U.S. Government Appeals Landmark Insider Trading Decision to the Supreme Court

This guest post was authored by our colleague Rimma Tsvasman, an associate in the firm’s Litigation Department in New York. Rimma concentrates her practice on corporate and securities transactions, investment management and commercial litigation. She can be reached at rtsvasman@mmwr.com or 212-867-9500. 

In a highly anticipated move following a denied request for a rehearing, the Government has petitioned the Supreme Court for a writ of certiorari requesting the high court to overturn the Second Circuit’s landmark insider trading decision in U.S. v. Newman.

Although the Newman decision has not reached far beyond New York’s borders, as noted by MMWR partner Lathrop Nelson in this recent Bloomberg article, there is no denying that the decision is a prominent one coming from what Supreme Court Justice Harry Blackmun has called the “Mother Court” for securities law.  Indeed, if the Supreme Court decides not to hear the case or if the decision is left to stand, it would represent a big change to the securities law landscape – both in New York and in other jurisdictions which historically have deferred to the Second Circuit on securities law matters – and a blow to U.S. Attorney Preet Bharara’s legacy in aggressively policing Wall Street in the area of insider trading.

The Government itself has conceded that the Newman decision will dramatically limit its ability to prosecute some of the most common forms of insider trading which involves downstream tipping to individuals two or three steps removed from the so-called insider.  As noted by MMWR partner Mark Sheppard in an earlier post reporting on the Newman decision, many of the Government’s highest profile cases have been built upon the cooperation of those “downstream” traders who would be more empowered to resist the government’s efforts to secure that cooperation.  And although Newman is a criminal case, the Second Circuit did not limit its holding to such cases.  Therefore, civil enforcement cases stand to be impacted as well.

Already, the change caused by Newman is palpable as industry professionals hold their breath to see what the Supreme Court will do.  In just several months following the decision, defendants – including S.A.C. Capital Advisors’s Mathew Martoma and Michael Steinberg – have begun to file appeals to overturn their convictions in reliance on Newman.    And some defendants have already had their guilty pleas vacatedJust over a month after the Newman case was decided, the District Court for the Southern District of New York applied the case to vacate four guilty pleas in an insider trading action involving tips about a 2009 acquisition by IBM.  In that case, United States v. Conradt, No. 12 CR 887 (ALC), 2015 WL 480419 (S.D.N.Y. Jan. 22, 2015), the court expanded Newman’s application to cases based on the misappropriation theory, which imposes liability on third parties – such as lawyers – who are entrusted with confidential information as part of their work and break that trust by divulging the confidential information to others.

Decided on December 10, 2014, the Newman court put the brakes on aggressive insider trading prosecutions by holding that the Government must prove that the defendant knew the insiders disclosed confidential information in exchange for a personal benefit, and that the benefit was consequential and represented at least a potential gain of a pecuniary nature.  In other words, under Newman, friendly tips are no longer actionable.

In its petition to the Supreme Court, the Government argues that the Newman decision is at odds with the Supreme Court’s decision in Dirks v. SEC, which sets forth the personal-benefit standard, as well as other appeals court rulings, and has troubling implications for the Government’s ability to police insider trading.

The Supreme Court begins its new term in October, and will likely decide this Fall whether to consider the Government’s appeal.  We will be sure to keep you posted.

UPDATE: Second Circuit Reverses “Downstream Tippee” Convictions

This guest post was authored by our colleague Mark B. Sheppard, a partner in the firm’s Litigation Department. Mark focuses his practice on white collar criminal defense, SEC Enforcement and complex commercial civil litigation. He can be reached at msheppard@mmwr.com or 215.772.7235.

As we predicted back in April, the Second Circuit Court of Appeals has dealt a significant blow to the Government’s ongoing efforts to successfully prosecute insider trading cases involving “downstream traders” or “tippees.” (United States v. Newman, 2d Cir., No. 13-1837, 12/10/14). In the ruling, the Panel court not only overturned the guilty verdicts of two hedge fund managers who traded on inside information received from other Wall Street analysts, it also took a shot at U.S. Attorney Preet Bharara’s aggressive enforcement of remote tippees, criticizing the “doctrinal novelty of (the Government’s) recent insider trading prosecutions….” This does not bode well for future prosecutions of downstream traders and will also limit civil enforcement activity against those traders who are two or three levels removed from the original insider source and imperils several high profile convictions and numerous guilty pleas.

In this case the defendant hedge fund managers “were several steps removed from the corporate insiders.” The Court also noted that the Government had failed to adduce evidence that either was aware of the source of the inside information or the circumstances under which it was conveyed. Despite this, the Government charged that the managers were criminally liable for insider trading because, as sophisticated traders, they must have known that information was disclosed by insiders in breach of a fiduciary duty, and not for any legitimate corporate purpose.

The Second Circuit disagreed. “In order to sustain a conviction for insider trading, the Government must prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.” (Emphasis in the original). Relying upon the Supreme Court’s decision in Dirks v. S.E.C., 463 U.S. 646 (1983), the Court explained “[t]he tippee’s duty to disclose or abstain is derivative from that of the insider’s duty.” Because the tipper’s breach of fiduciary duty requires that he “personally will benefit, directly or indirectly, from his disclosure a tippee may not be held liable in the absence of such benefit.” The jury instruction was therefore faulty because it permitted the jury to convict solely on a showing that the defendants knew that there had been a breach of fiduciary duty.

Having determined that the instruction was erroneous, the Court then turned to the evidence of personal benefit which it also found wanting.  It described the Government’s proof of personal benefit as “career advice” or the “ephemeral benefit… that one would expect to be derived from be derived from favors or friendship.” To accept such proof as sufficient would render the personal benefit requirement a nullity. Instead to maintain a conviction, the evidence of benefit must be “of some consequence” resembling “a relationship between the insider and the recipient that suggests a quid pro quo” or an intention to confer a future benefit. Finally and perhaps more significantly, even if the evidence of benefit were sufficient, the Government’s failure to prove the defendants’ knowledge of such benefit was fatal to the prosecution.

There is already debate as to the impact of this decision on efforts to regulate Wall Street professionals, with prosecutors downplaying it significance as limited to a “subset” of cases. This may be so but many of the Government’s highest profile cases have been built upon the cooperation of lower level “downstream” traders who will now be more embolden to resist the government’s efforts to secure that cooperation.

Government Swimming Upstream at Second Circuit Oral Argument on Downstream Insider Trading Liability

The Justice Department has been bullish over its rigorous enforcement of insider training over the past year, but on Tuesday a Second Circuit panel raised questions regarding the government’s theory of liability that led to the conviction of two “downstream” traders. Before the court was the issue of whether tippees – recipients of inside information – can be convicted if they did not know that the tipper received any personal benefit for disclosure of inside information. The case may implicate how far downstream from the insider prosecutors can go in prosecuting “remote tippees” for insider trading.

In United States v. Newman, two hedge fund managers were convicted for participating in an insider trading scheme. The fund managers received detailed inside information from a source, but did not know the identity of the original insider. Though not quite the level of six degrees of Kevin Bacon, the defendants contended that they were four degrees away from the original tipper and had no information regarding whether the tipper received any personal benefit. At trial, the judge instructed the jury that the defendants must have known that the material, nonpublic information upon which the defendants traded was disclosed by the insider in violation of a duty of confidentiality. The jury convicted both defendants under that standard.

At oral argument before the Second Circuit, both the defendants and the government sparred over the application of the Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1993), to downstream tippee liability. In Dirks, the Court held that an insider tipper does not violate the securities laws unless he has disclosed information in breach of a duty, which the Court defined as whether “the insider personally will benefit directly or indirectly from his disclosure.” Id. at 662. The Court also addressed tippee liability, holding that the tippee cannot be liable unless he “knowingly participates with the fiduciary in such a breach.” Id. at 659. In Newman, the defense asserted that Dirks thus requires that the tippee know that the tipper provided inside information for a personal benefit. The prosecution argued that it needed to prove only that the information was provided in violation of a duty of confidentiality.

According to reports, the Second Circuit panel pushed back at oral argument against the government’s theory of liability. Judge Barrington Parker observed:

We sit in the financial capital of the world and the amorphous theory you have gives precious little guidance to all these financial institutions and all these hedge funds out there about a bright-line theory as to what they can and cannot do.

Of course, attempting to determine how a court will rule based upon comments or questioning at oral argument (or better yet, based on “downstream” information from media reports) can be a fool’s errand (just as downstream inside information about a hot stock tip can be both factually wrong and legally perilous). But reports of the argument suggest a healthy skepticism of the government’s theory of liability. Ultimately, we must wait for the Second Circuit’s decision for guidance on what knowledge is necessary for a remote tippee’s liability and how the Second Circuit’s decision – assuming it provides clarity – affects the Department of Justice’s active insider trading prosecutions. Stay tuned to White Collar Alert for the latest.

Update: Second Circuit Limits Government’s “Stream of Payments” Statute of Limitations Theory

Last week, White Collar Alert editor Erin Dougherty reported on the Second Circuit’s unusual summary order reversing the convictions of three former General Electric Co. executives for bid rigging.  Yesterday, in a 2-1 decision, the Second Circuit confirmed the expected basis for the reversal, holding that ongoing (and artificially suppressed) interest payments under municipal derivatives contracts do not constitute overt acts in furtherance of a conspiracy sufficient to extend the statute of limitations.  The opinion provides an important check on the government’s efforts to extend the statute of limitations in financial crimes when a conspirator receives a continuous flow of economic benefits.

As explained in our post last week, the government charged Peter Grimm, Dominick Carollo, and Steven Goldberg with wire fraud conspiracies to deflate the interest rates of investment contracts with municipalities as part of the Antitrust Division’s municipal bond investigation.  The government did not allege any overt acts within the statute of limitations other than the continued interest payments that were made by the defendants’ employers (providers) to the municipalities.  The defendants contended that the last overt acts occurred upon the closing of the transactions; the government countered that the purpose of the conspiracy was economic enrichment and the continued interest payments by the providers at depressed levels were made “in furtherance of the conspiracy.”

The Second Circuit resolved this dispute by stating that although “economic enrichment” conspiracies continue “through the conspirators’ receipt of their economic benefits,” such a conspiracy does not continue indefinitely.  United States v. Grimm, No. 12-4310-cr, slip op. at 11-12 (2d Cir. Dec. 9, 2013) (citing United States v. Salmonese, 352 F.3d 608, 616 (2d Cir. 2003)).  Relying on both Salmonese and United States v. Doherty, 867 F.2d 47 (1st Cir. 1989) (Breyer, J.), the court explained:

[A] conspiracy ends notwithstanding the receipt of anticipated profits “where [ ] the payoff merely consists of a lengthy, indefinite series of ordinary, typically noncriminal, unilateral actions . . . and there is no evidence that any concerted activity posing the special societal dangers of conspiracy is taking place.”

Grimm, slip op. at 12 (quoting Salmonese, 352 F.3d at 616).

The court contrasted a conspirator’s receipt of stripped warrants over a ten-week period that was neither indefinite nor lengthy in Salmonese with the ordinary commercial obligations over a potentially 20-year period in Grimm.  The court rejected the government’s bright-line rule that so long as the stream of payments contains an element of profit the conspiracy continues.  Judge Jacobs, for the majority, echoing his comments at oral argument, noted that “a conspiracy to corrupt the rent payable on a 99-year ground lease would, under the government’s theory, prolong the overt acts until long after any conspirator or co-conspirator was left to profit, or to plot.”  Id. at 14.

Ultimately, the court held that where the continued economic benefit continues “in a regular and ordinary course” beyond “when the unique threats to society posed by a conspiracy are present,” the “advantageous interest payment is the result of a completed conspiracy and is not in furtherance of one that is ongoing.”  Id. at 15.  Judge Kearse, in dissent, argued that the majority ignored the fact that the providers were coconspirators and that the providers’ continuing payments, under existing circuit precedent, constituted continuing overt acts.

The majority’s holding reaches beyond merely the municipal derivatives contracts at issue in Grimm and provides a restraint on the government’s ability to rely on continuing payments under an “economic enrichment theory” to extend the statute of limitations.