The Second Circuit Court of Appeals in New York has rejected the Justice Department's request to rehear a case that severely damaged the government's ability to prosecute insider trading at hedge funds where the person making a trade is several steps removed from the source of the information.
The influential court of appeals refused to revisit the sweeping ruling it handed down in December throwing out the 2013 convictions of Todd Newman and Anthony Chiasson, the New York Times reported. That decision held that Newman and Chiasson couldn't be convicted of insider trading unless they knew they were acting on information that not only had been improperly obtained, but that the tipper was paid in some way for sharing it.
The Second Circuit said it was merely enforcing the law as established in U.S. Supreme Court decisions, but the reasoning it used puts in peril several high-profile prosecutions by the U.S. Attorney's office in New York run by Preet Bharara. Bharara's investigators have used wiretaps, emails and cooperating witnesses to go after the managers of hedge funds who the government says knew or should have known they were trading on material, non-public information. The Second Circuit ruling means prosecutors also must show the trader had scienter or guilty knowledge, an essential element for criminal liability.
"What Newman did is said you need to be able to prove the all the people in the chain of tippees knew the tipper received a benefit," said Stuart Slotnick, a managing shareholder with Buchanan Ingersoll & Rooney and a former prosecutor. "When you're proving someone has committed a crime, you need evidence."
The court's refusal to rehear the decision by a three-judge panel leaves Bharara in a tricky tactical situation, Slotnick said. He can appeal to the U.S. Supreme Court, but given the court's hostility toward prosecutorial overreach -- demonstrated most recently in the reversal of a conviction of a fisherman accused of violating Sarbanes-Oxley by disposing of underlength fish -- that could be risky. Right now, the tighter understanding of insider-trading violations is the law only in the Second Circuit, consisting of New York, Vermont and Connecticut. If he appeals to the Supreme Court and loses, it would be the law everywhere.
On the other hand, appeals courts elsewhere in the country may adopt the Second Circuit rules since it is considered to be an authority on securities law.
The disappointing thing for the government, Slotnick said, is the facts in the Newman case once appeared to make for a slam-dunk insider trading prosecution.
Newman, a portfolio manager at Diamondback Capital Management; and Chiasson of Level Global Investors, were convicted of making $72 million in profits for their firms by trading on tips that originated with insiders at Dell Computer and NVIDIA NVDA +0.24%, another technology company.
The government went after Newman and Chiasson, it said, because they were sophisticated traders who knew or should have known they were acting on inside information. But that’s not the test, said the three-judge panel, in an opinion by Judge Barrington D. Parker. The Supreme Court long ago rejected the Security and Exchange Commission’s theory that tippees must refrain from trading on any material, non-public information, the appeals court said. Their liability stems from the tipper, and only when the tipper has breached a fiduciary duty and received some compensation for it can the tippee be liable.
"The facts were good for the government before Newman," Slotnick said. "The facts are not good after Newman."
The decision already has had repercussions. Prosecutors in Bharara's office in January dropped insider-trading charges against a man accused of profiting on IBM stock on information that came from a lawyer who tipped an analyst to a pending deal. That information made its way with several hops to a hedge-fund manager who traded on the tip.
