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The Magnetism of Insider Trading: Part One

ironfilingsTodd Newman and Anthony Chiasson have won an appeal from their convictions of insider trading. The big outstanding question for alpha seekers is whether this decision will have a tempering effect on ongoing prosecutorial efforts, and (if so) whether that will make life easier, the paths less booby-trapped, for aggressive equity-oriented traders.

I hope to tackle that big question here in the near future. But as a preliminary, let’s talk today about the specifics of the issue before the three-judge panel of the Second Circuit that issued this decision on December 10th.

Newman was a portfolio manager at Diamondback Capital Management, and Chiasson held the same post at portfolio manager at Level Global Investors.

Instructions and Evidence

The element of the opinion that has received the most attention at first blush is the appeals’ judges’ criticism of the jury instructions delivered by the trial judge, Richard J. Sullivan, at the end of the six-week jury trial in the spring of 2013.

That’s important, but it is also important that the panel didn’t limit its decision to that consideration. Immediately after writing that Sullivan’s jury instruction was erroneous, Parker adds, “Moreover, we hold that the evidence was insufficient to sustain a guilty verdict….”

Note the word “hold.” The judges don’t just rule on the jury instructions and then incidentally opine that the evidence was insufficient anyway. If they had done that, the two defendants could be re-tried, on the same charges and the same evidence, with the sole consolation of knowing that the jury instructions will be more favorable to them the second time around. But the judges short-circuited that possibility. The insufficiency of the evidence isn’t “obiter dicta,” it is part of the holding.

The judgment of the court, then, was that the district court has been instructed to “dismiss the indictment with prejudice as it pertains to Newman and Chiasson.”

A Chain of Iron Filings

The case involves a chain of tips and tippees. “Insider” status for purposes of a securities fraud prosecution is a bit like magnetism. Original lodestone comes into contact with, and so magnetizes, iron filing A which makes contact with iron filing B and causes it to become magnetized, and then B makes contact with C and so on as Tuesday’s tippees become Wednesday’s tippers.

There is no controversy over the proposition that, in the current state of the law, such a “tipping chain” can occur and can be of indefinite length. What was at dispute in this case, though, was what it takes to magnetize the next iron filing. The defendants successfully contended that what it takes involves some guilty knowledge on the part of the defendant tippee/filing (however far out on the chain it is) about the nature of the culpability of the original lodestone.

Prosecutors said that insiders at Dell and NVIDIA tipped off “a group of financial analysts” about the earnings numbers of those companies before public release of the numbers both in May and in August of 2008. Newman and Chiasson were each “several steps removed from the corporate insiders.” In time, though, they did both hear the rumors and acted on them. Newman and Chiasson “executed trades in Dell and NVIDIA stock, earning approximately $4 million and $68 million, respectively, in profits for their respective funds.”

How much is necessary for a tippee to become magnetic? First, as both parties in this litigation conceded, “tippee liability requires proof of a personal benefit to the insider.” If an insider at Dell got drunk and started bragging about upcoming earnings data for no reason at all and if someone at the bar heard him and traded accordingly the next morning – there is no criminal insider trading liability for that trader. There is, as the Supreme Court once put it, no “general duty between all participants in market transactions to forgo actions based on material, nonpublic information.”

If, on the other hand, someone handed the insider a suitcase full of cash, or a neat gold-plated watch, in order to get an executive to spill the information about earnings … that is a different matter. That expensive watch or suitcase of cash makes him liable as the tipper, and it makes any recipient of the tip who gave him that benefit, or who knew that he had received such a benefit, liable too either for becoming a tipper in turn or for trading on this data so acquired.

The Precise Issue

Now we can define the issue in this appeal more precisely. Suppose the original tipper had been entrusted with a fiduciary duty, and had breached that duty by disclosing confidential information in exchange for a personal benefit, and suppose the eventual recipient of the information (the final tippee in the chain) knew the information was nonpublic material information, indeed, knew that it had been disclosed in violation of promises of confidentiality, but was not clear about the circumstances that had led to the original tipping – was not aware that the corporate exec had gotten a personal benefit. Is their state of mind in such a case sufficient to support a guilty verdict?

Naturally, this includes the question of what the court should have told the jurors before they began to weigh the evidence on their state of mind, but is not limited to that. The instruction given at trial could have allowed a “reasonable juror” to find the defendant guilty even without knowledge of the quid-pro-quo at the start of the chain, and that is what was wrong with the instruction. And, indeed, with the prosecution’s case generally.