market activity and criminal conduct always has been gray. This ambiguity very often has relegated this determination to a “game of chance.”

In 1980, and again in 1983, the United States Supreme Court handed down two important decisions, both of which frustrated and stymied the Government in its effort to prosecute the so-called “illegal” insider trading of various market participants.

Chiarella v. United States.[3] Chiarella was the first criminal insider-trading case ever brought by the Government. Chiarella was a printer who was hired to print documents used by acquirers when making tender offers. Such acquirers typically take steps to preserve the secrecy of the offer and the identity of the target prior to acquisition. If leaks occur, the target, then forewarned, may erect defensive measures to defeat the offer. Also, other bidders may enter the scene once a target is identified. The price of the target’s shares almost certainly will rise in anticipation of the offer. All of this then may make the offer more costly and less likely to succeed.

For these reasons, offerors when dealing with printers such as Chiarella, conceal the identity of the target corporation until the last possible moment. Preliminary drafts leave the name of the target blank or use a code. Chiarella’s employer, Pandick Press, swore all of its employees to secrecy. Trading was strictly prohibited. Chiarella knew well that his job was to print the documents and nothing more. Chiarella, however, “cracked” the code that was used to disguise the identity of prospective targets and proceeded to trade in their shares prior to the acquisition announcements. After being caught, he was criminally prosecuted and convicted. The Second Circuit affirmed the conviction.

On appeal to the United States Supreme Court, no one argued anything other than that Chiarella was an unsympathetic thief. Nevertheless, the Supreme Court reversed his conviction. In doing so, the Supreme Court rejected the SEC’s contention that the public has a right to equal access of information in securities markets. Rather, the Court found that each trader is free to trade, no matter how great his informational advantage, unless there is a relationship of trust and confidence – i.e., a fiduciary relationship – with the party on the other side of the transaction. Because Chiarella was not in a fiduciary relationship with the target shareholders – and, therefore, owed the target no fiduciary duty – the Supreme Court found that he could trade as he pleased without having illegally traded on inside information. The Supreme Court also found that Chiarella was not prohibited from trading on the ground that he breached a duty to his own employer – i.e., Pandick Press – because the Government had not made that argument in the trial court below.

Chiarella, then, teaches that trading on material nonpublic information, ipso facto, is not illegal; and, “financial unfairness” does not necessarily constitute fraudulent activity in violation of Section 10(b) of the Securities Exchange Act.[4]

Dirks v. SEC.[5] In Dirks, the United States Supreme Court again rejected the Government’s position on unlawful insider trading. Dirks was a securities analyst with a large network of client contacts. One of these contacts, Ronald Secrist, a former employee of an insurance company, Equity Funding Corporation, told Dirks that Equity Funding was perpetrating a massive fraud on both its policyholders and the public investors in the company. After investigating the tip, Dirks confirmed its accuracy and reported it to the press and to the SEC.

Both the press and the SEC ignored Dirks. They did not believe him because Equity Funding was one of the most successful and reputable insurance companies in the country. When Dirks reported the tip to his institutional investor clients, however, they immediately sold their Equity Funding stock. Sometime later, an investigation revealed that Dirks was correct when he reported to the press and the SEC that Equity Funding was in fact engaged in fraud. In response to the investigation findings, the price of Equity Funding’s shares plummeted.

Rather than commend Dirks for his efforts in exposing Equity Funding’s fraud, the SEC censured Dirks for engaging in illegal insider trading by tipping to his clients material inside information received from Secrist. The Supreme Court then agreed to hear the case.

The SEC’s position in Dirks was that Dirks had acted improperly because the securities laws “require equal information among all traders.” The Supreme Court rejected this contention, just as it had done several years earlier in Chiarella. The Court ruled that the key question was whether Secrist received a “personal benefit” in exchange for giving the information to Dirks. Since Secrist acted out of a desire to expose a fraud rather than merely to make money for himself, the Court held that Dirks acted lawfully. Secrist, a corporate insider, “provided the confidential information [to Dirks] in order to expose a fraud in the company and not for any personal benefit, and thus the Court found that the insider had not breached his duty to the company’s shareholders and that Dirks could not be held liable as a tippee.”[6]

Emphasizing the role of Dirks and his clients in exposing the fraud at Equity Funding, the Supreme Court went further than merely declaring that Dirks’ conduct was not illegal. Instead, Dirks’ conduct was viewed as beneficial conduct. The possibility of financial gain, in fact, had created the incentive for Dirks to ferret out the company’s fraud to begin with. Dirks’ fees, and the trading profits of his clients, were their reward for discovering and uncovering the fraud.

Thus, in Dirks, the Supreme Court recognized that insider trading is not always bad. Instead, trading while in possession of valuable nonpublic information sometimes is desirable; other times it is not. That still remains true to this day. But, prior to Chiarella and Dirks, the problem was that the SEC had no theory that admitted the existence of “good” insider trading nor any theory to distinguish it from “bad” insider trading.

Taken together, then, Dirks and Chiarella created fundamental problems for the Government. Both Dirks and Chiarella unquestionably profited by their possession of valuable non-public information, yet the Supreme Court held that neither had engaged in illegal insider trading. Both cases made clear that the SEC’s broad assertion that a trader threatened “public confidence” in securities markets would not establish a case of unlawful insider trading.

The “Misappropriation Theory” of Insider Trading Liability

In an effort to get around the Supreme Court’s decision in Chiarella, the Government developed a new theory of prosecution for illegal insider trading. Chiarella was never charged with misappropriating information from his employer or the acquirer, so the Supreme Court refused to affirm his conviction on those rounds. Chiarella went free, in other words, because the Government made the mistake of charging him with the wrong offense. In response to this mistake, after Chiarella, “misappropriation” became the Government’s new theory of prosecution.

The “misappropriation theory” revolutionized the law of insider trading. It holds that a person commits fraud “in connection with” a securities transaction, and thereby violates Section 10(b) and Rule 10b-5, when she misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, it is no longer relevant that a trader may not have breached any duty owed to the traders on the other side of the transaction. Instead, a trader is guilty of illegal insider trading as long as the information was obtained somewhere in the vicinity of a fiduciary duty owed to “someone.”

In 1997, the United States Supreme Court expressly held that criminal liability under Section 10(b) of the Securities Exchange Act may be predicated on the misappropriation theory.[7] This dramatically expanded the reach of the Government to prosecute a wide array of people, including lawyers, investment bankers, psychiatrists, and others who allegedly obtained and traded on information without the consent of their clients. The injured party under the misappropriation theory was whomever the information was taken from, not shareholders trading in the marketplace. The misappropriation theory also was tailor-made for prosecutorial overreaching.

Insider Trading in the 2000s

In recent years – not at all unlike the 1980s – it has been hard to find any court, at any level, that has been willing to let anyone accused of the heinous offense of “insider trading” off the hook. The Government’s success in prosecuting people who have traded on the basis of material, nonpublic information is amply demonstrated by a single and undeniable fact: in just the past few years, the U.S. Attorney for the Southern District of New York has ensnared almost 90 people who have either been convicted of, or pleaded guilty to, insider trading.

And, perhaps as a function of prosecutorial enthusiasm, stemming from its crescendo of ever-greater successful prosecutions, the Government’s focus has progressed ever more out and away from the fulcrum of the tipping chain. Thus, it has become ever more popular for the Government to prosecute tippees who have been further and further removed from the corporate insider who originally “leaked” the corporation’s nonpublic information. This overreaching has resulted in the prosecution of persons who were so far removed that even they had no idea who was the source of the inside information, much less whether the source had breached a fiduciary duty to someone by tipping inside information in exchange for some form of “personal benefit.”

Paradoxically, in many instances, the Government prosecuted the tippee who was three and four levels removed from the insider-corporate tipper, but chose not to prosecute the corporate insider or the inside traders who were three or more levels below the defendant-tippee. But now, given a very recent judicial paroxysm, the Government’s prosecutorial overreaching most likely has come to an abrupt end.

On December 14, 2014, the United States Court of Appeals for the Second Circuit pulled the Government up short and now has changed everything. In United States v. Newman, the Second Circuit dealt the Government what has been described as a “stinging blow” and, for all practical purposes, will “chill” the Government’s prosecutorial expansion of the participatory orbit of alleged “illegal” insider trading.

United States v. Newman.[8] In Newman, Rob Roy, a member of Dell’s investor relations department, tipped Dell’s consolidated earnings numbers to Sandy Goyal, a financial analyst at Neuberger Berman, before the numbers were publicly released. Goyal, in turn, tipped the nonpublic information to analyst Jesse Tortora at another firm (Diamondback). Tortora then provided the information to Todd Newman, who was Tortora’s manager at Diamondback. Tortora also tipped Dell’s earnings information to another analyst (Sam Adondakis) at a different firm (Level Global). Adondakas then passed the information to Anthony Chiasson.

Newman and Chiasson were three and four levels removed from the inside tipper (Roy). Nevertheless, the Government charged Newman and Chiasson with criminal insider trading.[9]

The Government presented absolutely no evidence that Newman or Chiasson knew that the corporate insiders – i.e., Roy and Choi – received any benefit in exchange for disclosing the admittedly material, nonpublic corporate earnings information.[10] The Government conceded that, under Dirks, a corporate insider has committed no breach of fiduciary duty unless he receives a personal benefit in exchange for disclosure.[11] But, the Government argued that, although the insider-tipper must have received something of value, it was not required to prove that Newman and Chiasson knew that the insiders at Dell and NVIDIA – i.e., Roy and Choi – received a personal benefit; instead, Newman and Chiasson still could be found liable simply because they were “sophisticated traders” and, therefore, they “must have known that information was disclosed by insiders in breach of a fiduciary duty, and not for any legitimate corporate purpose.”[12]

The district court accepted the Government’s argument. Following a six week jury trial, Newman and Chiasson were convicted. They appealed to the Second Circuit.

On appeal, the Second Circuit’s response to the Government’s argument was harsh and unequivocal. In pedantic fashion, the Court made two points clear:

  • First, there was no evidence that the corporate insiders – i.e., Roy and Choi – provided inside information in exchange for personal benefit which is required to establish tipper liability under Dirks. Because a tippee’s liability derives from the liability of the tipper, Newman and Chiasson could not be found guilty of insider trading.
  • Second, even if the corporate insiders – i.e., Roy and Choi – had received a personal benefit in exchange for the inside information, there was no evidence that Newman and Chiasson knew about any such benefit. Absent such knowledge, they could not be convicted of insider trading under Dirks.

The fact that Newman and Chiasson – or any others in the tippee chains – admittedly were trading on inside information was immaterial and beside the point. That, in and of itself, is not “illegal” insider trading; rather, it is lawful insider trading even though it still otherwise may be disreputable. The fact that this sounds counterintuitive may seem unfortunate but, as the Newman Court explained:

  • For purposes of insider trading liability, the insider’s disclosure of confidential information standing alone, is not a breach. Thus, without establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the Government cannot meet its burden of showing that the tippee knew of a breach.

Id. at *18 (Emphasis added). With that, the Second Circuit vacated the convictions, remanded the case back to the district court, and directed the court below to dismiss the indictments against Newman and Chiasson.

The Newman Implications Going Forward

Newman represents cold water on a burning fire. Trading on inside information by tippees is not necessarily unlawful for at least three reasons. First, the tippee’s liability derives only from the tipper’s breach of a fiduciary duty, not from trading on material nonpublic information. Second, the corporate insider has committed no breach of fiduciary duty unless she receives a personal benefit in exchange for the disclosure. What constitutes a “personal benefit” may include any reputational benefit that will translate into future earnings, but furtherance of a mutual friendship or other relationship – e.g., fellow alumni or church-goers – is not sufficient. Third, even in the presence of a tipper’s breach, a tippee is only liable if she knows or should have known of the breach – i.e., both the disclosure and the resulting personal benefit. In the absence of proof showing these requirements there is no tippee liability even though the tippee may have achieved a monetary windfall by trading on the material, nonpublic information.

The most immediate and tangible consequence of the Newman decision is this: the Government will – and already has begun to – review its current indictments of remote tippees, with a view toward dismissing those indictments voluntarily. Conversely, defense attorneys representing remote tippers – e.g., Michael Steinberg – will be looking closely at the Newman opinion with a view toward identifying appealable issues warranting the reversal of prior insider trading convictions. And, going forward, the Government may reconsider its prosecutorial overreach, keeping in mind the Second Circuit’s reproach:

  • 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.
  • 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. There is no doubt that Newman is in fact a “game-changer.”[13]

This article was prepared by James M. Mulcahy (, of the Irvine law firm of Mulcahy LLP. Mulcahy LLP is a boutique litigation firm that provides legal services to franchisors, manufacturers and other companies in the areas of antitrust, trademark, copyright, trade secret, unfair competition, franchise, and distribution laws.

Disclaimer: While every effort has been made to ensure the accuracy of this article, it is not intended to provide legal advice as individual situations will differ and should be discussed with an experienced franchise lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.

[1] United States v. Newman, 2014 U.S. App. LEXIS 23190, *18 (2d Cir. 2014).
[2] Id. at *21.
[3] 445 U.S. 222 (1980).
[4] 445 U.S. at 232.
[5] 463 U.S. 646 (1983).
[6] United States v. Newman, 2014 U.S. App. LEXIS 23190, *15 (2d Cir. 2014).
[7] United States v. O’Hagan, 521 U.S. 642 (1997).
[8] 2014 U.S. App. LEXIS 23190 (2d Cir. 2014).
[9] The Government also charged Newman and Chiasson with criminal insider trading of the securities of another technology company (NVIDIA). With respect to the NVIDIA tipping chain, the factual underpinnings were similar, except that both Newman and Chiasson were four levels removed from the inside tipper (Chris Choi, a member of NVIDIA’s finance unit). The Government did not charge any of the tippers below Newman and Chiasson in the Dell tipping chain or the NVIDIA tipping chain.
[10] 2014 U.S. App. LEXIS 23190, *32-33 (2d Cir. 2014).
[11] Id. at *16.
[12] Id. at *7. br> [13] Id. at *18-19 (Emphasis added).




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