Part V: SEC Enforcement Trends and Priorities 2008 – Insider trading

Key areas in which the SEC brought cases last year include, insider trading, the Foreign Corrupt Practices Act, financial fraud, hedge funds, options backdating and attorneys. In addition, the Enforcement Division created a subprime taskforce which is coordinating with other regulators to investigate that area.

Last year saw a renewed emphasis on insider trading enforcement. The emphasis stems from congressional directives to step up enforcement in this area, as well as reports of rampant insider trading in U.S. markets and those around the globe.

To step up enforcement a new elite “watch dog” has been created. A group composed of investigators from FINRA, ORSA, NYSE Regulation and the SEC has been put together to focus on serial insider trading rings. This group not only shares information, but has also developed new computer models to monitor the markets and identify suspicious trading. The SEC is also working closely with other regulators around the globe.

The SEC is also trying new approaches to detecting insider trading. The Office of Compliance and Examinations has been testing a new template for inspections which has an insider trading component. Enforcement also circulated a questionnaire to hedge funds and other large traders in an effort to collect information about those with access to inside information in an effort to create a profile. This effort proved so controversial and raised so many privacy issues that it was later withdrawn.

SEC enforcement is also pushing into new areas in its insider trading investigations. Enforcement officials have repeatedly noted that they are scrutinizing executive trading under so-called Rule 10b5-1 plans. Those plans were suppose to be safe harbors for executives to sell company shares without insider trading concerns. Since a new business school study suggested that executives were receiving abnormal returns – the same type of study which started the option backdating scandal – Enforcement has been examining this so-called safe trading with an eye toward insider trading liability.

In other instances, Enforcement is defining what constitutes insider trading with litigation and consent decrees. In SEC v. Barclays Bank, Civil Action No. 07-CV-4427 (S.D.N.Y. May 30, 2007), the Commission filed a settled insider trading enforcement action against the bank and its chief bond trader. The complaint alleged that the defendants violated the antifraud provisions by trading on information obtained from sitting on creditors committees in bankruptcy proceedings and then trading in the securities of those companies. Some of the trades involved the use of so-called “big boy” letters in which the bank told the trader on the other side that it may have additional material and undisclosed information. Following the settlement, SEC officials noted that, in their view, the use of “big boy” letters did not shield the trader from insider trading liability. This theory is controversial in academic circles.

Another critical enforcement case in which insider trading liability is being defined is SEC v. Dorozhko, Civil Action No. 07-cv-9606 (S.D.N.Y. Oct. 29, 2007). There, a hacker broke into the computer system of Thomson, obtained information about IMS Health, Inc. and traded. The district court dismissed the case, noting that while the defendant may have violated some law, it was not the insider trading laws, because there was no violation of duty. The SEC has appealed this case to the Second Circuit.

Next: Significant insider trading cases

This Week In Securities Litigation (April 18, 2008 edition)

This was a week of insider trading cases, market timing and late trading cases and the SEC budget. Insider trading cases continue to be a staple of the Enforcement Division. Market timing/late trading seems to be never-ending. And, the budget for fiscal 2009 for the SEC as proposed by the President seems to undercut the vigorous policing of the capital markets necessary to maintain their integrity.

Clash of regulators?

Last week, the SEC filed another in what seems to be an endless series of late trading/market timing cases. In SEC vs. Headstart Advisers Ltd., 08CV 348 (S.D.N.Y. April 10, 2008) the Commission alleged that U.K.-based hedge fund adviser Headstart Advisers and it chief investment adviser orchestrated a scheme to defraud U.S. mutual funds through late trading and market timing. According to the complaint, the scheme has netted the defendants about $198 million in illegal profits. The Commission’s Litigation Release is here.

This may not turn out to be the ordinary market timing case, however. Defendants issued a press release claiming that the suit is “misguided.” Specifically, defendants claim that the Financial Services Authority, Britain’s financial watchdog, reviewed the trades and found nothing improper. Defendants have vowed to litigate. Could this be SEC vs. FSA?

Pillow talk cases

Last year, the SEC brought a number of so-called “pillow talk” insider trading cases involving spouses either trading together or one spouse using inside information obtained from the other to trade. A variation on this theme was the “family” trading cases where various family members such as fathers and daughters and fathers and sons insider trade.

Last week, the SEC brought another of these cases, but with a twist. In SEC v. Stummer, Case No. 1:2008CV03671 (S.D.N.Y. April 17, 2008) the Commission filed a settled insider trading case involving family members. According to the complaint, Mr. Stummer traded on inside information about the impending acquisition of Ryan’s Restaurant Group. The inside information had been obtained from Mr. Stummer’s brother-in-law, who served as a director of a private equity firm advising the acquiring company. The Litigation Release is here.

Stummer, however, is not the typical family members trading together or even a case where Mr. Stummer’s brother-in-law told him about the deal in reliance on a promise of confidentiality. Rather, the SEC’s complaint alleges that Mr. Stummer snuck into his brother-in-law’s bedroom and stole the information off his computer after guessing the password. Whether Mr. Stummer knew the information was there or was engaged in a random act of burglary and got luck is not clear. However, the result is: Mr. Stummer settled by consenting to a statutory injunction and agreeing to pay disgorgement of over $46,000, prejudgment interest and a penalty equal to the trading profits.

The SEC’s budget

According to the prepared testimony of SEC Chairman Cox, under the President’s proposed budget for fiscal 2009 the SEC’s budget for fiscal 2009 will creep up about enough to maintain the staff at its current size and fund merit raises. The overall budget represents the first increase in years.

While the Chairman did not request an overall increase from what was proposed by the President, Mr. Cox did endorse additional funding to monitor credit rating agencies. While any increase would be useful, it still questionable at best as to whether the proposed budget will be sufficient to effectively police the capital markets, as discussed here.

Recent papers of interest

A new working paper in the New York University Law and Economics series analyzes the Supreme Court’s decision last year in Tellabs, Inc. v. Makor Issues & Rights, Ltd., and its impact on pleading standards. Specifically, the paper discusses the application of the Tellabs strong inference of scienter test and identifies issues which were left open by the decision. The paper, by Geoffrey P. Miller, is titled “Pleading After Tellabs” (April 16, 2008), is available as part of the New York University School of Law, NYU Law and Economics Working Papers, Paper 127.

A new paper by Wayne Sate University Law School Professor Peter J. Henning, analyzes how the Sarbanes Oxley Act impacted sentencing in white collar cases. It also includes a discussion of the Supreme Court’s decision in Gall v. U.S. The paper is titled “The Changing Atmospherics of Corporate Crime Sentencing in the Post Sarbanes-Oxley Act Era.” It is available here.