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Justice Dept. Seeks Clarification on Insider Trading

By Mark Wilson, Esq. on March 03, 2015 | Last updated on March 21, 2019

Last week, the United States went back to the Second Circuit to ask for a rehearing in United States v. Newman, where that court overturned the convictions of two hedge fund managers for trading on inside information.

The Second Circuit rejected Newman and Chiasson's convictions on a "tipper/tippee" theory of liability, prompting onlookers to urge Congress to clarify what the heck qualifies as insider trading.

The Insider Trading Classic Formula Was Better

The Newman case presents a set of facts similar to what you'd find in a final exam in business associations class. The inside information started with someone from Dell's investor relations department, who told an outside analyst, who told another analyst, who told Newman and Chiasson (the hedge fund managers), who traded on the information. A similar chain of events unfolded when the managers traded on inside information from NVIDIA.

Part of the problem with insider trading is that it relies on at least three different theories of liability, all of which have been judicially crafted to reflect different scenarios. Back in Ye Olden Times (i.e., before the 1980s), a corporate insider whispered inside information to a stock broker, who traded on the information. That's about as simple as you can get.

That's "classic" theory. There's also "misappropriation" theory, in which an "outsider" -- someone with no fiduciary duty to the company -- gives inside information to another person (who has a fiduciary duty to the outsider) who then trades on that information.

But what about the chain of inside information found in this case, which is typical of how whispers get spread around the stock analyst world? That's covered by "tipper/tippee" liability, which can occur only when "the insider personally will benefit, directly or indirectly, from his disclosure." A chain of liability can be strung together, with no showing of a fiduciary relationship between any of its members, as long as the original "tipper" gained from the disclosure. But if he didn't, then no one in the chain is liable.

Legislation Is the Answer

Here's a new wrinkle the Second Circuit added: Recipients of inside information have to know that the information is inside information. Because tipper/tippee liability is predicated on the tipper's personal benefit, the tippee additionally has to know that disclosing the information will benefit the tipper. The Second Circuit also took time out from its busy day to criticize insider trading cases "which are increasingly targeted at remote tippees many levels removed from corporate insiders," emphasizing that the hedge fund managers here were several levels away from the inside information.

Peter Henning, writing in The New York Times' Dealbook blog, observed that an en banc rehearing is unlikely (the Second Circuit is notoriously allergic to them), but said Congress might enter the fray to clarify -- and broaden -- the scope of judicially created insider trading liability: "There has not been a public outcry to allow more trading on confidential information, and recent concern about the impact of high-frequency traders that rely on tiny informational advantages is unlikely to generate support for allowing increased use of market-moving information to generate profits."

In other words, there is the potential for congressional buy-in to change the law (and House Democrats introduced such a bill yesterday), although big financial services companies, whose well-off employees donate to Congress, have a bit more of an outsized say in whether that happens.

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