This Week in Securities Litigation (March 7-13, 2008): Insider Trading, The End of A Controversial Hedge Fund Survey and the Sub-Prime Crisis

Insider trading – An international merger

Based on trading in advance of Eurex Frankfurt A.G.’s $2.8 billion cash merger with International Securities Exchange Holdings, Inc. (“ISE”), the SEC and the Department of Justice brought, respectively, civil and criminal insider trading actions against three individuals. Named as defendants were John F. Marshall, Vice Chairman of ISE’s board, Chairman of its Audit and Finance Committee, a member of its Executive Committee and a partner in Marshall-Tucker, a New York financial consulting partnership; Alan L. Tucker, a partner in Marshall-Tucker; and Mark Larson, also a partner in Marshall-Tucker.

According to the SEC’s complaint, Mr. Marshall, through his positions at ISE, received detailed information about the pending merger with Eurex. Defendant Marshall tipped his partners, Alan Tucker and Mark Larson by providing them with material non-public information about the pending merger. Messrs. Tucker and Larson used this information to purchase ISE securities in their personal brokerage accounts. Mr. Tucker invested more than $1 million in ISE securities, purchasing 20,000 shares of common stock and over 900 call options with a strike price above the then current trading price. About half of those purchases were paid for with $500,000 in Marshall-Tucker partnership funds wired to the account by Mr. Tucker. During the same period, Mr. Larson purchased 1,700 ISE shares on margin, putting up about $81,000. The three defendants communicated about their trading in a series of e-mails.

Following the April 30, 2007 announcement of the merger, ISE’s share price nearly doubled. By the close of trading Mr. Tucker had made over $1 million in illegal profits while Mr. Larson had over $31,000. Both cases are in litigation. The Litigation Release regarding SEC v. Marshall, Civil Action No. 08-CV-2527 (S.D.N.Y. March 13, 2008) is here.

Insider trading – by a subcontractor

Earlier this week, the SEC filed a settled insider trading case against Kent Barkouras. According to the complaint, Mr. Barkouras received material non-public information about Mentor Corporation through its subcontractor, MyPrint Corporation, of which he is the CEO and largest shareholder. Specifically, Mr. Barkouras learned that Mentor had received approval from the FDA to begin preliminary shipments of their breast implant starter kits. MyPrint was to store and ship the kits.

On the morning Mentor announced the FDA approval a MyPrint employee sent Mr. Barkouras an e-mail stating “Buy Mentor stock Now $$.” At the time, according to the SEC, Mr. Barkouras was purchasing 543 Mentor call options. He also tipped a relative who traded. Following the public announcement of the FDA approval Mentor’s shares increased over 10%.

To settle the action, Mr. Barkouras consented to the entry of a statutory injunction prohibiting future violations of the antifraud provisions of the federal securities laws. In addition, he consented to the entry of an order requiring him to disgorge his trading profits as well as those of a relative he tipped totaling over $166,000, prejudgment interest and a civil penalty equal to the amount of the disgorgement. The Litigation Release regarding SEC v. Barkouras, Civil Action No. SACV 08-0260 (C.D. Cal. Mar. 10, 2008) is here.

The end of the hedge fund survey

The SEC has decided not to proceed with a controversial questionnaire it tested last August as part of its war on insider trading. The questionnaire, distributed to hedge funds and other large traders, sought information about those who have access to material non-pubic information. Many complained that the questionnaire constituted an invasion of privacy. One of the leading critics was the U.S. Chamber of Commerce.

Yesterday, Bloomberg reported that SEC Chairman Cox has agreed to discontinue the use of the questionnaire.

The President’s Working Group on Financial Markets

The President’s Working Group on Financial Markets issued its “Policy Statement on Financial Market Developments” yesterday, discussing the current turmoil in the financial markets and the sub-prime crisis. While noting that events in these markets are currently unfolding, the report stated the principal underlying causes of the turmoil include: 1) a breakdown in underwriting standards for subprime mortgages; 2) a failure by those involved in the securitization process to obtain adequate risk disclosures; 3) flaws in credit rating agencies’ assessments of subprime residential mortgage-backed securities and other complex structured credit products including collateralized debt obligations; 4) risk management weakness at some large financial institutions; and 5) regulatory policies that failed to mitigate risk management weaknesses.

Based on its findings, the group made several recommendations which include: 1) reform key parts of the mortgage origination process; 2) enhance disclosure in the securitization process; 3) reform rating agencies’ process to ensure integrity and transparency; 4) ensure that financial institution take appropriate steps to address the weaknesses in risk management and reporting practices; and 5) ensure that prudential regulatory policies for banks and securities firms include capital and disclosure requirements and give strong incentives for effective risk management practices.

Using Confidential Sources To Plead Scienter After Tellabs

Following the Supreme Court’s decision last June in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), one key question in pleading a “strong inference” of scienter is whether plaintiffs can rely on facts supplied by confidential sources. Specifically, the question is whether the use of confidential sources is consistent with the holding in Tellabs. That ruling requires that to be strong, an inference of scienter must be “cogent” and at least equal to the opposing inference. In making, its ruling the Court noted without comment that the complaint was based in part on confidential sources.

Since the Supreme Court handed down its decision last June, five circuit courts have considered the impact of Tellabs on pleading a strong inference of scienter. Three of those cases examined the question of confidential informants.

Shortly after the Supreme Court’s decision, the Seventh Circuit, which had been reversed in Tellabs, handed down its decision in Higginbotham v. Baxter International, No. 06-1312 (7th Cir. July 27, 2007). There, the court affirmed the dismissal of a financial fraud case by the district court. In an opinion written by Judge Easterbrook, and joined by Judges Posner and Ripple, the court held:

One upshot of the approach that Tellabs announced is that we must discount allegations that the complaint attributes to five “confidential witnesses” – one ex-employee of the Brazilian subsidiary, two ex-employees of Baxter’s headquarters, and two consultants. It is hard to see how information from anonymous sources could be deemed ‘compelling’ or how we could take account of plausible opposing inferences. Perhaps these confidential sources have axes to grind. Perhaps they don’t even exist.

Slip op. at 3

The next month, the Fifth Circuit concluded that confidential sources could be used, but then declined to accept evidence proffered from these sources because it lacked sufficient detail. Central Laborers’ Pension Fund v. Integrated Electrical Services Inc., No. 06-20135 (5th Cir. August 21, 2007). In reversing the dismissal of a financial fraud complaint, the Fifth Circuit, citing a pre-Tellabs case, held that “confidential source statements are a permissible basis on which to make an inference of scienter.” Slip op. at 7. The court went on to discount the statements from these sources in this case, however because the complaint lacked details which would permit evaluation of the witnesses and their facts such as job descriptions, the identification of individual responsibilities, employment dates and similar items.

Finally, the Seventh Circuit, in permitting the Tellabs complaint to go forward on remand, adopted the Fifth Circuit approach. Distinguishing its earlier decision in Higginbotham, the Court, in an opinion written by Judge Posner, held that

The confidential sources listed in the complaint in this case, in contrast, are numerous and consist of persons who from the description of their jobs were in a position to know at first hand the facts to which they are prepared to testify. … The information that the confidential informants are reported to have obtained is set forth in convincing detail, with some of the information, moreover, corroborated by multiple sources. It would be better were the informants named in the complaint, because it would be easier to determine whether they had been in a good position to know the facts that the complaint says they learned. But the absence of proper names does not invalidate the drawing of a strong inference from informants’ assertions.

Slip op. at 17-18.

Read together, the three circuit court rulings suggest that when sufficient detail is pled so that the statements can be sufficiently evaluated, evidence from confidential sources can be used to support a strong inference of scienter. The key is the adequacy of the detail about the witness and the statements.