by T. GormanPosted on Posted in SECActions

This is the fourth in a series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

Employees, the company and insider trading

The enforcement of insider trading laws is a key SEC enforcement priority. Acting in conjunction with the U.S. Attorney’s Office in New York City, the Commission has brought a series of high profile insider trading actions. Many of those cases have focused on hedge funds and professional traders. As enforcement officials seek to protect the integrity of the markets however, increasingly employees of public companies are coming in their sights. This can result in liability for the employee and entangle the company in a law enforcement investigation, something which can be costly and time consuming.

The SEC has been very aggressive in utilizing its new tools. While criminal prosecutors tend to garner the headlines from outsized investigations and cases such as the Galleon and Expert Network series of cases, it is the Commission which is pushing the edge — some might say redefining – of what constitutes insider trading.

Bolstered by new enforcement techniques, the SEC’s approach to insider trading is increasingly aggressive. A series of insider trading cases have centered on events that employees viewed at work prior to trading. One group involves those which seem to focus on the mosaic theory. Traditionally, analysis and other market participants have investigated with an eye to gathering bits and pieces of information they fit together and utilize as the predicate for their predictions, hunches and outright guesses as to the direction of the market, a company or a particular security. This activity adds to the efficiency of the markets and improves price discovery. While the line between what constitutes permissible investigation and projection and acquiring actual inside information has always been difficult to draw with precision, the Commission seems to be redrawing it in a way which at least suggests that employees who gather virtually any information at work and then trade are at risk.

Typical of the cases in this group is SEC v. Steffes, Case No. 1:10-cv-06266 (N.D. Ill. Filed Sept. 30, 2010). There the defendants are all family members or friends. The case centers on acquisition of Florida East Coast Railway, LLC by Fortress Investment Group, announced on May 8, 2007. The transaction traces to December 4, 2006 when Morgan Stanley & Co. was engaged to sell the company. After inquiry by possible acquirers the company was in fact sold. Shortly prior to the sale each defendant traded in the securities of the company reaping total trading profits of $1.6 million.

The critical question in the case is whether the defendants actually possessed material non-public information at the time of the trades. The complaint specifies the bits of information from which the Commission concluded that a particular defendant possessed inside information at the time of the trades. For defendant Gary Griffiths, a vice president of the railroad who was not a member of the deal group, the complaint claims he had inside information because:

  • In early March the CFO asked him to prepare a comprehensive list of equipment owned by the company;
  • He became aware that there were an unusual number of yard tours by outside executives, that is, individuals were viewing properties owned by the railroad;
  • “He believed” these tours were provided to investment bankers;
  • Employees asked him if the company was being sold and they would lose their jobs; and
  • He also arranged and monitored a rail trip for Fortress executives in a special rail car reserved for visitors.

Defendant Cliff Steffes, a trainman at the company, had inside information according to the SEC because:

  • He observed that there was an unusual number of yard tours for people in business attire;
  • Many employees became aware of them;
  • Shortly before the tours began a number of employees expressed concern about the company being sold and the possible loss of jobs of their job; and
  • Fortress executives toured where he worked.

It is clear that those outside the company would not be privy to the fact that yard tours were being taken by executives in suits. Equally clear is the fact that speculation by employees about the meaning of the tours or the impact of a take-over on their job is just that – speculation and conjecture. Whether or not this type of information actually constitutes inside information is the subject of the on-going litigation. To date only defendant Robert J. Steffes has settled with the Commission, consenting an injunction and paying disgorgement and a penalty equal to the trading profits of $104,981. The other defendants are litigating the case. See also, SEC v. Carroll, Case No. 3:11-cv-00165 (W.D.Ky. Filed March 10, 2011)(employees learn bits of information that results in trading); see also SEC v. Ni, Case No. CV 11 0708 (N.D. Ca. Filed Fed. 16, 2011)(action against brother who overheard bits of a conversation by corporate executive sister).

While cases such as Steffes focused on what individuals observed at work, others suggest that even complying with company procedures may not be adequate to avoid liability. Many public companies have some type of insider trading policies and procedures. Typically the company institutes black out periods around earning releases and other significant events which preclude certain executives from trading. When the black out periods are not in effect those executives are generally permitted to trade although the policies may require pre-clearance with a designated individual.

In a recent action however, an executive informed the general counsel’s office of her intent to trade prior to the institution of a black out period but, nonetheless, was named as a defendant in a Commission enforcement action. SEC v. Knight, Civ. 2:11-cv-00973 (D. Ariz. Filed May 18, 2011).

The defendants in Knight are Mary Beth Knight, a senior vice president of Choice Hotels and her friend, Rebecca Norton. Ms. Knight learned at a senior management meeting that the company expected to miss expectations as to its quarterly earnings. At lunch following the meeting Ms. Knight told executives she planned to sell shares of the company. The next day she e-mailed the associate general counsel about her plan to sell company stock and asked about black out days. She received a response stating that the black out ran from June 30 to July 26. A copy of the insider trading policy was attached to the e-mail from the associate general counsel.

The next weekend Ms. Knight told her friend Rebecca the information she learned at the management meeting. She knew that her friend was a shareholder of the company.

Subsequently, on June 27 Ms. Knight sent a follow-up e-mail to the associate general counsel stating: “exercising 12,000 shares today. I also mentioned to [my boss] last week I would be doing so.” The complaint does not indicate that she received a response.

Prior to the black out period both Ms. Knight and her friend sold company shares. The day after the earnings announcement the share price dropped nearly 25%.

Both defendants settled, consenting to the entry of permanent injunctions. Ms. Knight agreed to pay disgorgement. That obligation was deemed satisfied by the fact that Ms. Knight had previously given the amount of the disgorgement to the company. No explanation is provided for that action. Ms. Knight also agreed to pay the disgorgement for her friend and pay a penalty. Ms. Norton agreed to pay a civil penalty.

Collectively there can be little doubt that Steffes, Carroll and Knight are aggressive enforcement. The SEC views these cases as straight forward insider trading actions. Others view them as pushing the edge of what constitutes insider trading. Which ever view is correct, the common thread is that employees observed or learned something while on the job, engaged in transactions in company stock, followed company procedures and were named in an enforcement action charging insider trading. While it might be argued that the cases tend to push toward the discredited “parity of information” theory of insider trading, perhaps the more important question is how to avoid becoming entangled in the cases in the first place. In view of these trends companies would do well to reconsider their policies and procedures and alert employees in programs about those procedures to avoid becoming entangled in a investigation.

Next: FCPA enforcement

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by T. GormanPosted on Posted in SECActions

This is the third in a series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

Directors and officers (cont)

While enforcement officials are focusing on the duties and obligations of directors in cases such as Krantz, they are also concentrating on ways to expand their reach. Negligent fraud, as in the Dell case, is one way. Another is through the use of Exchange Act Section 20(a), control person liability. This provision, which permits liability to be imposed on certain executives for failing to properly oversee operations, has been sporadically used over the years. Now, however, enforcement officials are using the provision to broaden the reach of SEC enforcement while avoiding the complexities of proving primary or aiding and abetting liability.

The cases brought the against executives of Nature’s Sunshine Products, Inc are illustrative of this new trend. There the first FCPA case imposing Section 20(a) liability was brought against company CEO, Douglas Faggioli and CFO, Craig D. Huff. SEC v. Nature’s Sunshine Products, Inc., Case No. 09CV672 (D. Utah Filed Jul. 31, 2009). The claims are based on payments made in 2000 and 2001 by the Brazilian subsidiary of the company to local regulators to circumvent new import restrictions. The company was charged with FCPA violations. The two officers were charged under Section 20(a) as “control persons.”

To resolve the case, the three defendants consented to the entry of permanent injunctions prohibiting future violations of the antifraud and books and records and internal control provisions of the federal securities laws. The company agreed to pay a civil penalty of $600,000. Messrs Faggioli and Huff each agreed to pay a civil penalty of $25,000. See also SEC v. SinoTechEnergy Ltd., Civil Action No. 2:12-cv-00960 (W.D. LA. Filed April 23, 2012)(Chairman and controlling shareholder alleged to have control person liability); SEC v. Harbert Management Corp., Civil Action No. 12 Civ. 5092 (S.D.N.Y. Filed June 27, 2012)(Funds charged with control person liability for failing to prevent controlled entities from engaging in manipulation).

Finally, the Commission is using a strict liability approach in clawback actions to recoup certain incentive based compensation of CEOs and CFOs. The cases here are being brought despite the fact the executive was not involved in any wrong doing.

Sarbanes-Oxley or SOX Section 304 and Dodd-Frank Section 954 each provide for the clawback of certain executive incentive based compensation when there is a restatement. Section 304 requires the repayment of certain CEO and CFO incentive-based compensation and stock trading profits when the company must restate its financial statements because of misconduct. The Section does not specify that the misconduct be that of the CEO or CFO.

Dodd-Frank Section 954, now Exchange Act Section 10D, is similar. It expands the class of those at risk using the undefined term “executive officers.” It also expands the time period from the one year in SOX to three while dropping the requirement that wrongful conduct cause the restatement. The remedy is more limited however, apparently being restricted to disgorgement. The requirement will be implemented through exchange listing standards under a yet to be written Commission rule.

The SEC has adopted a strict liability approach in SOX 304 cases. See, e.g., SEC v. Jenkins, Case No. CV 09-01510 (D. Ariz. Filed July 22, 2009); SEC v. O’Del, Civil Action No 1:10-CV-00909 (D.D.C. Filed June 2, 2010). Indeed, the complaints typically state that the defendant was not involved in the underlying wrongful conduct which may be the subject of a separate SEC and/or DOJ action. While the wisdom of the SEC’s view might be debatable, its position has been upheld by the Second Circuit. Cohen v. Viray, Case No. 3860-cv (2nd Cir. Sept. 30, 2010).

Collectively, these cases represent not just an aggressive approach to executive liability but one which is expanding and in some instances easing the SEC’s burden of proof. To be sure, cases such as Kravitz are based extreme sets of facts. Yet when viewed in the context of the expanding reach of SEC enforcement in this area there should be little doubt that in the future directors and officers need to be particularly cognizant of their monitoring obligations as good corporate stewards.

Next:Employees, the company and insider trading

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