Part V: SEC Enforcement Trends, 2009 — Insider Trading (continued)

Typically, the SEC settles most of its insider trading cases. Last year was no exception. Two high profile cases illustrate the point: the News Corp/Dow Jones case and the Guttenberg case, viewed by many as the most significant insider trading case brought in years.

SEC v. Kan King Wong, Civil Action No. 07 Civ. 3628 (S.D.N.Y. Filed May 8, 2007) centers on trading in advance of the May 1, public announcement of News Corp’s bid for Dow Jones. The initial complaint was filed seven days after the merger announcement. It named as defendants Kan King Wong and his wife Charlotte Ka On Wong Leung, both residents of Hong Kong. The complaint claimed the couple purchased 415,000 shares through a Merrill Lynch Hong Kong account before the announcement. When the husband ordered the sale, there were $8.1 million in profits from the increase in the share price following the announcement of the deal.

Subsequently, the SEC amended the complaint and settled the action. The amendment stated that News Corp. board member David Li told his close friend Michael Leung about the deal. Mr. Leung in turn told his daughter and son-in-law — the original defendants. Messrs. Li and Leung were added as defendants to an amended complaint which claims that Mr. Leung traded through the account of his daughter and son-in-law with their assistance.

To settle, each defendant consented to the entry of an order enjoining them from future violations of Section 10(b) and Rule 10b-5. In addition, Mr. Li was ordered to pay an $8.1 million civil penalty; Mr. Leung was ordered to pay $8.1 million in disgorgement plus pre-judgment interest and an $8.1 million penalty; and K. K. Wong was ordered to pay $40,000 in disgorgement plus prejudgment interest and a $40,000 civil penalty.

U.S. v. Guttenberg, 1:07-cr-00141 (S.D.N.Y. Filed Feb. 26, 2007) and SEC v. Guttenberg, Civil Action No. 07 CV 1774 (S.D.N.Y. March 1, 2007) are two more high profile insider trading cases that partially settled. The criminal case charged thirteen individuals while the SEC named as defendants fourteen individuals. The defendants were primarily Wall Street insiders.

The claims in each case involved two overlapping schemes. The primary scheme alleged that Mr. Guttenberg furnished others with information from his employer about up coming UBS recommendations on stocks prior to the announcement date. A second scheme centered on information obtained by a Morgan Stanley attorney who furnished others with inside information regarding up coming deals. The criminal case resolved with each defendant pleading guilty. The SEC case is still pending.

Many of the insider trading cases brought last year involved trading in advance of a corporate event such as a merger or an earnings release or had international aspects. SEC v. Tedder, Civil Action No. 3-08-CV-1013 (N.D. Tex. June 17, 2008) is an example of an insider trading case centered on a merger where the SEC took an aggressive position. The SEC, which obtained a portion of the facts alleged from a corporate internal investigation, claims that defendants Tedder and Carr, both employees of Aviall, Inc. traded in advance of the acquisition of their company by The Boeing Company.

The SEC’s insider trading claims are based on a series of events which it claims support an inference that the defendants traded on inside information. The mosaic of facts used to create the inference include extending a trading blackout, an executive tour at the company by Boeing executives, repeated closed door meeting by the in-house counsel and an e-mail inadvertently sent by the company CEO to 122 employees about a conference call involving due diligence and rumors. The case is in litigation.

SEC v. One or More Unknown Purchasers of the Call Options for the Common Stock of DRS Technologies, Inc., Civil Action No. 08-cv-6609 (S.D.N.Y. Filed July 25, 2008) is an example of an insider trading case with international aspects. The complaint here is based on trading in call options on two take over stocks through an account at UBS AG in Zurich, Switzerland. The first instance involved a proposed transaction between Schneider Electric SA and American Power Conversion Corporation. According to the SEC’s complaint, Schneider sent a letter to American Power in September 2006 expressing interest in acquiring the company. Shortly after the letter, an unknown purchaser bought 2,830 American Power out of the money call options. After the deal was announced the share price of American Power rose 26%. Subsequently the options were liquidated for a profit of about $1.7 million.

The second involved a proposed transaction in which Finmeccanica SpA would acquire DRS Technologies, Inc. Prior to an announcement by Finmeccanica on May 12, 2008 that it would acquire DRS for $5.2 billion, the unknown purchaser bought 1,820 DRS call options that were out of the money and due to expire shortly. As a result of the announcement the share price of DRS increased significantly after which the options were liquidated for a profit of about $1.6 million. The case is in litigation.

Last year the SEC brought insider trading cases against a wide variety of defendants including directors, audit committee members, in-house counsel, auditors and others. For example:

• Director and outside counsel: SEC v. Boshell, Civil Action No. 08-CV-3292 (N.D. Ill. April 28, 2008) is a settled insider trading case which named as defendants a board member who learned about a potential acquisition at a board meeting and an attorney with an outside law firm doing due diligence on the deal.

• Audit committee member: SEC v. Gad, Case No. 07-CV-8385 (S.D.N.Y. Sept. 27, 2007) is an insider trading case brought against an audit committee member who is alleged to have tipped his close friend after learning there would be an earnings short fall. The case settled last year. See also SEC v. Erickson, Civil Action No. 03-07-CV-0254 (N.D. Tex. Filed Feb. 7, 2007) (action against an audit committee member who allegedly participated in negotiations regarding the acquisition of his company and then traded. The case settled last year).

• General counsel: SEC v. Heron, Civil Action No. 07-cv-01542 (E.D. Pa. Filed April 18, 2007). After litigating, this action settled last year. The defendant is the former general counsel of the company who is alleged to have repeatedly traded on inside information about his company.

• Outside auditors: SEC v. Raben, Case No. CV-08-0250 (N.D.CA. Filed Jan. 15, 2008) is a settled insider trading case brought against two former PwC auditors for trading in advance of pending deals of audit clients.

• Securities professionals: SEC v. Stephanou, Case No. 09 CV 325 (S.D.N.Y. Filed Feb. 5, 2009) is an insider trading case brought against two securities professionals and a hedge fund manager. The complaint alleges that the defendants traded in advance of pending deals. The case is in litigation. See also SEC v. Devlin, Case No. 08-CV-1101 (S.D.N.Y. Filed Dec. 18, 2008) (insider trading case against securities and legal professionals and their friends and clients which alleges illegal trading on a series of deals. This case is in litigation.)

• Public figures: SEC v. Cuban, Civil Action No. 3-08-CV-2050 (N.D. Tex. Filed Nov. 17, 2008). This insider trading action was brought against Mark Cuban, the owner of the Dallas Mavericks, HDNet and Landmark Theaters. The case is based on a PIPE offering made by Mama.com, Inc. According to the SEC, in 2004 when the company was planning the offering, Mr. Cuban, its largest known shareholder, was contacted several times about the proposed offering. Before information about the transaction was provided to him Mr. Cuban agreed to maintain its confidentiality. Mr. Cuban was reportedly upset by the offering because it would dilute his interest. He declined to participate. Shortly before the public announcement Mr. Cuban sold his entire stake in the company, avoiding what the SEC claims was potentially a $750,000 loss. The case is in litigation.

In view of the aggressive posture of insider trading enforcement, all companies should consider implementing and/or updating their compliance procedures. Brokerage firms are required under the securities laws to have insider trading compliance procedures. Non-regulated entities are not. The SEC recently stressed the importance of having insider trading compliance procedures, however. In Retirement System of Alabama, Release No. 574461 (March 6, 2008) the SEC resolved an insider trading investigation against an Alabama state pension fund by issuing an Exchange Act Section 21(a) report of investigation rather than brining an enforcement action. The resolution centered on the system agreeing to adopt insider trading procedures.

Next: Financial fraud

Part IV: SEC Enforcement Trends, 2009: Insider Trading

Insider trading has long been a high priority of SEC enforcement. Last year, the number of insider trading cases brought by the agency increased by about 25%, according to SEC statistics. Beyond the statistics, the emphasis on insider trading is evidenced by the new market surveillance approach created last year, as well the often aggressive manner in which cases were brought and the wide variety of defendants named in those actions.

The new market surveillance program was announced in August 2008. NYSE Regulation and the Financial Industry Regulatory Authority (“FINRA”), under the supervision of the SEC, entered into an agreement under which the two self regulatory organizations will supervise eleven current insider trading programs on various exchanges. The new approach calls for NYSE Regulations to be responsible for the detection of insider trading for New York Stock Exchange and NYSE Acra listed securities. FINRA will be responsible for American Stock Exchange and NASDQ listed securities. Participating in this arrangement include the American, Boston, CBOE, Chicago, International, NASDAQ, National, New York, NYSE Acra, and the Philadelphia. Appropriate cases will be referred to the SEC for further inquiry.

The new arrangement replaces the prior system under which each exchange conducted its own investigation. It is designed to enhance detection of possible insider trading.

Year end statistics from NYSE Regulation suggest that the new program may be having the desired effect. At year end 2008, NYSE Regulation reported a small increase in suspicious trading and the number of cases referred to the SEC

More significantly however, the composition of the cases seems to have changed. In 2007, about 72% of the referrals for further investigation involved hedge funds. In 2008, only about half of the cases related to hedge funds while the other 50% involved insiders, a significant increase over 2007. These statistics may reflect in part the dynamics of the marketplace, with hedge fund trading declining because of the market crisis. At the same time, the rise may suggest an increase in insider trading by corporate insiders.

The aggressive posture of the SEC in this area is reflected in the cases it selected to litigate. In SEC v. Talbot, Case No. 06-55561 (9th Cir. June 30, 2008), the Commission won a significant victory in a court ruling discussing the nature of the breach of duty which is required to sustain an insider trading charge. There, the SEC brought and insider trading action against Mr. Talbot, a director of Fidelity National Financial for insider trading.

LendingTree was in negotiations to be acquired. The CEO of that company told a vice president of Fidelity about the proposed transaction and requested that the information be kept confidential. The Fidelity vice president later told his CEO who, in turn told the board at a regular meeting attended by Mr. Talbot at a time when Fidelity owned 10% of LendingTree. There was no request that the information be kept confidential. One director at the meeting stated however, that this was inside information. Mr. Talbot later purchased shares of LendingTree before the public announcement.

The district court dismissed the SEC’s complaint, concluding that it failed to establish a breach of duty. The court found there was no continuous chain of fiduciary relationships from Mr. Talbot to the source of the information. The Ninth Circuit reversed, holding that a continuous chain is not necessary, just a breach of duty. Here, Mr. Talbot breached a duty to his company the circuit court concluded by trading on the information. That breach is sufficient.

The breach of duty issue is also central to the SEC’s claims in SEC v. Dorozhko, Civil Action No. 07-9606 (S.D.N.Y. Oct. 29, 2008). In this case the Commission’s complaint was brought against Mr. Dorozhko, a Ukrainian resident. The complaint claimed he hacked into a company’s computer files and stole inside information which was later used to trade.

The district judge dismissed the SEC’s complaint, concluding that there was no deception. Absent deception, which typically flows from a breach of duty in an insider trading case, there is no violation of Section 10(b). The SEC’s appeal of this action is pending before the Second Circuit. That court did extend an asset freeze order the Commission obtained prior to the dismissal of its action.

The SEC also took an aggressive posture in SEC v. Patton, Civil Action No. 02 cv2564 (E.D.N.Y. Filed April 30, 2002), one of the few insider trading cases tried to a jury. There, the SEC prevailed in a case against a downstream recipient of a tip, Constantine Stamoulis, after criminal charges against him had been dismissed.

The SEC’s complaint centers on alleged insider trading in the securities of WLR Foods, Inc. prior to the September 2000 announcement that the company was being acquired by Pilgrim’s Pride Corporations. The fourteen defendants include Eric Patton, the former Director of Manufacturing for the Turkey division of the company, his brother Steve Patton, his registered representative Michael Nicolaou, and several others. Mr. Stamoulis was allegedly tipped by his business partner, John Tsiforis, who the complaint claimed was tipped by his friend Michael Nicolaou, who had been tipped by Steven Patton.

Criminal insider trading charges were brought against Eric and Steve Patton, Mr. Stamoulis and others. Three defendants pled guilty. The criminal charges against Mr. Stamoulis were dismissed. Following the verdict in the SEC’s case however, the court enjoined defendant Constantine Stamoulis from future violations of the antifraud provisions and directed him to disgorge his trading profits and pay prejudgment interest as well as a fine equal to three times his gain.

The SEC’s aggressive posture in this area has not always served it well. In SEC v. Mangun, Civil Action No. 06-CV-531 (W.D.N.C. Filed Dec. 28, 2006), the Commission had its Section 5 charges and insider trading claims dismissed.

Here, the SEC’s complaint claimed that defendant John Mangun, a registered representative and hedge fund operator, engaged in the sale of unregistered securities and insider trading in connection with a PIPE offering. According to the complaint, Mr. Mangun agreed to participate in a PIPE offering and just prior to its announcement sold the underlying shares short. Later, he used the shares from the resale registration to cover. The court rejected the SEC’s claim that this constituted a violation of Section 5 because at the time of the short sale the shares used to cover were not registered. The court also rejected the charge that this constituted insider trading.

In SEC v. Boutraille Corp., Case No. 05 CV 9300 (S.D.N.Y. Filed Nov. 4, 2005) the Commission was aggressive in filing insider trading charges and obtaining an emergency freeze order over $3 million in assets only to dismiss its case after years of litigation.

The initial complaint, apparently predicated on a suspicious trading pattern, was brought against unknown purchasers of call options in the common stock of Placer Dome, Inc. In October 31, 2005 Barrick Gold Corp, a Canadian based gold mining company announced an offer to purchase Placer Dome, also a Canadian based gold mining company.

Prior to the announcement of the deal, the SEC claimed that unknown purchasers, while in possession of inside information and through overseas brokers, bought over 10,000 call options for Placer stock. At the time, over 5,000 of the options were out of the money and set to expire in November, within weeks of the purchases. The account had what the SEC claims was $1.9 million in illegal profits.

Subsequently, the complaint was amended to name Boutraille Corporation, Trinity Partners Ltd. and John C. Fraleigh as defendants. After years of litigation however, the SEC was forced to dismiss the case.

Next: Significant settlements in insider trading cases