The Changing Face of Insider Trading

06/10/2015 | By: Adam M. Felsenstein, Esq. | Summer 2015 Newsletter

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For the past six years, the U.S. Attorney's Office for the Southern District of New York has been prosecuting and convicting financial professionals for insider trading with increased frequency and great success. Many of the more recent prosecutions involved recipients of insider information and who were far removed, and knew little about, the original source of the information.

Preet Bharara, the U.S. Attorney for the Southern District, has been the target of substantial criticism for his zeal and ardor in pursuing charges against these remote information recipients. On December 10, 2014, the Court of Appeals for the Second Circuit, perhaps in reaction to Mr. Bharara's overzealousness, released its decision in United States v. Newman, which imposed substantial limits on his ability to prosecute such remote recipients going forward.

The Newman decision deals primarily with a defendant's intent to commit a crime by using inside information. Prior to Newman, the government merely had to prove that the recipient of inside information knew that the source breached a duty of confidentiality by divulging inside information. This was a fairly low standard for the government to meet in order to successfully prosecute a defendant for insider trading. This knowledge of the breach of confidentiality supplies the requisite intent to willfully capitalize on inside information.
The facts of Newman involved defendants three or four steps removed from the source of the inside information. At trial, the prosecutors introduced no evidence establishing that the defendants were aware of the original source of the information. The intent to trade illegally was to be inferred from the fact such confidential information could only have been obtained by a breach of the original source's duty of confidentiality.

In its decision, the Court of Appeals vastly expanded the quantum of proof required to secure an insider trading conviction. Not only must the individual being prosecuted know that the original source broke a duty of confidentiality, but they must also be aware that that the source received a personal benefit for divulging such information. This ruling represents a substantial obstacle to the prosecution of remote recipients of insider information as it requires the recipient to have a much greater level of knowledge about the source of the inside information before that recipient can be subject to criminal prosecution. The Court of Appeals has, in essence, provided a level of protection for individuals down the chain who are unaware of the source of the information, and may be unaware of the fact it was taken inappropriately.

In a broader sense, the U.S. Attorney's Office for the Southern District has received a stinging rebuke from the Court of Appeals for its overzealousness in prosecuting remote insider trading defendants. The Court of Appeals sent a clear message that insider trading laws were never meant to impose criminal liability on such remote recipients. This censure has shaken the government's pursuit of insider traders to the core. For example, Judge Andrew Carter of the Southern District has already gone so far as to vacate guilty pleas of defendants where the pleas did not outline that the defendants knew that the source had received a personal benefit. Judge Jed Rakoff has called for a wholesale redrafting of insider trading laws to more closely conform with the conduct Congress intended to criminalize. For its part, the Securities and Exchange Commission has announced its intent to seek civil enforcement penalties, which require a lower quantum of proof, with greater frequency rather than lobbying the U.S. Attorney's Office to bring criminal charges.

Going forward, the Newman decision represents an important new tool for defense attorneys representing clients accused of insider trading. Newman allows defense counsel to explore the source of insider information, and argue that a defendant lacked the intent to criminally trade on inside information given their distance from the source. Individuals who are notified that they may be the target of an insider trading investigation should work with counsel to promptly investigate the source of the information in order to preserve and develop this important defense.

About the author: Adam M. Felsenstein is an associate at Gallet Dreyer & Berkey, LLP. His practice focuses on civil and criminal litigation matters, including trial work in the state and federal courts. Mr. Felsenstein can be reached at amf@gdblaw.com.