Wall Street’s Sigh of Relief

October 30, 2015

Earlier this month, traders across the country breathed a collective sigh of relief. Why?  High profile money managers Todd Newman and Anthony Chiasson are finally free from the threat of an insider trading conviction, as the Supreme Court denied certiorari to review the Second Circuit’s new, more forgiving view on what and is not allowed.
So what exactly happened, and what lies ahead? In 2012, hedge fund managers Newman and Chiasson were found guilty of illegal insider trading after trading on tips regarding tech giants Nvidia and Dell. A group of financial analysts working at a variety of firms had been exchanging inside information amongst each other. The analysts would then pass this information up to their portfolio managers who executed favorable trades on the basis of that information. Newman and Chiasson were three and four levels removed from the tips when the information reached them; at trial, it was found that they did not know whether the information was leaked in exchange for a benefit for the tipper. Thus, while they were fully aware that the information was probably illicitly obtained, they simply didn’t know whether the tipper had been paid off for that information. They were convicted at trial, but in December of 2014, the Second Circuit overturned the ruling, focusing on the hedge fund manager’s lack of knowledge about the source of the tip.
Overturning prior case law, the decision stated that “even in the presence of a tipper’s breach, a tippee is liable only if he knows or should have known of the breach.” The effect? It is now much, much more difficult to be convicted of trading on inside information if your buddy tips you off.
On October 5th, the Supreme Court denied certiorari, in the face of adamant pleas by Preet Bharara, the United States Attorney in Manhattan. The decision has led to a variety of responses in the media, varying from despair about unfair treatment for the super-rich to valiant defenses of the decision as cutting back on excessive insider trading prosecution. Since the Supreme Court’s decision not to hear the case , the Attorney General’s quietly dismissed charges against seven other insider trading defendants, knowing that under the new law they could no longer win.
Moving forward, it will certainly to be interesting to see how this affects the landscape of securities law, especially in light of how advancing communication technologies have made sharing information so monumentally easy. On the one hand, the SEC brings a lot of insider trading lawsuits every year. It is unlikely that this pace will slow, even in light of the new requirements in the Second Circuit. While their ability to go after recipients of information has been scaled back, the SEC can still prosecute the informants. But now, it seems unlikely that there will be any way to target high profile fund managers, who have insulated themselves with layers of analysts who can gather this information. John Zach, the former prosecutor in the Newman case has said,

“One of the motives you see time and again is friendship and relationships. In the post-Newman world, it will be difficult, if not impossible, for the government to prosecute that type of tipping.”

Some have considered this decision disastrous for prosecuting insider trading, but the holding may not be that extreme. While it does require that the final trader “knew or should have known” the information was exchanged for a material benefit, precedent may make this easier than it seems. Benefits have been found in exchanging information for reputation, an expectation for a similar favor in the future, for being a co-worker, or for being family. In the early 2000’s, the SEC issued two regulations it hopes will eventually close up friend and family tipping, Rules 10b5-1 and 10b5-2. Thus far, courts have been hesitant to adopt either of these expressly, although the Newman ruling could cause the SEC to revive efforts to use these regulations in their prosecutions of insider trading.