Who cares whether the original tipper got a quid pro quo?
Todd Newman and Anthony Chiasson –hedge fund portfolio managers whose 2008 convictions and prison sentences1 for insider trading were just vacated by the Second Circuit Court in New York — can thank a Wall Street insurance analyst by the name of Raymond Dirks for their new-found innocence and freedom.
Dirks was the petitioner in a 1983 Supreme Court case (Dirks v. SEC) in which his SEC censure for aiding and abetting insider trading was reversed on the ground that the corporate insider from whom he had obtained material, non-public information (MNPI) had not received a “personal benefit” for tipping him.
As the story goes, Dirks was told by a disgruntled employee of a NYSE-listed, life insurance company he was following called Equity Funding Corporation of America that the company was creating fake insurance policies in order to pump up the value of its assets and the price of its stock. Dirks passed that information on to clients and notified the SEC.2 His clients sold their Equity Funding stock before the accounting fraud was uncovered and the consequent collapse of the company. Despite Dirks’ attempts to publicly expose the fraud, the SEC charged him with aiding and abetting insider trading.
Dirks got off with only a censure from the SEC, but he nevertheless appealed the ruling – over the next ten years — all the way to the Supreme Court which reversed the result in a landmark decision that established the elements of ‘tippee liability’. Fortuitously for Newman and Chiasson, one of those elements cemented their successful appeal.
Elements of insider trading liability
In Dirks, the Supreme Court explained that insider trading liability is based on the unfairness of allowing someone with access to inside information meant to be used solely for a corporate purpose to exploit that information in a securities transaction without disclosing it to his uninformed counterparty (“disclose or abstain”). The Court stated that fraud liability does not arise from the mere possession of MNPI but from the insider’s breach of a fiduciary duty to his company by using confidential information to perpetrate a market deception for his own personal gain.
“the antifraud provisions of the law [do not] require equal information among all traders”
Since tippees typically have no fiduciary duty to the companies whose stocks they trade, they only inherit that duty if their tippers have breached their own fiduciary duties. In other words, a tippee assumes an insider’s fiduciary duty to a company’s shareholders not because he receives MNPI, but because he obtains it improperly and, the Court added, knows of the impropriety. It is the last element that establishes his criminal intent. The 6-3 Dirks opinion stated flatly that “the antifraud provisions of the law [do not] require equal information among all traders”.
Critically, the Court went on to say that an insider’s tip constitutes a breach of fiduciary duty only if the insider receives a “personal benefit” in exchange for the disclosure, which establishes the impropriety of its purpose. Since the Equity Funding employee who initially tipped Dirks about the accounting fraud received no personal benefit for divulging it3, he didn’t breach his fiduciary duty to the company’s shareholders and Dirks was therefore off the hook.
In the just-decided U.S. v. Newman case, the Second Circuit based its reversal of Newman’s and Chiasson’s convictions on the fact that no evidence was adduced at trial indicating that the two remote tippees knew of any quid pro quo the insiders at Dell and NVIDIA might have received for passing unreleased earnings results on to analysts who in turn relayed that confidential information to the defendants who ultimately used it to reap a total of $72 million in profits for their respective hedge funds.4
Clipping the SEC’s wings
Dirks has been the law for over thirty years. In the recent spate of insider trading cases brought by the SEC and the U.S. Attorney’s Office in New York, the personal benefit requirement has been chipped away by what the Second Circuit dismissed as “amorphous” and “ephemeral” benefits fabricated by the SEC. While the Newman court interpreted Dirks to require a concrete pay-off to the original tipper, the SEC’s legal position seems to be that no insider would pass on MNPI for nothing in return, especially given the risks and penalties. The Second Circuit derided that argument as highlighting “the doctrinal novelty of [the SEC’s] recent insider trading prosecutions”.
Now that Newman has brought insider trading jurisprudence back to basics, my question is why should a tipper need to be paid off in order to establish both his breach of a fiduciary duty to his company and the derivative criminal liability of any tippee of his who knew the tip was both confidential and market-moving when he traded on it for his own benefit? Is knowing of the original pay-off really necessary to ascribe criminal intent to a downstream tippee? Certainly in the cases of Todd Newman and Anthony Chiasson – seasoned hedge fund portfolio managers with numerous connections to securities analysts and public company executives – the defendants believed they were trading on tips that had been provided initially by company insiders. Perhaps a special exemption from the “personal benefit” test should be carved out for professional investors relying on secretly-transmitted tips they obtain from one another.5
1 Newman got 4½ years and Chiasson 6½ years.
2 Dirks even tried to get The Wall Street Journal to report on the fraud, but its editors demurred fearing that the exposé might be deemed libelous.
3 In fact, the tipper’s intent was to expose the Equity Funding fraud not to benefit from it.
4 Diamondback Capital Management in the case of Newman and Level Global Investors in the case of Chiasson.
5 In Newman, the SEC did charge the defendants with conspiracy to commit fraud, but the Second Circuit also rejected that charge on the ground that no fraud had been committed.