THE SEC/CFTC REPORT ON HARMONIZATION: ENFORCEMENT

The SEC and the CFTC released “A Joint Report of the SEC and CFTC on Harmonization of Regulation” on Friday, October 16, 2009. The report was prepared pursuant to the Treasury White Papers released last June, and discussed here, which called for the two agencies to work together in an effort to harmonize their regulatory approaches. The report is supposed to be a part of comprehensive financial regulatory reform. The Administration sent proposed legislation up to Capitol Hill following the release of the White Paper. Various committees are considering the issues presented by that proposed legislation, as well as the market crisis.

Part of the Joint Report discusses enforcement, making recommendations for proposed legislation as part of the overall effort to harmonize the regulatory approaches of the two agencies. Overall the enforcement segment of the report focuses on manipulation, insider trading and aiding and abetting authority.

First, as to manipulation, the Report notes that both agencies have authority in this area. While there is some overlap in the types of cases brought, there are different issues in the futures markets involving activities such as corners and squeezes. The authority of the CFTC with respect to disruptive trading practices is, however, limited and needs to be enhanced.

Second, a key area of difference is insider trading. The market integrity provisions of the securities laws prohibit insider trading. In this regard there is a developed body of law regarding the use of corporate material non-public information and the duties of corporate officials and personnel.

The CEA’s insider trading prohibitions, in contrast, focus on employees and agents of the CFTC and of SROs and markets regulated by the agency. Historically, the markets have permitted hedgers to use their non-public material information to protect themselves against risks to their commodity positions. Counterparties to these transactions may not have access to the same kind of information. Corporate officials and personnel generally do not have a similar fiduciary duty with respect to those counterparties. Rather, their duty is to properly protect against risk. Some extension of the insider trading prohibitions under the futures laws is appropriate, according to the report. This would include an extension of the prohibitions applicable to CFTC and registered entity personnel to all SROs, government agencies and members of Congress.

Third, there are differences in enforcement remedies. For example, the CFTC has specific statutory authority for aiding and abetting all violations of the Act it administers and its regulations. The SEC in contrast does not. At the same time, neither agency has the ability to rely on whistleblowers to assist in detecting violations of the statutes.

The report makes five recommendations with respect to enforcement matters:

1) Whistleblowers: There should be legislation on whistleblower protections to encourage individuals to come forward with relevant information.

2) Restitution: There should be legislation to clarify that in CFTC civil actions that restitution is defined in terms of the losses sustained by persons as a result of the unlawful conduct.

3) Disruptive trading practices: There should be legislation to enhance the CFTC’s authority over disruptive trading practices.

4) Insider trading: There should be legislation to expand the scope of insider trading prohibitions under the CEA to make it unlawful to misappropriate and trade on the basis of material non-pubic information from any governmental authority.

5) Aiding and abetting: There should be legislation to expand the authority of the SEC to bring actions for aiding and abetting under each of the statutes it administers.

A UNIQUE INSIDER TRADING CASE

The largest insider trading cases in history involving a hedge fund, and the first to be based intercepted conversations from a wire tap, were filed on Friday by the U.S. Attorney’s Office for the Southern District of New York and the SEC following a joint news conference in New York. Criminal charges were brought in two complaints, U.S. v. Rajaratnam and U.S. v. Chiesi. The SEC filed civil insider trading charges, SEC v. Galleon Management, LP, Civil Action No. 09-CV-8811 (S.D.N.Y. Oct. 16, 2009). See also DOJ Press Release, “Manhattan U.S. Attorney Charges Hedge Fund Managers, Fortune 500 Executives, And Management Consulting Director In $20 Million Insider Trading Case” (Oct. 16, 2009) and SEC Litig. Rel. 21255, (Oct. 16, 2009). The case also raises unique issues.

The actions name six individuals as defendants, Raj Rajaratnam, the managing member of Galleon Management, LLC, a large hedge, private hedge fund; Danielle Chiesi, an employee of New Castle Funds, LLC, formerly the equity hedge fund group of Bear Stearns Asset Management; Mark Kurland, a senior executive of New Castle; Rajiv Goel, a director in strategic investments at Intel Capital, the investment arm of Intel Corporation; Anil Kumar, a director at McKinsey & Co., Inc., a global management consulting firm; and Robert Moffat, senior vice president and group executive at IBM. The SEC complaint also names Galleon and New Castle as defendants.

The overlapping insider trading schemes, which have gone on since as early as 2006, are claimed to have yielded about $20 million in illegal trading profits and involved trading in the shares of Polycom, Hilton Hotels, Google, Clearwire, Akamai, Advanced Micro Devices and People Support, Intel and Sun. In part, the inside information was obtained from some of the defendants. In other instances, it is alleged to have been obtained from an unidentified source who is cooperating with the government and apparently set up some of the taped conversations.

The insider trading allegations involve several different schemes. In one, beginning in January 2006 through July 2007, Mr. Rajaratnam is alleged to have traded on inside information about Polycom, Hilton and Google. The information here was obtained from the confidential, cooperating witness. That person supposedly obtained the information from various sources including an insider at Hilton and a source at Moodys. Galleon traded in the shares of these companies and made approximately $12.7 million. In exchange for the information, the confidential source obtained inside information on other deals from Mr. Rajaratnam.

From March 2008 through October 2008, Messrs. Rajaratnam and Goel engaged in a scheme involving Clearwire. Here, Mr. Goel is alleged to have obtained the inside information from Mr. Goel’s employment at Intel Capital. Again, Galleon traded based on the information and made a profit of over $500,000. Mr. Goel was paid when Mr. Rajaratnam placed profitable trades in his personal brokerage account. The year before these trades, Mr. Goel is alleged to have furnished Mr. Rajaratnam inside information about Intel which was also used to trade.

A third scheme took place from August 2008 to October 2008 involving Mr. Rajaratnam and Ms. Chiesi and trading in the shares of Akamai and AMD. Here, Ms. Chiesi is alleged to have furnished Mr. Rajaratnam inside information about Akamai. Ms. Chiesi obtained the information from an executive at Akamai, according to an intercepted telephone conversation. Based on the information both traders shorted the stock. New Castle made a profit of over $2.4 million.

During this period Ms. Chiesi and Mr. Rajaratnam also obtained inside information from at least two sources regarding AMD. One source was Mr. Kumar, who obtained inside information about certain McKinsey clients including AMD. Another was Mr. Moffat, who had access to information concerning the same AMD deal through his employment at IBM. Mr. Kurland also participated in some of these intercepted conversations. Both trades used the information to trade.

Ms. Chiesi also obtained inside information, according to the court papers, concerning IBM and Sun Microsystems from Mr. Moffat. That information was also shared with Mr. Kurland. New Castle used the information to trade making profits of $500,000 in IBM and $900,000 in Sun Microsystems.

A unique feature of these cases is the fact that the government appears to have monitored at least a significant portion, if not all of the insider trading. In the typical insider trading case, the SEC or criminal prosecutors learn about the claimed insider trading after it takes place. Frequently the investigations stem from market surveillance by New York Stock Exchange Regulation and FINRA. Investigators then try to work backwards and determine the source of the information.

Here, however it appears that the government secured a confidential source who was arbitraging inside information to the hedge funds involved here and others. At some point, that source began cooperating with the SEC and tape-recording conversations. This gave the government and the SEC the ability to monitor the claimed insider trading activities as the unraveled over the last several years making this a very unique case and, perhaps raising critical issues for law enforcement.