On September 26, 2006 SEC Enforcement Director Linda Thomsen told the Senate Committee on the Judiciary that insider trading remains a priority for the Division. Ms Thomsen pointed out in her testimony that since 2001 the agency has brought 300 actions against over 600 individuals and entities for insider trading violations. Over that period insider trading cases have made up 7 –12% of the Commission’s case load.After recounting some of the more Division’s more significant insider trading cases, the Enforcement Chief noted the Division’s Office of Market Surveillance is in daily contact with the various SROs who perform primary surveillance over the markets. The SROs monitor the markets for unusual peaks and valleys in trading, sudden changes in the price of a stock or other unusual market activity.

Insider trading cases are very difficult to prove according to the Enforcement Chief. Since there typically is no “smoking gun” the cases are based largely on circumstantial evidence. In this regard Ms. Thomsen told the Committee that “[building an insider trading case based on circumstantial evidence can be frustrating, risky and time-consuming. Because of these challenges, we also have to accept that a number of the insider trading investigations we open may not result in a filed enforcement action –not for any lack of diligence on the part of the staff, but for lack of evidence.”

The requirements for proving an insider trading case using circumstantial evidence are discussed in a forthcoming article in the fall issue of Securities Regulation Law Journal titled Is Evidence of Contacts Followed by Trading Sufficient to Infer and Prove Tipping in an Insider Trading Case? The “Plus Factor” Rule.

Typically the SEC seeks a “one-time” penalty in an insider trading case which is equal to the amount of the illegal profits realized or the losses avoided according to the testimony, particularly where the case settles before litigation according to Ms. Thomsen. In some egregious cases the agency has sought an enhanced penalty such as where there were “extraordinary measures” to conceal the trading or where there is a history of fraud. In some instances the agency has settled for less than a one-time penalty.

The testimony comes about one month after a front page New York Times article about insider trading. That article, discussed in an August 29, 2006 post in this blog, was based on a study commissioned by the newspaper. That study suggested that there was a significant about of increased trading activity in advance of many mergers. The article notes that this may be from insider trading. Interestingly, the article did not discuss the economic theory of leakage. Under that theory the increased business activity surrounding a potential merger partner prior to the transaction may explain increases in trading which are not based on insider trading. In discussing the difficulty of proving insider trading cases Ms. Thomsen acknowledged that frequently the staff is confronted with alternate explanations for trading although she did not specifically mention the New York Times article or leakage.

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Internal investigations appear to be the flavor of the month. It’s become increasingly difficult to pick up a news paper without reading that a company is conducting an internal ingestion regarding a possible impropriety. The SEC and the justice department as well as other regulators encourage these investigations.  No doubt this is good policy from the prospective of the government. Internal investigations can help detect improper conduct and practices.  They can also serve as the predicate for the adoption of procedures which can prevent a reoccurrence of the underlying conduct.But are internal investigations always a good thing? Or can there be to much of a good thing? Perhaps. To begin with, an internal investigation has to be independent if it is to have any credibility with the government, regulators or the courts. Independence means outside counsel that does not regularly work for the company. To often in the rush to conduct and inquiry the counsel retained is not independent. Rather, the counsel selected is, if not the regular outside counsel of the company, a firm that periodically does work for it. No doubt the attorneys at such a firm can conduct an investigation and they clearly know much more about the company than new counsel. But it will not be viewed as independent by skeptical government attorneys. Regardless of how good the work is, any outsider reviewing the inquiry will have to wonder if the relationship between the parties has impacted the findings, scope or conclusions. Under these circumstances it can be difficult to convince those outside the company that investigation results which exonerate the company and/or key employees are correct. If the report lacks independence the task is much more difficult and perhaps impossible. More importantly, the lack of independence may suggest that the company has something to hide.

A second problem with internal investigations can be the work. An investigation which is not complete can be worse than no investigation at all. An inquiry which fails to fully assess the facts, which was improperly limited in scope or which reaches seemingly unsupported conclusions favoring the company and/or its employees can be read by outsiders as a white wash. If the inquiry is viewed as a white wash it can suggest that the company is covering something up. Whether in fact this is true, under these circumstances the investigation which was suppose to help solve a problem has just made things worse. Now government or other investigators will have to determine the true nature of the original problem, the reasons for the incomplete report and whether there has been obstruction of justice — the difficult situation which spawned the investigation has just become much much worse.

The bottom line here is that an internal investigation can be a very useful tool. When conducted by independent counsel and properly done it can help solve a potentially difficult problem. If not properly configured and conducted, the company may well have compounded its difficulties rather moved toward a solution.

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