Overturning the criminal convictions of former Diamondback Capital Management, LLC portfolio manager, Todd Newman, and former Level Global Investors, L.P. portfolio manager, Anthony Chiasson, for insider trading, the federal appeals court in New York has held the government “failed to present sufficient evidence that the defendants willfully engaged in substantive insider trading or a conspiracy to commit insider trading in violation of the federal securities laws.”  United States v. Newman and Chiasson, Nos. 13-1837 & 13-1917 (2dCir. Dec. 10, 2014).  The Court also dismissed the indictments with prejudice.

This is stunning news for the securities industry and brokerage community and deals a blow to United States Attorney Preet Bharara for the Southern District of New York, who has had a nearly perfect record investigating and prosecuting insider trading violations within New York’s financial industry, particularly in the unregulated hedge fund sector.

At issue was what Newman and Chiasson knew about the information they allegedly received from a tightly connected group of financial analysts who had contacts “inside” two technology companies. When the companies’ quarterly earnings numbers were leaked by the insiders to members of the analyst network, the information reached Newman and Chiasson after filtering through four layers of analysts. The two promptly executed trades in the two companies’ stocks, earning their firms approximately $4 million and $68 million in profits, respectively.

At the close of the evidence in the insider trading trials, the defendants moved for judgment of acquittal, arguing the government had failed to offer any evidence the corporate insiders passed “inside” information to the analysts in exchange for some “personal benefit” — a prerequisite to establish “tipper” or “insider” liability under the Supreme Court’s Dirks v. SEC, 463 U.S. 646 (1983).  They argued they were “not aware of, nor participants in, the tippers’ fraudulent breaches of fiduciary duties to [the companies].” The trial court refused to instruct the jury on this issue and the jury returned guilty verdicts on all counts for both defendants.

However, the Court of Appeals agreed with the defendants, ruling their knowledge “of an insider’s breach necessarily requires knowledge that the insider disclosed confidential information in exchange for personal benefit.” The Court rejected the government’s attempts to revive “the absolute bar on tippee trading that the Supreme Court explicitly rejected in Dirks” (tippee’s liability derives only from the tipper’s breach of a fiduciary, not from trading on material, non-public information) and Chiarella v. U.S., 445 U.S. 222 (1980) (no general duty among all participants in market transactions to forego actions based on material, nonpublic information).

The Court defined the elements necessary to sustain an insider trading conviction against a tippee:

(1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade in a security or tip another individual for personal benefit.

Lesson: Insider liability is less likely the further removed the “tippee” is from the insider and the original source of the “tip.”