Much like the game of telephone, the final recipient of inside information may know little about who started the process or how many steps it took before arriving. When prosecutors want to pursue charges against the recipients of confidential information â€" the tippees â€" the issue is often how far down the chain they can go before they can no longer prove a violation.
How much knowledge a defendant must have is often crucial in white-collar crime cases because the issue is rarely about what the person did, but what was intended. Figuring out what a tippee has to know has become a central issue in the appeal of Anthony Chiasson and Todd Newman, two former hedge fund managers who were way down on the chain of inside information about two technology companies, Dell and Nvidia. But they were still convicted. Their appeal was heard on Tuesday.
Mr. Chiasson and Mr. Newman got information about upcoming company earnings that was traceable to insiders. But they never dealt directly with the sources of the information. Instead, the information was passed through a phalanx of analysts before finally reaching them. In the parlance of insider trading, they were remote tippees, well removed from the original tippers.
A tippee can still be held responsible for insider trading so long as the government shows that person knew the tipper breached a duty of trust and confidence to the source of the information by passing it along to someone who would profit by trading on it. To prove that breach, the Supreme Court stated in Dirks v. S.E.C., “The test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders.â€
Referred to as the quid pro quo requirement, the benefit received by the tipper can be monetary or just the warm feeling generated by making a gift to family or friends. It can even be a more ephemeral benefit like enhancing one’s reputation in the eyes of the tippee.
If this all sounds rather opaque, that’s because the law of insider trading has been developed piecemeal by the courts over the past 40 years. There is no specific statute outlining the elements of the violation. Instead, it is considered a species of securities fraud. So judges have been left to define its contours.
The Dirks opinion is the cornerstone for holding a tippee liable, but that decision is hardly a model of clarity. That case even involved a rare â€" and perhaps unique â€" situation before the Supreme Court because the federal government argued against itself, with the Securities and Exchange Commission coming out in favor of finding a violation while the Justice Department opposed it.
The case arose from the collapse of the insurance and mutual fund firm Equity Funding Corporation of America in 1973, the largest Wall Street fraud until Bernard L. Madoff’s Ponzi scheme came to light in 2008. A corporate officer told Raymond L. Dirks, a brokerage firm analyst, about accounting fraud at the company. Mr. Dirks spoke to various company employees who corroborated the charges, and as a result of his inquiries, regulators eventually began their own investigations.
Rather than being celebrated by the S.E.C. as a whistle blower, however, the agency filed civil insider trading charges because Mr. Dirks shared information about the fraud with investors, who then sold their shares before it became public. The issue before the Supreme Court was whether Mr. Dirks could be held liable as a tippee for passing along information from a company insider.
The court rejected the S.E.C.’s argument that anyone who received confidential information violates the law just by trading while in possession of it. Instead, the justices found that tipping is a violation “only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.â€
The United States Court of Appeals for the Second Circuit in Manhattan is considering the issue of tippee liability. It heard oral arguments in Mr. Chiasson and Mr. Newman’s case on Tuesday
The crucial issue is how much knowledge the government must prove for someone who is not a first-level tippee dealing directly with the source but is instead at least one step removed from the original disclosure. The Supreme Court did not have to address that issue because Mr. Dirks dealt directly with the insider. So the question in that case was whether there was any breach of a duty in the disclosure.
Mr. Chiasson and Mr. Newman argue that the government must show that the two men knew the tipper received a personal benefit from dispensing the information, not just that the information was confidential. Not surprisingly, the government disagrees, arguing in its brief that it only needs to prove “knowledge of enough facts to distinguish conduct that is likely culpable from conduct that is entirely innocent.â€
The panel of judges hearing the appeal appeared to be skeptical of the government’s argument that only a minimal degree of knowledge needs to be proven to hold a tippee liable.
Proving knowledge is always difficult in a criminal case because a jury cannot read a defendant’s mind. So it is usually a matter of evaluating circumstantial evidence to come up with a plausible understanding of what the person knew at the time. Prosecutors can also try to prove knowledge by arguing that a defendant was willfully blind to what was going on, asking a court to give the “ostrich instruction†that allows a jury to infer knowledge from conduct intended to avoid learning the truth.
The Second Circuit has been friendly to the government’s arguments in the most recent wave of insider trading cases, upholding all the convictions that have come before it. But the court did allow Mr.. Chiasson and Mr. Newman to remain free on bail while their case is on appeal, and the questioning during the oral arguments showed that the defendants have a good chance at a new trial and an outside chance at an acquittal.
The challenge for Mr. Chiasson and Mr. Newman is persuading the appeals court to recognize a higher threshold of knowledge that could lead to a reversal of their convictions and a new trial.
Requiring proof of specific knowledge about the benefit the tipper received would make it harder for the government to make its case, giving remote tippees another avenue to fight charges. The problem is that courts are often loath to give defendants too many ways to claim ignorance because that can encourage gaming the system by creating plausible deniability.
One defendant who could benefit from a decision imposing a heightened knowledge requirement is Michael S. Steinberg, a former portfolio manager at SAC Capital Advisors who was convicted of insider trading in December. He was also a remote tippee.
The case could even present the Supreme Court with an opportunity to clarify the parameters of tippee liability, an issue it has not taken up since the Dirks decision in 1983. As insider trading cases have involved increasingly sophisticated groups who pass around information, there is a need for some additional guidance on what the government must prove to hold traders liable.
