Insider trading prosecutions were hollow at the core – 2nd Circuit

December 11, 2014

(Reuters) – To bring an insider trading case in the 2nd U.S. Circuit Court of Appeals, prosecutors must prove both that the tipster received a personal benefit from leaking confidential information and that those who traded on the information knew of the benefit. That is now established beyond any doubt, after an emphatic 2nd Circuit opinion Wednesday that erases the government’s case against former hedge fund executives Todd Newman and Anthony Chiasson.

The opinion not only sets clearer definitions for future insider trading prosecutions but also undermines the foundation of at least a half-dozen guilty pleas the Manhattan U.S. attorney’s office has already obtained. According to the 2nd Circuit, the government hasn’t proved the illegality of the insider disclosures underlying those pleas.

Newman, a onetime portfolio manager at Diamondback Capital, and Chiasson, a co-founder of Level Global Investors, were several steps removed from insiders at Nvidia and Dell who originally provided the tips that eventually made its way to Diamondback and Level. Prosecutors persuaded U.S. District Judge Richard Sullivan of Manhattan to instruct the jury at their 2012 trial that the hedge fund executives could be convicted of insider trading as long as the government had proved Newman and Chiasson were aware their trades were based on improperly disclosed confidential information. Sullivan is the only one of the Manhattan federal judges who have presided over recent insider trading trials whose jury instructions did not require prosecutors to prove defendants knew about benefits to tipsters.

The 2nd Circuit opinion, written by Judge Barrington Parker for a panel that also included Judges Ralph Winter and Peter Hall, chastised prosecutors for the “doctrinal novelty” of their remote tippee theory, which, according to the court, relied too heavily on extraneous statements plucked from previous appellate opinions. The panel was skeptical of the prosecution of cases that “are increasingly targeted” at traders far removed from corporate tipsters, and pointed out that traders as far down the chain as Newman and Chiasson have never been held criminally liable for insider trading. Much as U.S. Attorney Preet Bharara and his assistants might wish it to be so, the panel wrote, under the U.S. Supreme Court’s 1983 ruling in Dirks v. Securities and Exchange Commission, not all trades based on confidential information are illegal.

That’s a momentous conclusion. It will undoubtedly curtail future insider trading prosecution, as the U.S. attorney’s office conceded in a statement that said, in part, that the 2nd Circuit decision “appears in our view to narrow what has constituted illegal insider trading.” But the opinion’s analysis of what the government must prove about the knowledge of remote tippees was not really a surprise. The 2nd Circuit judges previously telegraphed their doubts about Sullivan’s instructions to the jury in the Newman and Chiasson case when they heard oral arguments in the appeal last April. After those arguments, the 2nd Circuit was widely expected to vacate the convictions and find traders cannot be found guilty without proof they were aware that tipsters breached their duty in exchange for a personal benefit.

The surprise in Wednesday’s ruling came in the decision’s last eight pages, which discussed the sufficiency of the government’s evidence at the Newman and Chiasson trial. The 2nd Circuit concluded that prosecutors failed to prove Dell and Nvidia insiders – Dell investor relations employee Rob Ray and Nvidia accounting manager Chris Choi – received any personal benefit from passing tips to analysts who traded on the information.

The government had portrayed Ray, the Dell employee, as a business school acquaintance of Sandy Goyal, an analyst at Neuberger Berman, who, in turn, passed the information along a chain of traders. In exchange, according to prosecutors, Ray received career counseling from Goyal. Nvidia insider Choi first gave Nvidia financial information to Hyung Lim, a former tech executive he knew from church. Prosecutors claimed Choi benefitted from his friendship with Lim.

The 2nd Circuit said those connections were too tenuous to warrant an inference that the insiders passed information illegally. The definition of personal benefit, “although permissive, does not suggest that the government may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature,” the opinion said. “If that were true, and the government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity.”

The appeals court, in other words, broke the very first links in the chain that led to Newman and Chiasson. The liability of the recipients of insider information derives from the liability of the tippers who provide it. (Neither Choi nor Ray has been charged with a crime; Ray, the subject of a great Bloomberg piece last month, hasn’t even been sued by the SEC.) Without proof that corporate insiders Ray and Choi received a personal benefit from breaching their duty of confidentiality, prosecutors don’t have a case against anyone who received their information.

Newman and Chiasson are only part of that group, which also includes former SAC Capital trader Michael Steinberg, another remote recipient of tips about Dell and Nvidia. Like Newman and Chiasson, Steinberg was tried before Judge Sullivan, who used a similar jury instruction in his case. He was convicted in 2013. The 2nd Circuit’s ruling Wednesday, according to Steinberg counsel Barry Berke of Kramer Levin Naftalis & Frankel, “clearly means that Michael Steinberg is innocent of any crime and his conviction will be vacated as well.”

But what about all of the people who have already entered guilty pleas for trading on information that originated with Ray and Choi? In addition to Goyal and Lim, the first recipients in the chain, at least four other defendants have pleaded guilty to illegally trading on tips first passed by Ray and Choi. Those guilty pleas are all based on facts that the 2nd Circuit deemed to be insufficient to justify a conviction.

I talked to three white-collar defense lawyers Wednesday about whether the defendants who have entered pleas have any recourse now. None of them represent defendants who have pleaded in the Dell and Nvidia cases, and only one, Howard Schiffman of Schulte Roth & Zabel, spoke on the record. All of the lawyers agreed that it’s extremely difficult to withdraw a guilty plea, particularly when there are no new facts in the case. Moreover, defendants who have pleaded guilty may be restricted by the terms of their cooperation agreements with the government.

The government can also use any statements they’ve made either in court or in meetings with prosecutors, so they would be hampered by admissions they’ve committed a crime. In the Newman and Chiasson decision, after all, the 2nd Circuit said just that facts were “as consistent with an inference of innocence as one of guilt,” so maybe additional facts, testimony or admissions in the cases of defendants who have pleaded guilty would tip the inference. Schiffman said that in general, defendants who enter pleas give up the chance to challenge their convictions based on a change in the law.

Newman was represented by Stephen Fishbein and John Nathanson of Shearman & Sterling, who said in a statement that the 2nd Circuit ruling “is not a mere technicality, but rather a considered judgment that Mr. Newman did not commit a crime.” Chiasson had counsel from Gregory Morvillo of Morvillo, Mark Pomerantz of Paul Weiss Rifkind Wharton & Garrison, and Alexandra Shapiro of Shapiro Arato & Isserles. In a statement, Morvillo said that Chiasson “is deeply gratified that the decision issued today unequivocally re-establishes his innocence under the law.”

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