Earlier this month, in a pivotal decision on how far the government can go to prosecute insider trading, an influential federal court of appeals clarified that the recipient of a juicy corporate tip is not guilty of insider trading for acting on the tip unless he or she knew that it came from an insider who revealed it in return for a personal benefit.
The appeal was based on the convictions of two men who were three to four degrees of separation downstream the passing of tips from corporate insider to one person to another (and another). Although the men were indicted alongside other, fellow “tippees” who were upstream from them, none of the corporate insiders—that is, the “tippers”—were charged civilly, criminally, or administratively for insider trading or anything else.
One of the men was sentenced to 54 months and a $1 million fine. The other got 78 months and a $5 million fine.
On appeal, the U.S. Court of Appeals for the Second Circuit, which covers New York, Vermont, and Connecticut, reversed the convictions because the jury was not properly instructed on when a tippee could be convicted of insider trading. First, a corporate insider must actually have committed insider trading, meaning the insider not only breached a fiduciary duty by revealing the information but derived a personal benefit of some kind, directly or indirectly, by doing so. If the insider didn’t derive a personal benefit, it may still be something else, but it’s not insider trading. Next, to convict a tippee, the government must prove that he or she knew the tip was dirty and the insider derived a benefit from it. In other words, it’s not enough that a tippee traded on an inside tip; he or she must also have known that a corporate insider had traded the tip for a personal benefit.
In sum, the Court held that insider trading for tippees requires proof beyond a reasonable doubt of each of the following:
- A corporate insider was entrusted with a fiduciary duty;
- the insider breached his duty by disclosing confidential information in exchange for a personal benefit;
- the tippee knew that the information was confidential and divulged for personal benefit; and
- the tippee still used that information to trade in a security or tip someone else for personal benefit.
Against this standard, the government presented insufficient evidence to prove that any corporate insiders committed insider trading—and no evidence at all that the two men knew they were trading on the fruits of insider trading—so the Court reversed their convictions and sent the case back with instructions to dismiss the indictment with prejudice.
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