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By Julie M. Riewe and Jarrod L. Schaeffer
Julie M. Riewe is a partner and Jarrod L. Schaeffer is an associate at Debevoise & Plimpton LLP.
While numerous commentators and practitioners have discussed the impact of Salman v. United States, 558 U.S. ___ (2016), on insider trading law – particularly in the Second Circuit, where open questions remain about the viability and continuing effect of that court’s decision in United States v. Newman, 773 F.3d 438 (2d Cir. 2014) – most have focused largely on the “personal benefit” requirement for insider trading liability. Although the personal benefit requirement is certainly at the core of both cases, there is far more to Newman that survives the Supreme Court’s decision. This article focuses on a less discussed yet important aspect of the Newman opinion: the Second Circuit’s unusual treatment of material non-public information, which may mark a departure from past approaches and have significant implications for future enforcement actions.
On December 6, 2016, the United States Supreme Court decided Salman, which affirmed an insider trading conviction out of the Ninth Circuit and pared back the Second Circuit’s interpretation of the personal benefit requirement announced in Newman – at least as to tippers providing information to family members. Hailed as a victory for prosecutors, the Court in Salman rejected as inconsistent with its prior decision in Dirks v. S.E.C., 463 U.S. 646 (1983), a requirement that the Government prove tippers “receive[d] something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends,” Salman, 558 U.S. at ___ (quoting Newman, 773 F.3d at 452), before a jury could infer that a tipper received a “personal benefit” for disclosing inside information. Id. Left undisturbed by Salman was Newman’s additional holding that the Government must prove that the tippee knew the tipper had received a personal benefit. Id. at __ n.1 (citing Newman, 773 F.3d at 453–54).
Another aspect of Newman that remains good law following the Court’s decision in Salman may temper the scope of the Government’s victory. While analyzing whether the tippee defendants in Newman, Todd Newman and Anthony Chiasson, knew that tipping insiders had received a personal benefit, the Second Circuit opined that “the Government presented absolutely no . . . evidence that Newman and Chiasson knew that they were trading on information obtained from insiders,” 773 F.3d at 453, and rejected the Government’s contention that “the specificity, timing, and frequency of the updates provided to Newman and Chiasson about Dell and NVIDIA were so ‘overwhelmingly suspicious’ that they warranted various material inferences that could support a guilty verdict.” Id. at 454. In doing so, the court recounted several instances in the record that demonstrated insiders routinely shared confidential information prior to the information being released to the general public. Id. This close parsing signals the Second Circuit’s intent to take a closer look at the nature of information actually disclosed by insiders in such cases – an inquiry that could complicate future enforcement actions involving downstream tippees.
Some general background may be helpful to frame this discussion. Confidential information underlying allegedly illicit trades is usually called “material nonpublic information.” At bottom, this is information available only to an insider by virtue of his or her status as an insider, which affords an unfair trading advantage. Notably, unlike other countries with major securities exchanges, the United States does not have a statute that explicitly bars insider trading. Rather, under federal law the insider trading prohibition stems from a duty not to abuse a fiduciary relationship by trading on, or tipping, material nonpublic information. Dirks, 463 U.S. at 659–60. A tippee acquires a duty not to trade on material nonpublic information only when a tipper has breached a fiduciary duty by disclosing the information in exchange for a personal benefit and the tippee knew (or, in a civil matter, should have known) that such a breach had occurred. See Salman, 558 U.S. at ___ (citing Dirks, 463 U.S. at 662); Dirks, 463 U.S. at 660–62. In the context of the classical theory of insider trading liability, “the defendant breaches a duty to, and takes advantage of, the shareholders of [a] corporation,” Salman, 558 U.S. at ___ n.2 (quoting United States v. O’Hagan, 521 U.S. 642, 651–652 (1997)) (internal alterations omitted), while “the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him [or her] with access to confidential information.” O’Hagan, 521 U.S. at 652. The Supreme Court has made clear that “[n]ot to require such a fiduciary relationship” in insider trading cases “would ‘depart radically from the established doctrine that duty arises from a specific relationship . . . and would amount to ‘recognizing a general duty between all participants in market transactions to forgo actions based on material, nonpublic information.’” Dirks, 463 U.S. at 654–55 (quoting Chiarella v. United States, 445 U.S. 222, 231 (1980)) (internal alterations omitted).
This brings us to Newman. Neither Newman nor Chiasson (the alleged tippees) knew the source of the information they received, and the Second Circuit concluded that no reasonable jury could have inferred that Newman or Chiasson knew – or deliberately avoided knowing – that the information was the kind of material nonpublic information that can form the basis of insider trading liability. While there is no bright-line rule specifying what kind of information is considered confidential, see, e.g., Robert A. Prentice, The Internet and Its Challenges for the Future of Insider Trading Regulations, 12 Harv. J.L. & Tech. 263 (1999) (“There is no clear rule regarding when information leaves behind its secret status and enters the public domain.”), courts generally recognize that information is freely available only when it “ha[s] been effectively disclosed in a manner sufficient to [e]nsure its availability to the investing public,” SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 854 (2d Cir. 1968). Historically, this has been interpreted as some “formal announcement to the entire financial news media” or an “official release known to the media,” id., though what constitutes a manner sufficient to make information available to the investing public has become more complicated with the advent of the Internet. See generally Prentice, supra note 12, at 279 (“[T]he Internet and other new technologies have further roiled these murky waters. These technologies create new means of making disclosures and thereby create new situations where it is unclear whether the information has been made ‘public.’”). Alternatively, information may be freely available when it is “fully impounded into the price of [a] particular stock.” United States v. Libera, 989 F.2d 596, 601 (2d Cir. 1993). This understanding draws on the efficient market hypothesis and concludes that information reflected in a stock’s price should not serve as the basis for insider trading liability because “[o]nce the information is fully impounded in [the] price, such information can no longer be misused by trading because no further profit can be made.” Id. The information ultimately relayed to Newman and Chiasson hardly satisfied either standard. After all, it concerned internal corporate earnings data and was shared by company insiders with a select group of industry analysts in advance of any official announcement.
So why did the Second Circuit conclude that no reasonable jury could have inferred Newman or Chiasson knew they were illegally trading on inside information, even though the information they received at first blush appears to be material and nonpublic? Although the information shared with Newman or Chiasson was confidential corporate earnings data that had not been released, the court concluded that the record showed such information was “of a nature regularly and accurately predicted by analyst modeling,” Newman, 773 F.3d at 455, or could have been revealed through sanctioned corporate channels without violating any fiduciary duty. As the Second Circuit recognized, “analysts at hedge funds routinely estimate metrics such as revenue, gross margin, operating margin, and earnings per share through legitimate financial modeling using publicly available information and educated assumptions about industry and company trends,” and use information “solicited . . . from companies in order to check assumptions in their models in advance of earnings announcements.” Id. at 454. And the court further noted that the record in Newman demonstrated that “NVIDIA and Dell’s investor relations personnel routinely leaked earnings data in advance of quarterly earnings.” Id. (internal quotation marks omitted). Given the routine flow of otherwise confidential information in this manner, the court was unconvinced that Newman and Chiasson knew, or consciously avoided knowing, that the information on which they traded originated with corporate insiders, much less in breach of any insider’s fiduciary duty.
Newman thus signals that the Second Circuit intends to scrutinize carefully the confidential label applied to information disclosed by insiders when evaluating whether such disclosures really amount to breaches of fiduciary duties – particularly in insider trading cases involving “remote tippees many levels removed from corporate insiders.” Id. at 448. This more rigorous focus on what rises to the level of a breach sufficient to trigger liability may be motivated by practical realities in today’s financial sector, where widespread industry practices can result in the unequal dissemination (while Regulation FD in theory limits companies’ selective disclosure of material nonpublic information, see 17 C.F.R. pt. 243, as a practical matter companies regularly speak to shareholders and analysts) of possibly material information and industry participants often have better access to corporate information than members of the general public. Such an approach also finds support in Dirks, where the Supreme Court rejected “the idea that the antifraud provisions [of the securities laws] require equal information among all traders,” precisely because “[i]mposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market.” 463 U.S. at 657–58. By looking to the nature of and existing disclosure practices regarding inside information, Newman portends a closer inquiry that challenges assumptions about insiders’ confidentiality obligations and hews more closely to the Supreme Court’s teachings that tippee liability can flow only from a known breach of fiduciary duty.
So what does this mean for the industry and the bar? While distilling a clear rule from Newman will require further elucidation in future cases, the Second Circuit’s renewed focus on current disclosure practices with respect to inside information may suggest that industry participants and attorneys should scrutinize closely the nature of any information allegedly disclosed in insider trading cases. In particular, industry participants should also review how they treat confidential information, asking whether protections accorded to such information demonstrates that disclosure is restricted not just in theory, but also in practice.
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