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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Today, 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  The complaint alleges that since 2001 several participants, including among others three hedge funds and two broker-dealers, traded using inside information misappropriated by a UBS executive to trade ahead of UBS analyst recommendations.  Additionally, the complaint alleges that several securities industry professionals and a hedge fund traded using inside information misappropriated by an attorney at Morgan Stanley to trade ahead of corporate acquisition announcements.  

Specifically, the complaint alleges that, from at least 2001 through 2006, Mitchel S. Guttenberg, an executive director in the equity research department of UBS, secretly   furnished inside information in violation of the securities laws concerning upcoming UBS analyst upgrades and downgrades to at least two Wall Street traders, Erik R. Franklin and David M. Tavdy, in exchange for sharing in the illicit profits from their trading on that information.  Franklin then illegally traded on the information in his personal accounts, his father-in-law’s personal accounts, and for two hedge funds he managed.  According to the complaint, Tavdy illegally traded on the inside information in his personal account, the accounts of a relative and friend, the accounts of Jasper Capital LLC, a day-trading firm with which Tavdy was associated, and for Andover Brokerage, LLC and Assent LLC, registered broker-dealers where Tavdy was a proprietary trader.      The SEC further alleges that Franklin and Tavdy tipped others including Mark E. Lenowitz, who illegally traded on this inside information personally and for DSJ International Resources Ltd. (dba Chelsey Capital), a private hedge fund, and three registered representatives at Bear Stearns. Additionally, the complaint alleges, David A. Glass, the owner of Jasper Capital, also traded on Tavdy’s UBS tips.    

The complaint also alleges that several of the participants in the UBS scheme, and others, traded ahead of corporate acquisition announcements. According to the complaint, Randi Collotta, an attorney for Morgan Stanley, together with her husband, Christopher Collotta, an attorney in private practice, tipped inside information to Marc Jurman, a registered representative in Florida, in exchange for sharing in Jurman’s illicit profits from trading on this information. The complaint alleges that Jurman had several downstream tippees who also traded, including Franklin and the Q Capital hedge fund, and two registered representatives at Bear Stearns, Babcock and Okada, who also were involved in the UBS Scheme.  Today, the U.S. Attorney’s Office for the Southern District of New York also announced criminal charges against Guttenberg, Franklin, Tavdy, Lenowitz, Babcock, Okada, Glass, Randi Collotta, Christopher Collotta, Jurman, and others in connection with these two insider trading schemes.   

 Several high ranking SEC officials commented on the day’s events:  “Our action today is one of several that will make very clear the SEC is targeting hedge fund insider trading as a top priority,” said SEC Chairman Christopher Cox.    “Today’s events should send a message to anyone who believes that illegal insider trading is a quick and easy way to get rich. No matter how clever you are, no matter how hard you try to avoid detection, you underestimate us at your peril,” said SEC Enforcement Director Linda Chatman Thomsen. “Illegal insider trading undermines the level playing field that is the hallmark of our capital markets. It is, however, particularly pernicious when Wall Street insiders – who derive their already substantial livelihood from the capital markets and those markets’ investors – shamelessly compromise the markets’ integrity and investors’ trust for a quick buck.”   

SEC Associate Director of Enforcement Scott W. Friestad said, “Today’s action is one of the largest SEC insider trading cases against Wall Street professionals since the days of Ivan Boesky and Dennis Levine. It involves fraud by employees of some of the biggest brokerage and investment banking firms in the country. We will do everything possible to make sure that, in addition to any other remedies or sanctions imposed, none of these individuals ever works in the securities industry again.”    As Associate Director Friestad apply points out, today’s cases are reminiscent of the large SEC insider trading cases of the 1980s involving Ivan Boesky, Michael Milken and other large Wall Street players, tales of which are chronicled in the best selling book, Barbarians at the Gate.  The cases in the 1980s were noteworthy for the often larger than life characters at the center of the scandals and the results.   Many of the key figures in those scandals, such as Messrs. Boesky and Milken, settled with the U.S. Attorney and the SEC rather than taking their cases to trial.  Those who settled typically landed in jail and barred from the securities business.  In contrast, may of those caught up in the scandals of the 1980s who contested the government’s claims were acquitted.     

The cases brought by the SEC and the DOJ today are clearly reminiscent of the trading scandals of the 1980’s.  Like the initial cases of that time period, the cases today may be only the first of more to come.  The SEC is also conducting a sweep of Wall Street brokers to determine if information was leaked to hedge fund customers about institutional trade orders in advance of the execution of those orders so that the hedge funds could trade ahead of the institutions – that is, insider trade – at another brokerage firm, as previously reported in this blog.  At the same time a noteworthy feature of the cases brought today is that, unlike most SEC enforcement actions, these cases were not settled at the time they were filed.  Rather, the defendants are contesting the charges.  As these cases proceed we will see if they truly are like those of the 1980s with the SEC and DOJ winning in settlement but not in court.      Next week we will continue our series on SEC enforcement trends.     

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