SEC Enforcement Trends:  Insider Trading 

Insider trading is more than a traditional area of emphasis by enforcement, it is clearly a high priority that should be of concern at least to corporate officers and directors who may periodically have transactions in company shares.  Earlier this month the SEC brought what may be its most significant insider trading case since the days of Ivan Boesky, Dennis Levine and Michael Milken in the late 1980’s.  In SEC v. Guttenberg, et al., No. 07 CV 1774 (S.D.N.Y Mar. 1, 2007), 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 and 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 (see blog posting 3/2/07).  This action follows Congressional hearings last fall in which Congress reviewed the SEC’s enforcement efforts in the area and Enforcement Chief Linda Thomsen emphasized that the SEC would continue to be aggressive in the area despite difficult proof problems with the cases (see blog posting 3/5/07).

The aggressive posture of the agency is reflected not only in the Guttenberg case, but also in cases brought in 2006 and in comments made by Ms. Thomsen in a recent speech.  For example, in SEC v. Rocklage, 2006 WL 3290965 (1st Cir. Nov. 14, 2006), the SEC filed an insider trading action against the wife of a corporate CEO and her brother.  The key question on a motion to dismiss was whether the SEC had adequately alleged deception in pleading the cause of action.  The complaint claimed that the CEO told his wife material non-public information about the company, expecting her to maintain its confidentiality.  Later that day the CEO and his wife had a second conversation about the corporate information.  At the conclusion of that discussion the wife informed her husband that she intended to tip her brother under an pre-existing arrangement pursuant to which she had agreed to inform him of any key events at the company so he could trade.  Although the CEO urged his wife to keep the information confidential, she tipped her brother who traded on the next trading day and prior the public announcement of the company news.  The defendants argued that the case should be dismissed because the SEC failed to adequately plead the key element of deception, contending that the wife’s disclosure of the secret deal with the brother eliminated any deception. The district court rejected this contention and the First Circuit affirmed.  The Circuit court held that the complaint pled deception because the wife did not disclose the deal with her brother in the first conversation when her CEO husband informed her about the corporate information believing that the information would remain confidential.  The SEC also took an aggressive legal position in the Martha Stewart insider trading case, SEC v. Stewart, et al., 03 Civ. 4070 (RJH) (S.D.N.Y. Aug. 7, 2006).  There the SEC charged that Ms. Stewart was illegally tipped and traded on inside information when her Merrill Lynch broker told her that the former Chairman of ImClone was selling his shares causing Ms. Stewart to sell her ImClone shares.  According to the complaint, the broker breached his duty to the shareholders of Merrill Lynch.  That theory varies from the traditional insider trading theory where the insider (or tipper) breaches a duty to the shareholders whose stock is traded.  Stewart and Rocklage suggest that the SEC is willing to take very aggressive positions in insider trading cases.

During 2006 the SEC also brought a series of cases based on the misuse of clinical information.  In these cases a pharmaceutical companies typically received material information about a product from the FDA which was used by an insider, tippee or consultant to trade prior to the public announcement.  Examples of these cases include the following:

SEC v. Thomas J. Bucknum, (D. Mass. Jan. 12, 2006).  Director consented to injunction and payment of over $2 million in disgorgement and prejudgment interest and a penalty of $969,232 where he placed order to sell stock, went to board meeting and learned material negative information about a company drug and then reaffirmed the sell order which was executed prior to company news announcement.

 SEC v. Sanjiv S. Agarwala, (S.D. Cal. Feb. 16, 2006).  Doctor/consultant consented to injunction and payment of $14,784 in disgorgement, $498 in prejudgment interest and a penalty of $29,568 where complaint alleged insider trading based on advance knowledge of FDA position on drugs. 

SEC v. Alexander J. Yaroshinsky, (S.D.N.Y  March 28, 2006).  Court ordered asset freeze against drug executive where complaint alleged he traded based on advance knowledge of FDA position on drug tests.

SEC v. Marnie L. Sharpe and Leonard P. Leclerc, (N.D. Cal. May 2, 2006).  Action against daughter and father alleging she learned of favorable drug information prior to public announcement from friend at the company and tipped father who traded.  Father and daughter consented to injunction and payment of over $120,000 in disgorgement and penalties.   In 2007 the SEC will undoubtedly continue to be aggressive in bringing insider trading cases. 

This point is clearly demonstrated by the recent SEC v. One or More Unknown Purchasers of Call Options for the Common Stock of TXU Corp., Civil Action No. 07C1208 (N.D. Ill. Mar. 2, 2007) case brought earlier this month (see post of 3/5/07).  Key issues for corporate officers, directors and others in this area involve the question of spring-loaded and bullet-dodging options, as previously discussed in Part V of this series on backdated options (see post of 3/7/07).  An emerging issue in the insider trading area that will be of concern to many directors and officers is the use of 10b-5-1 plans.  This rule was issued to create a safe harbor for executives to trade shares using essentially a pre-set mechanical formula.  Enforcement Chief Linda Thomsen noted in a recent speech, however, that the staff is taking a “hard” look at these plans to determine whether they are being abused.  Her comments were prompted by a recent academic study suggesting that executives using the safe harbor are achieving higher than expected returns on stock transactions.  It was this kind of academic study that touched off the current options scandal.  Accordingly, directors and officers should beware that the once safe harbor of 10b-5-1 may no longer be safe (more on this later in another post).  Ms. Thomsen’s comments, along with the SEC’s recent cases, suggest that the agency will continue to be very aggressive in this area.  All of this suggests that it would be prudent for issuers to review carefully their compliance programs on insider trading and that any director, officer or other corporate insider carefully review the arrangements under which they trade in company shares – even if the transactions are under the once, but perhaps no longer, safe harbor of 10b-5-1.

Trial of Former Qwest CEO Joe Nacchio Begins
Additionally, the trial of former Qwest CEO Joe Nacchio begins on Monday, March 19, in the federal district courthouse in downtown Denver.  The blog, http://www.theracetothebottom.org/ < http://www.theracetothebottom.org/>  will provide daily coverage of the trial.  Faculty and students will rotate through the eight week trial with the expectation that there will be at least two posts each day the trial is in session (the trial will not be held on Friday).  Primary materials on the case can also be found at the DU Corporate Governance web site

(http://law.du.edu/jbrown/corporateGovernance/qwest/index.cfm).

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The purpose of SEC and NYSE enforcement actions is to protect the markets, investors and public, not explore history.  Two settled enforcement actions filed yesterday raise significant questions about their purpose.

Yesterday, the SEC announced settlements in two actions in which it claimed that two major Wall Street firms disadvantaged their customers by violating the securities laws.  First, in a settled administrative proceeding against Banc of America Securities the SEC claims the broker willfully violated Sections 15(f) and 15(c) of the Securities Exchange Act of 1934 by failing to provide clear and effective internal policies and to detect failures in its internal controls to prevent the misuse of forthcoming research reports by the firm or its employees, including analyst upgrades and downgrades, and for issuing fraudulent research.  http://www.sec.gov/news/press/2007/2007-42.htm  According to the SEC, failure to comply with these procedural requirements significantly disadvantaged BofA Securities’ clients because the broker traded ahead of its own clients, using its own research reports to trade for its account prior to releasing those reports to its unsuspecting clients.  This informational advantage was very profitable for BofA Securities according to the SEC.  To resolve the action BofA Securities agreed to a censure, a cease-and-desist order, and payment of $26 million in disgorgement and penalties.   Linda Thomsen, Director Division of Enforcement, took the opportunity to reiterate the SEC’s Wall Street focus, “We are determined to plug the improper leak of information on Wall Street . . . . Today’s action makes it clear that firms must have appropriate safeguards on all their nonpublic information, including upcoming research reports.”

In a second settled administrative proceeding the SEC and the NYSE claimed that Wall Street giant Goldman Sachs violated regulations that require brokers to accurately mark sales long or short and restricting stock loans on long sales.  http://www.sec.gov/news/press/2007/2007-41.htm  According to the SEC and the NYSE, selected Goldman customers were permitted to trade short in advance of public offerings of the companies’ securities by improperly disguising their short trade as long trades.  According to the Order, two Goldman customers’ pattern of trading and Goldman’s records reflected that the customers were selling securities short in violation of Rule 105 and Rule 10a-1(a).  The SEC’s Order also found that Goldman was a cause of its customers’ violations of the short sale rules.  The NYSE Decision further cited the company for failure to supervise its business activities.  The SEC Order and the NYSE Decision censured Goldman for its conduct and compels the firm to pay $2 million in civil penalties and fines. 

If these actions are serious violations of the law as the SEC and the NYSE claim, one has to wonder where these regulators have been.  The conduct in these cases is several years old; since 1999-2001 in the BofA Securities and from 2000-2001 in the Goldman action.  Bringing these actions years after the conduct began and ended does not seem to serve the investor protection purpose of enforcement actions.  Indeed, there seems to be little purpose in ordering that conduct cease and desist now when it began and ended years ago.  Likewise imposing penalties years later is hardly remedial, although it may be arguably a deterrent and punitative.  The bottom line is that if enforcement actions are to protect the public they need to be brought in a timely fashion. 

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