By Andrew C. Whitman
The Supreme Court needs to make sure that the limits courts have placed on tippee insider trading liability do not render insider trading laws incapable of meeting their underling policy goals. In United States v. Newman,1 the Second Circuit clarified its precedent on insider trading and limited the ability of prosecutors to charge “downstream” tippees under Section 10(b) of the Securities Exchange Act2 and SEC Rule 10b-5.3 “Tippees” are those who may be held liable when they trade on inside information received from an insider in breach of a fiduciary duty.4 From this point forward, prosecutors must prove that a defendant tippee actually knows that the original tipper received a personal benefit by releasing material, non-public information. The holding in Newman correctly interprets Dirks, but the reading will make it easier for traders to avoid insider trading liability by setting up systems of plausible deniability. This goes against the policy arguments courts and academics have set out as justifications for insider trading laws. The Supreme Court should thus grant certiorari and interpret 10(b) to include “enterprise” liability for tippees in order to combat such a policy outcome.
The Supreme Court in Dirks established that a tippee’s liability is premised upon the tipper’s breach of duty, which flows to the tippee.5 Such liability includes a requirement that a tipper receive a benefit, direct or indirect, from the release of material, non-public information to the tippee.6 In doing so, the court rejected the notion that access to insider information carries per se liability.
Before Newman, the Second Circuit required that a tippee have knowledge that the information traded on was received by a tipper through a breach of a fiduciary duty, but did not require that the tippee know that the tipper received a personal benefit.7 The Second Circuit also held that prosecutors could prove scienter by a showing that a defendant displayed a “reckless disregard for the truth.”8 Under these interpretations, prosecutors were becoming increasingly strident in their prosecutions of tippees that were two, three, or more steps removed from the initial tipper-tippee information transfer. Prosecutions of insider trading were a “rare bright spot” for the government in the wake of the financial crisis and the dearth of successful prosecutions arising from it.9 In Newman, however, the court stopped this trend by finding that a tippee does indeed need to have such knowledge.
The Newman court says that the new requirement “follows naturally,” from the previous Dirks requirement that the tippee know that that there has been a breach of duty.10 Dirks says that the receipt of a personal benefit is an element of the breach.11 Thus, the Newman court posits, any “knowledge of breach” requirement must include knowledge of such benefit.12 This is a correct reading of Dirks, which clearly states that there is no breach without a personal benefit.
This requirement, however, violates public policy. Policy rationales underlying insider trading are controversial and varied.13 Some have argued that insider trading should be allowed from a market efficiency standpoint, as perfect information is the ideal situation for capturing a stock’s true value. It is also arguable that insider trading is a “victimless crime,” because the faceless victims on the other side of a financial transaction buy or sell based on a known quantity of information. They would have bought or sold regardless of whether their financial counterpart had access to non-public information. In addition, insider trading probably has a negligible effect on the stock price, so other stockholders are unaffected by the transaction.
The public at large, however, clearly supports restrictions on insider trading.14 The main policy rationale seems to be that it is unfair to grant those with superior access to information an advantage over those who are not financial professionals. Relaxing rules on insider trading may threaten trust in the markets, reduce investment by individuals who do not believe they are getting a fair shake, and discourage business investment in obtaining such information.15 Congress has implicitly shown approval of insider trading laws by allowing current SEC interpretations of 10(b) to stand and by passing the Insider Trading Sanctions Act of 1984, though it has not exactly clarified why it supports limits on insider trading.
Such a policy decision is necessary and Congress should act to define what it wants to prohibit. However, absent Congressional action, the Supreme Court must decide why certain defendants should be found liable. I argue it should do so by overturning Newman and refining Dirks. The policy behind insider trading laws should be to discourage anyone from gaining an advantage in the marketplace by way of greater access to material, non-public information while minimizing the chance that defendants truly ignorant of a duty breach are convicted.
Under this definition of public policy, the Supreme Court should face the reality that requiring a specific knowledge requirement allows sophisticated businesspeople to easily avoid liability. Professor William Black points out that the post-Newman legal structure makes insider trading a “perfect crime.” Tippees can merely keep their colleagues in the dark and gain untold profits.16 Requiring that tippers receive a personal benefit allows insiders to legitimately release information to analysts, and protects people like barbers from being charged with insider trading when they slip information. Extending this standard to tippees, however, does not carry the same policy consequences.
To directly address these policy concerns, courts should recognize an “enterprise liability” standard, finding liability (1) where a tipper releases information in order for the tippee to trade and (2) where the tippee knew or should have known that such a scheme had been set up so that he may trade on some insider information. This would incorporate the “conscious avoidance” standard recognized in Obus,17 and restrict the brunt of the law to the most likely culprits: sophisticated businesspeople.
Newman establishes a lenient standard for liability. Experience has shown, however, that a strict liability standard may be proper for sophisticated defendants. For example, large companies have been held strictly liable for product defects in the products liability context. Here, the above-proposed standard would be similar to strict liability because it would not require the government to show that the tippee knew that the tipper actually breached a certain law. As we have seen in the financial crisis, financial experts have shown skill in avoiding liability where the government has been required to prove a breach of duty. Strict liability may be the only way to change Wall Street incentives.
Newman is not like the classic case of a barber being prosecuted for unknowingly giving a tip to a tippee because, here, all parties involved are sophisticated businesspeople.18 A jury should be allowed to conclude that such a businessman should have known that information being traded upon was received through a breach of duty. Such businessmen also have the acumen to devise schemes to enrich friends and colleagues. Laws should recognize this ability. To put it succinctly, businesspeople should have a higher level of professional responsibility—and therefore liability—than a barber, when dealing with issues within the professional’s domain. A sophisticated trader can most easily avoid liability because she can ensure that her company has adequate compliance mechanisms to protect her.