The next several segments of our series on SEC enforcement trends will examine significant cases in key areas from 2006.  Specifically, we will analyze cases concerning:

·        Backdated Options

·        Hedge Funds

·        Insider Trading

·        Financial Fraud

·        FCPA

·        Market Timing

·        Trading Practices

·        Gate Keepers

In our analysis we will tie significant cases in these areas from 2005 to inquiries and actions being currently brought by the Enforcement Division to project trends for 2007 and beyond.  Identification of those trends will give companies the opportunity to examine key compliance programs and take other necessary precautions to ensure compliance and avoid liability.  At the same time, it may also serve as a caution to those facing expanding liability, such as, directors, in-house and outside counsel, auditors and consultants.  Identification of these trends should also aid those dealing with an SEC investigation or enforcement action, and a parallel inquiry or action being brought by DOJ or the AUSA, and facilitate its resolution.  

Next:  Backdated stock options: A rapidly expanding area.

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Since the Senate held hearings in September 2006 on “Illegal Insider Trading: How Widespread is the Problem and is there Adequate Criminal Enforcement?” federal regulators and prosecutors seem to have been re-energized in their hunt for those who seek to profit from illegal insider trading.  During those hearings, SEC Enforcement Director Linda Thomsen testified that proving insider trading can be extremely difficult.  Ms. Thomsen went on to note that that in response to, among other things, increased merger activity and concerns about insider trading by hedge funds, the SEC had recently “shifted our enforcement focus yet again.” Testimony Concerning Insider Trading, Linda Chatman Thomsen, Director, Division of Enforcement, U.S. Securities & Exchange Commission, Before the U.S. Senate Committee on the Judiciary September 26, 2006.  Professor Coffee echoed Ms. Thomsen’s comments about hedge funds and leaked information.  Testimony Concerning Insider Trading, Professor John Coffee, Professor of Law Columbia Law School, Before the U.S. Senate Committee on the Judiciary September 26, 2006. 

Shortly after the Senate hearings, the SEC began a sweep of major Wall Street brokers centered on trading activity in the last two weeks of September 2006.  Specifically, the sweep focuses on the activities of hedge funds and other large brokerage customers and potential conflicts of interest involving what is called front running, which is based on a complex factual theory and a difficult legal theory.  The inquiry seeks to determine whether brokers leaked information about large trades by institutional investors, such as mutual funds, to hedge funds or other large preferred customers so they could trade at another brokerage firm.  Front running is trading in advance of a large customer trade.  The practice has long been a concern on Wall Street because it gives the trader an informational advantage by knowing about large transactions of firm customers that could impact the security’s price. 

While hedge funds may be a focus because they are huge pools of capital that are largely unregulated – SEC attempts to regulate the funds were rejected last year by the courts – the new round of insider trading cases seem to be coming from more traditional sources, such as Wall Street players and corporate executives.  Last week the SEC brought insider trading cases that hearken back to the 1980s rather than keying on the activities of current day hedge funds.  On March 1, the SEC filed insider trading charges against fourteen defendants who are reported to have made at least $15 million in illicit profits in connection with two related insider trading schemes in which Wall Street professionals serially traded on inside information tipped to them by insiders at UBS Securities LLC and Morgan Stanley & Co., Inc. in exchange for cash kickbacks.  http://www.sec.gov/litigation/litreleases/2007/lr20022.htm (see blog posting 3/1/07)  In the release, SEC Chairman Christopher Cox is quoted stating that “[o]ur action today is one of several that will make very clear the SEC is targeting hedge fund insider trading as a top priority.”  Recall that in the scandals of the 1980s it was securities professionals such as arbitrageur Ivan Boskey and Drexel trader and junk bond king Michael Milken and other Wall Street players who were the center of the scandals, just as in the cases filed last week.   

Similarly, in the case filed on Friday, March 2, the SEC again seems to be returning to the 1980s.  On March 2, the SEC obtained a temporary retraining order in the United States District Court for the Northern District of Illinois freezing assets against unknown purchasers of call options for TXU Corporation common stock prior to an acquisition announcement for orders placed from foreign accounts.  http://www.sec.gov/litigation/litreleases/2007/lr20028.htm  According to the complaint, the “Unknown Purchasers” engaged in illegal insider trading.  Allegedly, highly profitable and suspicious purchases of over 8,020 call option contracts for the common stock of TXU Corp. were placed by the Unknown Purchasers through overseas accounts in late February 2007 prior to the announcement that TXU had executed a merger agreement with private equity groups headed by Kohlberg Kravis Roberts & Co., Texas Pacific Group and Goldman Sachs & Co.  As the complaint alleges, the call option contracts were “out of the money” and most were set to expire in March, within weeks of the purchase date and, as a result of the increase in price of TXU stock following the announcement, the unrealized illicit profits on these option contracts total approximately $5.4 million.  In addition to freezing approximately $5.4 million in assets, the Court’s order (i) requires that the Unknown Purchasers identify themselves, (ii) provides for expedited discovery, and (iii) prohibits the defendants from destroying evidence.  Trading through foreign brokerage accounts was a favorite during the scandals in the 1980s as Dennis Levine, a key figure in those cases, demonstrated. 

The reports on Friday, March 3, by the NYT that Federal prosecutors and securities regulators are investigating sales in the shares of New Century Financial Corporation that occurred before the company’s announcement on February 7 that it would restate earnings for three quarters look like old fashioned insider trading by corporate executives.  NYT, Vikas Bajaj and Julie Creswell, “Authorities Investigate Big Lender,” Mar. 3, 2007.  Reportedly, the SEC has requested a meeting with New Century executives and, on February 28, New Century learned of a parallel criminal investigation in the United States attorney’s office in Los Angeles.  While the article notes that it is unclear what stock sales investigators are looking at, it surmises that “two of the company’s top executives sold sizable blocks of shares in the second half of last year. Robert K. Cole, a former chairman and a founder of the company, sold stock worth $6.7 million in the third and fourth quarters after not selling significant numbers of shares for the previous three quarters. And Edward F. Gotschall, another founder and vice chairman, sold shares worth $14.7 million after not selling significant numbers of shares for the previous six months. Earlier last spring, the executives, both of whom are still on the board, said they would be moving out of their leadership positions. They later disclosed plans to sell stock.” 

With all the talk about hedge funds and their enormous influence on Wall Street, if the cases and investigations of last week are any indication it is Wall Street traders and corporate executives who have forgotten the lessons of the insider trading scandals of the 1980s.  As the option backdating scandals go on and pick up pace with more cases and guilty pleas, it seems that a second series of corporate scandals may be about to unfold involving the more traditional problem of insider trading.

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