The outcome of an appeal pending in the U.S. Court of Appeals for the Second Circuit in Manhattan on the question of defining ‘tippee-liability’ for insider trading could become a turning point in the prosecution of insider trading cases. Assailing the jury instruction in the case, the Court of Appeals panel criticized the trial judge for making convictions for insider trading ‘too easy’ by not requiring proof that the defendant-appellants, who were remote tippees, knew that the tipper personally benefitted by disclosing the material nonpublic information.
The arguments of the lawyer for the United States were met with tough questioning by the panel which included U.S. Circuit Judge Barrington Parker, who remarked that the “amorphous theory” of liability advocated by her leaves the Wall Street firms at the mercy of the government because it gave them little notice on how they could legally use nonpublic information.
The U.S. Supreme Court, in Dirks v. Securities and Exchange Commission, 463 U.S. 646 (1983), held that a tippee must disclose material nonpublic information or abstain from trading on it when the tipper has breached his fiduciary duty to the company by disclosing the information to the tippee and the tippee knows or should have known that there has been such a breach. Thus, the question of tippee-liability is intertwined with the tipper’s breach of fiduciary duty and the tippee’s knowledge of such a breach. According to the Supreme Court, the finding of a breach of fiduciary duty by the insider depended largely on whether the insider used “inside information for personal advantage” and courts should make an objective enquiry as to whether the insider received a direct or indirect personal benefit in exchange of the information.
The amicus brief argues that a criminal securities conviction requires a ‘willful’ violation or proof of “a realization on the defendant’s part that he was doing a wrongful act” and that in this case, to establish criminal liability for violation of Rule 10b-5, the prosecution has to show the defendants’ knowledge that the source of the inside information leaked the information in return for some personal benefit. While the Supreme Court in Dirks stated that the tippee has a duty not to trade on material nonpublic information when he knows or should know that there has been a breach, the amicus brief contends that in that case the Court was writing in the context of an SEC civil enforcement proceeding and that in a criminal prosecution, imposition of criminal liability based on what the defendant “should know” would be inconsistent with the requirement that only “willful” violations of the Securities Exchange Act are criminal.
The arguments raised by the appellants are persuasive and calls for an appraisal of liability theories employed in previous insider convictions. In SEC v. Musella, 678 F. Supp. 1060 (S.D.N.Y. 1988), the court based the tippees’ liability on the ground that they “made a conscious and deliberate choice” not to find out about the source of the information when they should have known that fiduciary duties were being breached. Therefore, a willful disregard or indifference as to the truth might still suffice to meet the willfulness or knowledge requirement under Dirks. Further, there are also rare cases where the tipper is acquitted while the tippee is still found criminally liable for insider trading. In the case of United States v. Evans, 486 F.3d 315 (2007), the Seventh Circuit held that it is possible that an insider acted without the requisite level of intent to hold him criminally liable and yet that he nevertheless breached his fiduciary duty. Here, the court held the tippee, a friend of the insider, liable for “duping the insider into breaching her duty of confidentiality” using an inducement theory even absent a proven personal benefit to the tipper.
The amicus brief finally urges that the Supreme Court in Dirks, had explicitly acknowledged that the efforts of analysts “to ferret out and analyze” market information benefitted the investors and therefore, in order to serve the larger public interest, it is crucial to draw a line between innocent trading on leaks of inside information and trading coupled with full knowledge of breach of fiduciary duty by corporate insiders. The appeal urges that such delineation is particularly critical while assessing the liability of remote tippees like the defendants because, at some point down the line, valuable nonpublic information, even if originally disclosed improperly, becomes “just one more piece of market intelligence that is circulating among analysts and portfolio managers.”
Securities lawyers, compliance officers, the federal judiciary and investment advisors are closely watching the appeal, the outcome of which is expected to resonate through Wall Street. While a favorable ruling for the appellants will provide new ammo to defense lawyers in insider trading cases and threaten to unravel many high-profile insider convictions, an unfavorable ruling will be a significant victory for prosecutors who will continue to pursue insider convictions with increased vigor.