The SEC staff confirmed last week at a conference in Washington, D.C. that the Office of Compliance and Inspections is conducting a sweep of selected Wall Street brokers for insider trading. Reportedly, the sweep is focusing on the last two weeks of September 2006. Members of the enforcement staff indicated that they will be looking at the sweep results to determine whether to follow up with investigations or enforcement actions.
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 here would be based on a complex factual theory and a difficult legal theory. Factually, the focus of the inquiry is to determine whether the 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.
Proof in any cases resulting from the sweep may be difficult. As SEC Enforcement Chief Linda Thomsen noted in her Congressional testimony last fall (see blog entry 9/27/06), proof in any insider trading case is difficult. In the typical front running case, establishing the misuse of the information and linking it to the trade is a difficult task. The difficulty of establishing the factual predicate for the type of case on which the sweep is based would be even more difficult given the complex nature of the suspected transactions.
The legal theory is also complex. The classic insider trading case is premised on a breach of fiduciary duty where the corporate insider breaches a duty owed to the shareholders of the company by using material non-public or “inside” information to trade in the company’s shares. A variation of this theory is the misappropriation theory where the information used to trade is misappropriated or essentially stolen. The legal theory for the sweep situation does not fit squarely under either theory, although traditionally the SEC has not been shy about trying to expand the statutory language of Exchange Act Section 10b, which deals with fraud and manipulation and does not specifically mention insider trading, through case law to accommodate its theories.
In this case, the information belongs to the brokerage house and its customer trader. The new theory argues a breach of duty not to the traditional company shareholders, but to the shareholders of the brokerage house. The breach occurs when the brokerage employee gives the information to another customer to trade in the company stock at another brokerage house. This is the same theory that was used in the Martha Stewart insider trading case that was settled in 2006. This is an aggressive theory premised on the conflict of interest that can arise from large trader clients at brokerage firms and the inherent unfairness of the situation. But, as the Supreme Court has made clear, conflicts and unfairness are not the predicate for insider trading.
All of this suggests that the sweep is an aggressive move by the SEC because there would be inherent difficulties in prevailing on the legal theory and establishing the factual predicate for the cases. On the other hand, it is a well know fact that companies – and particularly regulated entities such as brokers – often make business decisions to quickly resolve virtually any case, and at any cost, to preserve the company as a going concern.