STING OPERATION CATCHES TWO INSIDER TRADING

Last year so-called blue collar tactics – wire taps and informants – resulted in the Galleon insider trading cases, discussed here. In January, an undercover sting operation yielded 22 arrests for FCPA violations, discussed here. Yesterday, another undercover sting operation resulted in criminal and civil insider trading charges being brought against Yonni Sebbag and Bonnie Hoxie. Ms. Hoxie is an administrative assistant to a high level executive at The Walt Disney Company. Mr. Sebbag is her boyfriend. U.S. v. Hoxie & Sebbag (S.D.N.Y. Filed May 26, 2010); SEC v. Sebbag (S.D.N.Y. Filed May 26, 2010).

In March 2010, anonymous were letters about insider trading sent to several hedge funds in New York, other U.S. states and European countries, according to the SEC’s complaint. Specifically, the letters claimed pre-release access to Disney’s 2Q-2010 quarterly earnings report which could be shared for a fee. The FBI obtained the letters and set up an undercover sting operation.

FBI agents, posing as traders, contacted Mr. Sebbag. According to the SEC, the agents and defendant Sebbag exchanged a series of e-mails which are extensively quoted in the complaint. In those e-mails, Mr. Sebbag made it clear that he was looking to establish a business relationship in which he would make available the inside information in return for payment and part of the trading profits.

Eventually, defendant Sebbag made arrangements with two FBI traders to furnish them with inside information about Disney’s 2Q-2010 earnings in return for compensation. Under one arrangement, he agreed to furnish the information in exchange for $15,000 and a 50% split of the trading profits. In a May 4 e-mail, Mr. Sebbag promised to provide the inside information.

Two days before the Disney second quarter earnings announcement, Mr. Sebbag emailed the FBI traders a Disney document titled “The Walt Disney Company Q2 Fiscal 2010 Key Topics Speaking Points.” It was marked “confidential” and contained the talking points for the up coming earnings call. In the text of the e-mail, Mr. Sebbag stated that he expected to have the actual earnings report about 2-3 hours before the market close. He promised to forward it.

The actual earnings report was never furnished to the traders, however. Ms. Hoxie was not able to obtain the document. She did obtain the EPS number for Disney which was furnished to the traders. It was 48 cents per share.

Subsequently, Disney announced its earnings which were 48 cents per share. During the earnings call much of the information contained in the confidential report furnished to the traders was discussed.

On May 14, 2010 Mr. Sebbag met with the two traders and was paid $15,000 in cash. At that point defendant Sebbag, who had previously used an alias in his communications, identified himself. He went on to inform the agents how he obtained the inside information. Later, defendants Hoxie and Sebbag were arrested. In the criminal case the two were charges with wire fraud and conspiracy to commit securities fraud. The SEC’s complaint alleges violations of Exchange Act Section 10(b). Both cases are pending.

CRAFTING AN EFFECTIVE APPROACH TO ENFORCEMENT REMEDIES

The effective use of remedies in resolving SEC enforcement actions is critical to protecting investors and the markets. SEC Commissioner Luis Aguilar recently discussed this question in calling for a re-evaluation of the use of penalties and selected other remedies.

In remarks at Compliance Week 2010, Commissioner Luis Aguilar emphasized the need for a rigorous enforcement program as part of effective regulation. Such a program hinges on deterrence, the Commissioner noted. He went on to define effective deterrence, stating this “means that we need to make sure that our enforcement program embodies the credible threat of punishment for violations.” Speech: Market Upheaval and Investor Harm Should Not be the New Normal, May 24, 2010, available here.

In the initial segment of his remarks on remedies, Commissioner Aguilar addressed the question of penalties. To “ensure that fraud does not pay . . .” penalties are a critical, he noted. In this regard, the 2006 statement of the Commission regarding corporate penalties is misguided – a comment that Commissioner Aguilar has made previously. That statement focuses on questions centered on determining if the company received a direct benefit and the impact a penalty would have on the shareholders. Neither of these considers the nature of the misconduct which is the critical question.

In asserting that corporate penalties should be tied to the nature of the misconduct, Commissioner Aguilar rejected the claim that the money paid simply comes out of the pocket of the shareholders. In the first instance, the funds were never in the shareholder’s pocket. In any event, it is the management that controls how corporate funds are spent. In this regard, Commissioner Aguilar suggested that perhaps corporate penalties should be required to be paid first from the budget and bonuses for the people or group that are most responsible for the misconduct.

The Commissioner went on to reject the notion that corporate penalties are an inappropriate substitute for pursuing individuals. Quoting the SEC’s first Enforcement Director, Irving Pollack, he argued that the Commission should pursue both the individuals and the corrupt entity.

More meaningful sanctions require more than a revamped approach to penalties however. The SEC also needs to expand it efforts toward individuals. For insider trading cases, Commissioner Aguilar suggests that the SEC abandon the traditional one plus one formula where the individual pays a penalty equal to the amount of the disgorgement. To ensure sufficient deterrence the Commission should come “closer” to the remarks of Former Chairman Richard Breeden: Leave them “naked, homeless, and without wheels.”

Better protection should also be afforded to investors by increasing the use of remedial sanctions. Here, Commissioner Aguilar is calling for an increased use of officer and director bars and Rule 102(e) to ban professionals from practicing before the Commission. Enforcement also needs to make more use of industry bars for market professionals. Those can be coupled with collateral bars if the pending legislation in Congress is passed. These bars would extend not just to the profession in which the defendant is currently employed such as the brokerage business, but to others such as being an investment adviser.

This is not the first time Commissioner Aguilar has called for a new policy on corporate penalties and tougher sanctions. While it seems clear that the current corporate penalty policy should be reassessed, it is questionable at best that larger corporate penalties will achieve the deterrence which is the center piece of Commissioner Aguilar’s remarks. As the Commissioner correctly notes “sanctions should not be an acceptable cost of doing business for fraudsters.” Rather, it is essential that the sanctions not just punish past conduct, but also ensure against a future repetition of the conduct so that investors and the markets are protected. If the recent debacle in the Bank of America case teaches anything, it is that large corporations are willing to pay millions of dollars in penalties to settle a case and move on. Indeed, the bank virtually said as much in explaining the reason it agreed to pay the initial penalty which was rejected by the court as discussed here.

What is curiously absent from Commissioner Aguilar’s remarks is any discussion of remedial remedies for corporations. Those remedies are designed not to be punitive, but protective, ensuring against a repetition of the wrongful conduct in the future. Long before the Remedies Act gave the SEC the authority to impose penalties, the Commission effectively used an array of remedial measures to protect investors and the markets from a repetition of wrongful conduct. Those remedies were critical to the success of the SEC’s Enforcement program during the period it was considered one of the best in government.

Commissioner Aguilar raises an important point by calling for a reconsideration of the SEC’s corporate penalties policy. Any such evaluation, however, should be made as part of an overall evaluation of all of the tools available to the Commission to halt, penalize and prevent a future reoccurrence of wrongful conduct. Only then can an effective enforcement policy be crafted.