Returning to common-law principles of insider trading after United States v. Newman.

• Author: Epstein, Richard A.

FEATURE CONTENTS INTRODUCTION I. NEWMAN AND CHIASSON IN THE DOCK II. BACK TO FIRST PRINCIPLES A. Contract Versus Regulation B. The Classical and Misappropriation Theories of Insider Trading 1. Insiders 2. Tippees III. A CRITIQUE OF REGULATION FD IV. BACK TO NEWMAN: OF PERSONAL BENEFITS AND INFORMATION FLOWS A. Personal Benefit B. The Information Transfer to the Defendants V. NEWMAN AND THE MISAPPROPRIATION THEORY IN OTHER CASES CONCLUSION INTRODUCTION

On December 10, 2014, the Second Circuit handed Preet Bharara, the hugely ambitious United States Attorney for the Southern District of New York, one of his rare defeats in securities fraud litigation. In United States v. Newman, (1) the Second Circuit unanimously reversed, with prejudice, the insider trading convictions for securities fraud and conspiracy to commit securities fraud of two analysts, Todd Newman and Anthony Chiasson. The actions were brought pursuant to Section 10(b) of the Exchange Act and Rule 10b-5, which are set out in the margin. (2) In the words of Judge Parker: "The Government alleged that a cohort of analysts at various hedge funds and investment firms obtained material, nonpublic information from employees of publicly traded technology companies, shared it amongst each other, and subsequently passed this information to the portfolio managers at their respective companies." (3) According to the indictment, these analysts then passed this information on to Newman and Chiasson, who "willfully" participated in the scheme by trading on this information in the course of their own business. (4) The taint arose because this behavior was inconsistent with Regulation Fair Disclosure (Regulation FD), which requires that the information must be disclosed simultaneously to all outsiders if it is disclosed to any. (5)

The unexpected outcome in this case has fueled an effort to reexamine the fundamental principles governing insider trading, which are still in flux even today. In order to reexamine these principles, this Feature proceeds as follows.

Part I gives an account of the various factual and legal issues that were arrayed in Newman to set the stage for a more comprehensive reexamination of the fundamental principles of insider trading.

Part II examines--in light of Newman--the two major forms of insider trading liability, the so-called classical theory and the more modern misappropriation theory, first as they apply to insiders and then as they apply to tippees (those persons who traded on the tipped information). Part II argues two points. First, it argues that contractual solutions work better than regulatory solutions to constrain various forms of misrepresentation, concealment, and nondisclosure that arise in connection with insider trading. Second, it argues that the standard doctrines of the constructive trust do better than the so-called personal-benefit test of Dirks in identifying which tippees should be subject to liability for receiving information; this is the case where a constructive trust theory undoes the unjust enrichment that takes place if tippees are allowed to use that information for their own benefit.

Part III extends the analysis of the misappropriation theory of securities violation to critique Regulation FD. Regulation FD places an unfortunate straitjacket on how various firms do business with analysts of their stock. The insiders owe no fiduciary duties to analysts. But they do owe such duties to their shareholders, and the firms' officers and directors should be allowed to authorize their employees to make selective disclosures of inside information so long as these officers and directors have concluded in good faith that the release of that information will increase overall firm value.

Part IV applies the conclusions reached in the earlier three parts to examine more closely the role that the personal-benefit test and information flows have in dealing with insider trading. On the former, the Second Circuit incorrectly stiffened the government's burden on the personal-benefit test relative to what it was in Dirks. On the latter, the government's inability to trace the flow of information from the insiders to the defendant tippees moots the former error--at least on the evidence accepted in the Second Circuit--and justifies the outcome, but not the reasoning, in Newman.

Part V then applies this general analysis to other recent cases, both before and after Newman, to further examine the contours of the misappropriation theory. In general, the cases are correct to downplay the personal-benefit prong of the test. These cases also illustrate the vast gulf that exists between the disclosure of information in the ordinary course of business, for which no liability should be imposed either on the insider or any tippees, and the clandestine release of information, which in virtually all cases should result in criminal liability.

A short conclusion then urges a return of the law of securities fraud to its traditional contours, which should limit criminal prosecutions to insiders and their tippees who make deliberate use of information that they know was limited to use for firm purposes. The most appropriate goal of insider trading laws is not to advance some ad hoc theory of fairness, which typically shrinks the size of the pie without offering any coherent account of how that reduced stock of wealth should be divided. Instead, insider trading laws should work to increase capital market efficiency, which often requires the Securities and Exchange Commission (SEC) to shrink its oversight role.

1. NEWMAN AND CHIASSON IN THE DOCK

   In May 2013, Todd Newman and Anthony Chiasson were both sentenced for securities fraud and conspiracy to commit securities fraud after a six-week trial before Judge Sullivan. (6) Newman was a portfolio manager at Diamondback Capital Management, LLC, and Chiasson was a portfolio manager at Level Global Investors, L.P. (7) The two men were charged with trading on inside information that originated inside two companies, Dell and NVIDIA. (8) Neither man received the information directly from parties inside the companies, but only through a set of intermediaries. (9)

   With respect to Dell, Newman's inside source of the information was Rob Ray, an employee in Dell's investor relations department. Ray tipped some information about anticipated earnings reports to Sandy Goyal, an analyst at Neuberger Berman. That information was in turn relayed to Jesse Tortora, an analyst at Diamondback, who in turn gave that information about Dell first to Newman and then to Spyridon Adondakis at Level Global, who in turn passed the information on to Chiasson. Newman was thus three persons removed from the original source and Chiasson was four persons removed. The identical information was also given to other analysts from different companies.

   The chain of communication with NVIDIA started with Chris Choi, who worked in NVIDIA's finance unit, who tipped information about NVIDIA's earnings projections to Hyung Lim, an executive at another technology company, whom Choi knew from church. Thereafter, Lim shared the information with Danny Kuo, an employee at Whittier Trust, who in turn circulated it to a group of analysts including both Tortora and Adondakis, who in turn gave the information respectively to Newman and Chiasson, so that in both cases the chain contained three links.

   In dealing with these two criminal indictments, the district court held that the government could make its case by showing that the defendants "knew that the material, nonpublic information had been disclosed by the insider in breach of a duty of trust and confidence" owed to his employer. (10) At no point did the district court instruct the jury that the corporate insiders who had provided the inside information to the defendants must have done so in exchange for some personal benefit to them, which was required for a conviction under the Supreme Court's decision in Dirks. (11) Defendants were convicted on all counts. Newman had to pay about $1,738,000 in fines and forfeitures and was sentenced to fifty-four months in prison followed by one year of supervised release. (12) Chiasson had to pay up to seven million dollars in fines and forfeitures and was sentenced to seventy-eight months in prison followed by one year of supervised release. (13)

   Two questions were posed on appeal. The first was whether the evidence introduced into the record could support the proposition that the insider had received a personal benefit on the strength of his personal and social ties. (14) The second was whether the chain of causation that linked the defendants as remote tippees of the leaked information was tight enough to support the claim that the two defendants "knew that they were trading on information obtained from insiders." (15) Regarding the personal-benefit issue, the Second Circuit reached two conclusions. The first was that the personal benefit to the insider standard required showing more than some social friendship or connection. (16) The second was that, in light of the weakness of the evidence, the failure of the District Court to instruct on the personal-benefit question should not be disregarded as "harmless" error. (17) On the chain-of-causation issue, the court found that the government presented "absolutely no testimony or any other evidence" on the critical scienter requirement--that is, whether Newman and Chiasson knew that they received forbidden information. (18) One conclusion from that observation is that the original insiders may have been guilty, but the recipients of the information were not.

   In my view, the Second Circuit's decision to dismiss the complaint with prejudice was correct under current law. However, for purposes of this Feature, the outcome of the case is less important than the legal framework used to decide it; there are doctrinal and institutional issues raised by Newman, both under current law and as a matter of...