In my new book, Insider Trading Law and Policy, I discuss liability in cases in which inside information is passed from one tipper to another in a so-called tipping chain:
Suppose, for example, that Tipper tells Tippee #1 who tells Tippee #2 who trades. Can Tippee #2 be held liable? If the preconditions of tipping liability are satisfied, there is nothing in Dirks to foreclose such liability. Donald Langevoort, for example, suggests that liability in tipping chain cases should require a three-part showing: “each person in the chain (1) was given the information expressly for the purpose of facilitating trading based on inside information, (2) knew that the information was material and nonpublic, and (3) knew or had reason to know that it came to him as a result of some breach of duty by an insider.” He goes on to note, however, that tipping chain cases—“albeit without any substantial judicial discussion of the underlying issue”—generally have imposed liability “simply on a showing that the person came into possession of information that he knew was material and nonpublic and which he knew or had reason to know was obtained via a breach of fiduciary duty by an insider.”
In Obus, for example, the Second Circuit opined that:
A tipper will be liable if he tips material non-public information, in breach of a fiduciary duty, to someone he knows will likely (1) trade on the information or (2) disseminate the information further for the first tippee’s own benefit. The first tippee must both know or have reason to know that the information was obtained and transmitted through a breach and intentionally or recklessly tip the information further for her own benefit. The final tippee must both know or have reason to know that the information was obtained through a breach and trade while in knowing possession of the information.
Obus, 693 F.3d at 288. The court further explained that the tippee could be held liable on the basis of “conscious avoidance,” citing SEC v. Musella, 678 F. Supp. 1060, 1063 (S.D.N.Y.1988), for the proposition that Dirks was “satisfied where the defendants, tippees at the end of a chain, ‘did not ask [about the source of information] because they did not want to know.’ ” Obus, 693 F.3d at 288–89.
As the WSJ reported on Monday, this issue is now on appeal before the Second Circuit:
The appeal is being pursued by Todd Newman and Anthony Chiasson, two portfolio managers whose 2012 insider-trading convictions were a significant victory for prosecutors. ...
The original trial judge told jurors that Messrs. Chiasson and Newman could be convicted of insider trading even if they hadn't known that the person who leaked the information had done so in return for a "personal benefit."
Lawyers for Messrs. Newman and Chiasson say prosecutors must show that their clients knew the tippers were somehow compensated for the tips and that the judge's instruction was erroneous. The inside tips on which the pair traded were conveyed through a network of analysts before reaching analysts who worked for Messrs. Chiasson and Newman, the lawyers said in court documents. Their clients didn't seek out or knowingly use inside information, they said.
Prosecutors have said they need only show that people who used the tips were aware the tipper disclosed the nonpublic information in breach of a fiduciary duty when they traded on it.
Even if the instruction was erroneous, the jury would have concluded the two men inferred the information was given in exchange for a reward, prosecutors said in court documents.
Given the phrasing of the Obus standard, the jury instruction may well hold up on appeal. On the other hand, the seminal Dirks v. SEC decision makes clear that the requisite breach of fiduciary duty is one in which the tipper gets a personal benefit in return for the tip, so shouldn't the personal benefit requirement be made explicit?
The problem here is that the Obus case erroneously phrased the Dirks standard. According to the Second Circuit:
The [Supreme] Court held that a tipper like the analyst in Dirks is liable if the tipper breached a fiduciary duty by tipping material non-public information, had the requisite scienter (to be discussed momentarily) when he gave the tip, and personally benefited from the tip. Id. at 660–62, 103 S.Ct. 3255. Personal benefit to the tipper is broadly defined: it includes not only “pecuniary gain,” such as a cut of the take or a gratuity from the tippee, but also a “reputational benefit” or the benefit one would obtain from simply “mak[ing] a gift of confidential information to a trading relative or friend.” Id. at 663–64, 103 S.Ct. 3255. When an unlawful tip occurs, the tippee is also liable if he knows or should know that the information was received from one who breached a fiduciary duty (such as an insider or a misappropriator) and the tippee trades or tips for personal benefit with the requisite scienter. See id. at 660, 103 S.Ct. 3255.
The highlighted text is the source of the problem. It suggested that the personal benefit and fiduciary duty requirements are separate. Under Dirks, however, they are one and the same:
In determining whether a tippee is under an obligation to disclose or abstain, it thus is necessary to determine whether the insider's “tip” constituted a breach of the insider's fiduciary duty. ... [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. And absent a breach by the insider, there is no derivative breach.
463 U.S. at 661-62. In other words, no personal benefit, no breach. Therefore, it seems to me, the jury should have been instructed that the prosecution has to prove that the tippees knew of recklessly avoided knowing that the tipper got a personal benefit.