THE RENEWED CAMPAIGN ON INSIDER TRADING: Part II: If This is A Return to the “Den of Thieves,” is the Answer Better Enforcement?

In a widely quoted comment, an SEC enforcement official recently noted that insider trading is “rampant.” Another SEC official stated earlier that there is an increase in insider trading among market professionals. Both of these comments are reflected in the ever increasing number of insider trading cases brought by the SEC. Indeed, the trend seems to be reminiscent of the days chronicled in James Stewart’s book, Den of Thieves, about the insider trading scandals of the 1980’s.

Perhaps the 1980’s have returned. Consider, for example, SEC v. Guttenberg, Case No. 1:07-cv-01774-PKC (S.D.N.Y. Filed March 1, 2007) and related cases (originally discussed here). There, the SEC brought insider trading cases against 14 defendants. The cases involved two basic insider trading schemes. One scheme is the UBS scheme which ran from 2001 to 2006 where UBS insider Guttenberg tipped two Wall Street traders regarding up coming UBS analysts’ recommendations. The two traders had downstream tippees at other firms and hedge funds.

The second scheme involved a Morgan Stanley attorney, her husband attorney and other professionals. There, according to the allegations, the Morgan Stanley attorney misappropriated M&A information and tipped others.

What is perhaps most significant about the cases is the defendants: a “who’s who” of Wall Street players: a UBS registered representative, a Morgan Stanley attorney, a Lyford Cay hedge fund manager, an Andover brokerage representative, a Chelsey Capital portfolio manager, a representative from Jefferies & Co. and others.

The criminal case, U.S. v. Jurman, Case No. 1:07-cr-00140-TPG (S.D.N.Y. Filed Feb. 26, 2007) (and related cases) contained many of the same Wall Street professionals as defendants.

A second significant case involving Wall Street professionals is SEC v. Barclays Bank, Civil Action No. 07-CV-04427 (S.D.N.Y. Filed May 30, 2007). There, a major Wall Street bank and its proprietary trader for distressed debt were named as defendants in an insider trading case. The complaint alleged illegal profits from trading in debt securities of bankrupt companies where the bank and its trader obtained the inside information from positions held on various creditors committees.

While the Barclays case raises significant questions about the use of so-called “Big Boy” letters, discussed here, what is perhaps more important is the fact that is was brought directly against a major Wall Street institution.

A third case brought this year named a fund manager as a defendant, SEC v. Frohna, Civil Action No. 07-C-0702 (E.D. Wis. Filed August 1, 2007). In this case, the fund manager is alleged to have received inside information from his brother, who was leading a major clinical study for a significant drug at XOMA. The fund, which held a large stake in XOMA, is alleged to have avoided a large loss based on information Mr. Frohna obtained from his brother about the study. While there are significant materiality questions raised by this case, which are discussed here, again what is perhaps more significant is the defendant: another Wall Street professional.

These cases and another involving two Wall Street professionals, SEC v. Smith, discussed here, follow last year’s block buster cases, SEC v. Anticevic, Case No 05 Civ. 6991 (S.D.N.Y. Filed August 5, 2006) and the related criminal case, U.S. V. Plotkin, Case No. 06 CR 380 (RLH) (S.D.N.Y.) (and related cases). These cases involved three overlapping insider trading schemes: one involving inside information obtained from on Merrill Lynch M&A deals; a second involving advance information on copies of Business Week; and a third involved inside information concerning a grand jury inquiry into Bristol Myers. Again, however, what is disturbing is the involvement of Wall Street professionals.

Collectively these cases raise significant questions regarding the reasons for the current wave of “rampant” insider trading. While many argue that the current generation of traders have forgotten the lessons of the past that explanation seems a bit to glib. No doubt the amount of money to be made is tempting. Perhaps this wave of rampant insider trading says something about compliance and enforcement. Prevention often begins with good compliance not only by Wall Street players, but also every company. At the same time, no compliance program is bullet proof. In the end, consistent, effective enforcement by the SEC is key to preventing “rampant” insider trading. While the SEC is clearly stepping up its efforts in this area and there is no doubt that investigation and proof of these cases is difficult, perhaps it is time to carefully reevaluate enforcement in this critical area.

The Week in Review (October 26 to November 1, 2007): Key SEC Enforcement Trends and A Significant Litigation Loss

This past week key cases brought by the SEC, highlight areas of focus over the past year and signal the direction of enforcement efforts to come: insider trading and the Foreign Corrupt Practices Act. At the same time a litigation loss may impact future PIPE and hedge fund cases, another area of emphasis for the enforcement division.

INSIDER TRADING – In SEC v. Cao, Civil Action No. CV 06-1269 (C.D. Cal. Filed October 29, 2007), the Commission is a settled insider trading case against the former vice president of Countrywide Financial Corp. The complaint alleges that Mr. Cao traded while in possession of negative financial information about subprime mortgage giant Countrywide Financial. The action was settled simultaneous with the filing of the complaint. The defendant consented to the entry of a statutory injunction prohibiting future violations of the antifraud provisions and to the entry of an order requiring the payment of disgorgement, prejudgment interest and a civil penalty equal to twice the amount of the disgorgement. Related press reports suggest that the SEC in investigating to determine whether others at Countrywide were abusing Rule 10b5-1 plans.

INSIDER TRADING – In SEC v. Durozhko, Civil Action No. 07-CV-9606 (S.D.N.Y. Filed October 29, 2007), the Commission alleges that the defendant traded while in possession of negative earnings announcement regarding IMS health. According to the complaint, Mr. Durozhko purchased 300 out of the money and 330 at the money put options on the common stock of IMS that would expire just three days later. On October 17, 2007, after the close of the market, IMS reported third quarter earnings that were 28% below the consensus analysts estimates. The next morning the stock price fell about 28%. The same day the defendant sold all of his IMS Health options, realizing a profit of over $287,000. Simultaneous with the filing of its complaint the SEC sought and obtained a freeze order over Mr. Dorozhko’s assets. The case is currently in litigation.

FCPA – In SEC v. Ingersoll-Rand Co., Ltd., Civil Action No. 107-CV-01955 (D.D.C. Filed October 31, 2007) the Commission filed a settled FCPA case. The SEC’s complaint alleged that defendant Ingersoll-Rand based on payments made to Iraq under the U.N. Oil for Food Program. Essentially, the complaint alleged that over a three-year period, four subsidiaries of the defendant entered into contracts in which over $950,000 in kickbacks were made. The company settled the action, consenting to a statutory injunction and the payment of disgorgement, pre-judgment interest and a civil penalty along with certain undertakings regarding its FCPA compliance program. The company also paid a fine under a deferred prosecution agreement executed with the Justice Department.

LITIGATION LOSS – PIPE CASE – SEC v. Mangan, Civil Action No 3:06-CV-531 (W.D.N.C. Filed December 28, 2006) is one of a series of cases brought by the SEC in recent months relating to short selling in connection with a PIPE offering. Frequently, these cases involve hedge funds, a key regulatory focus. In this case a registered representative from the investment banking firm of Friedman, Billings, Ramsey & Co. was alleged to have sold shares of CompuDyne Corp. short after learning of a PIPE offering but prior to the public announcement. The complaint alleged violations of Section 5 based on the theory that Mr. Mangan intended to cover the short sale with the PIPE shares and insider trading based on an allegation that he sold short prior to the public announcement of the deal. Previously, Friedman Billings had settled similar allegations based on the same PIPE offering. Mr. Mangan, however, filed a motion to dismiss which was granted in part. Count I of the complaint regarding the PIPE offering was dismissed while the Court expressed significant skepticism about the insider trading claim.

No doubt the SEC has a large inventory of cases in other areas such as option backdating and financial fraud. Yet, week after week there seems to be increasing numbers of insider trading cases and a growing inventory of FCPA cases. This trend, of course, counsels that issuers should carefully review their compliance programs in these areas as well as any executive Rule 10b5-1 plans.

At the same time the ruling in Mangan may suggest that the SEC will have to reconsider its PIPE cases. Until now, the SEC had been aggressively pursuing these cases. The court’s ruling however not only dismissed the Section 5 claim but was critical of the theory on which it was based. This may cause the SEC to reconsider its position on this issue.