SEC ENFORCEMENT TRENDS 2011: INSIDER TRADING
This is the eighth in a series of articles that will be published periodically analyzing the direction of SEC enforcement.
Insider trading has long been an enforcement priority. In recent years however it has become a focal point not just for the SEC but also the Department of Justice and, in particular, the U.S. Attorney’s Office for the Southern District of New York. Working under the auspices of the President’s Executive Order creating a broad financial fraud task force, the SEC and the New York USAO have developed a close working relationship. Together they have adopted an aggressive stance which may rewrite the definition of insider trading.
These developments will be analyzed in two posts. Today Segment A will consider blue collar tactics, the vanishing line between criminal and civil cases and the aggressive posture of SEC enforcement. Segment B will discuss cases relating to specific groups of traders such as market professionals, executives and family members as well as Reg. FD.
Blue collar tactics
The Galleon cases, which began with criminal and civil charges against hedge fund mogul Raj Rajarantnam, New Castle Funds LLC trader Danielle Chriesi, and others, were the first insider trading cases to make wholesale use of what many consider to be blue collar tactics. U.S. v. Rajaratnam, Case No. 09 mg 2307 (S.D.N.Y.); U.S. v. Chiesi, Case No. 09 Mg 2307 (S.D.N.Y.); SEC v. Galleon Management, L.P., Civil Action No. 09-CV-8811 (S.D.N.Y. filed Oct. 16, 2009). The cases are built in large measure on the repeated use of wire taps, wired informants and similar techniques. While law enforcement has long utilized these tactics in organized crime and drug prosecutions, the use in white collar cases has been limited.
The charges in the two cases are predicated on overlapping insider trading schemes involving trading in multiple securities. Those include shares of Polycom, Hilton, Google, AMD and Clearwire. The information supposedly came from multiple sources including insiders at the company.
Shortly after the Galleon cases were brought, another insider trading ring was uncovered. This one centered on information flow from the law firm of Ropes and Gray. U.S. v. Goffer, Case No. 9 Mg. 2438 (S.D.N.Y.); SEC v. Cutillo, Civil Action No. 09-09208 (S.D.N.Y. filed July 2, 2009). Firm lawyer Arthur Cutillo and another attorney, Jason Goldfarb, were at the center of the ring which included a number of hedge fund traders. Following these indictments more charges were brought. To date fourteen have pleaded guilty. Nine civil settlements have been executed. Ms. Chiesi and each of the defendants charged with her has pleaded guilty. The central figure of the cases, Raja Rajaratnam, is scheduled for trial shortly.
These cases were the beginning of what now appears to be a continuing trend. The Manhattan U.S. Attorney’s Office and the SEC recently unveiled the so-called “expert network” investigation. This inquiry, built on the same blue collar tactics, focuses on information flow from expert networks that grew up in the wake of SEC Reg. FD. That regulation was intended to level the playing field for the dissemination of corporate inside information. If that result was achieved is debatable. It did however help create specialty organizations which offered industry expertise to professional market traders such as private equity funds, mutual funds and others. In part this expertise comes from retaining officials at various companies who offered insight into the business.
The question in the investigations is whether insight is inside information. The inquiry surfaced with multiple, coordinated FBI raids to seize records from companies. None of the companies searched is a target of the investigation.
Shortly after the raids, the first cases were brought by the U.S. Attorney. U.S. v. Shimoon, Case No 10 Mg 2923 (S.D.N.Y.) named four individuals as defendants. One was previously employed by expert network Primary Global Management while three were corporate consultants. The case focused solely on information flow – the charges are conspiracy and wire fraud, not insider trading. The SEC did not initially file an enforcement action. After more criminal charges were filed which include insider trading, the agency brought an insider trading enforcement action. SEC v. Longoria, Civil Action No. 11-CF-07530 (S.D.N.Y.). The government has stated the investigation is in its early stages.
Galleon and the expert network cases represent more than just changing face of insider trading enforcement tactics. These cases also part of a larger trend which may all but eliminating the dividing line between civil and criminal cases while redefining what constitutes the edge of insider trading.
The vanishing line
Traditionally the dividing line between civil and criminal violations of the federal securities laws has been reflected in the requirement of Sections such as 32(a) of the Exchange Act in which congress added the element of “willfulness” for a criminal violation. Repeated court decisions defining the element of “scienter” in a civil action based on the antifraud provisions however have expanded the element to include reckless disregard. See, e.g., Tellabs, Inc. v. Makor, 551 U.S. 308 (2007); Sundstrand Corp. v. Sun Chem.. Corp., 553 F. 2d 1033, 1045 (7th Cir. 1977). At the same time courts have included in the definition of “willful” for criminal violations the concept of willful blindness. See, e.g., U.S. v. King, 351 F. 3d 859, 866 (8th cir. 2004). An analysis of the definition of these definitions suggests that in fact there is little if any real distinction between the two concepts.
In practice, criminal cases have tended to be more egregious, such as professionals involved in serial insider trading rings or repeated violations of the law. This distinction however rests not so much on legal limitations as the discretion of the charging prosecutor. This leads to what at best might be viewed as inconsistent results. SEC v. Poteroba, Civil Action No. 10 10-cv-2667 (S.D.N.Y. Filed Mar. 24, 2010) and U.S. v. Poteroba (S.D.N.Y. Filed March 24, 2010) are good examples of repeated conduct involving market professionals which was charged as civil and criminal violations. The defendants here are Igor Poteroba, a former Managing Director at UBS Securities and Alexel Koval. The criminal case alleges that over a period of four years beginning in 2005 Mr. Poteroba illegally tipped Mr. Koval six times about up coming mergers. The SEC complaint alleges eleven illegal tips. See also U.S. v. Tajyar, Case No. 2: 210-cr-00310 (C.D. Cal.); SEC v. Tajyar, Case No. CV 09-03988 (C.D.Ca.. Filed June 4, 2009)(employee at an investor relations firm and a market professional trading on misappropriated inside information). But see SEC v. Sebbag, Case No. 10-CV-4241 (S.D.N.Y. filed May 26, 2010); U.S. v. Hoxie & Sebbag, (S.D.N.Y.)(Bonnie Hoxie, girlfriend of Yonnie Sebbag, misappropriated inside information from her employment at Disney which her boyfriend marketed to an under cover FBI agent; at sentencing Ms. Hoxie was given probation based on a finding by the court that her boyfriend duped her).
In contrast SEC v. Benhamou, Civil Action No. 10-CV-8266 (S.D.N.YU. filed Nov. 2, 2010) and U.S. v. Benhamou, S.D.N.Y. Filed Nov. 2, 2010) are, respectively, civil and criminal insider trading cases, against French physician Yeves Benhamou who was a consultant to biopharmaceutical company Human Genome Sciences, Inc. The cases focus on multiple updates to traders about an adverse event during a drug trial.
The tips center on an adverse event during a drug trial. Following the event, the doctor furnished multiple updates as the company tried to work through the significance of the information. In some instances those tipped traded. In some instances they did not or only small trades were made. Ultimately the trader clients sold their stake at a time shortly before the disclosure of what proved to be significant adverse information. Later the traders re-established their position in Human Genome stock. These cases are in litigation.
Aggressive SEC enforcement
While the U.S. Attorney may be taking the lead in the Galleon and expert network cases, SEC enforcement has adopted an aggressive approach built on a careful and sometimes vary rapid analysis of trading and the surrounding factual circumstances. In some of these cases the Commission has brought insider trading charges based on little more than the trading data. In some the identity of the traders has not been ascertained or any source of inside information. Typically these cases are brought within days of a major corporate announcement to halt the flow of potentially illegal trading profits out of the country.
As the end of 2010, for example, the Commission brought two insider trading cases based on little more than the trading. SEC v. One or More Unknown Purchasers of Martek Biosciences Corporation, Case No. 10 Civ. 9527 (S.D.N.Y. Filed Dec. 22, 2010) and SEC v. One or More Unknown Purchasers of Options of InterMune, Inc., Case No. 10-Civ. 9560 (Filed Dec. 23, 2010). Martek was filed just days after the event in order to freeze trading profits of persons as yet to be identified. The case is based on the take over by Royal DSM N.V., a Dutch company, of Maryland based Martek Biosciences Corporation. It was announced on December 21, 2010. Just days before the announcement 2,616 Marteck call options were purchased through an account at UBS. The purchases represented over 90% of the volume for the transaction days. When the deal was announced the share price increased by 36% giving the account an unrealized profit of $1.2 million. The Commission filed its complaint alleging violations of the antifraud provisions on December 23 and obtained a freeze order.
InterMune is similar. It centers on an announcement from the European Union’s Committee for Medicinal Products for Human Use regarding a drug of InterMune, Inc., a biotechnology company based in Brisbane, California. When the Committee announced it would recommend the drug for approval on December 17, 2010, the share price for the company increased about 144%. Just days before the announcement 400 call options were cleared through UBS Securities LLC. On one day the purchases represented 100% of the volume while on another they were 57%. A few days later 237 option contracts cleared through Barclays Capital, New York. The unrealized profits for the two accounts are $912,000.
Again the Commission quickly filed a complaint and obtained a freeze order. See also SEC v. Di Nardo, Civil Action No. 08-cv-6609 (S.D.N.Y. filed July 25, 2008)(insider trading action filed against unknown purchasers of DRS Technologies securities where in discovery the identity of the trader was determined; the trader settled last year). See also SEC v. Condroyer, Case No. 1:09-cv-3600 (N.D. GA. Filed Dec. 22, 2009)(insider trading case against two French nationals residing in Belgium who traded just before a take over announcement; the SEC obtained a freeze order despite the fact that there is no evidence in the complaint alleging a source of inside information or any connection between the individuals). But see, SEC v. Rorech, Civil Action No. 09 Civ. 4329 (S.D.N.Y.)(Commission lost first insider trading case based on swaps where tipping could not be established as discussed here).
In other cases the SEC has pushed the edges of the mosaic theory. In SEC v. Steffes, Case No. 1:10-cv-06266 (N.D. Ill. Filed Sept. 30, 2010) the case is based on the trading of family and friends. The group is alleged to have made about $1.6 million in trading profits.
Gary Griffiths and Cilff Steffes, who are related, both work for Florida East coast Railway, LLC. On May 8, 2007 it was announced that Fortress Investments Group LLC would take over the company. The transaction traces to a determination of the board in December 2006 to solicit bids for the company. Over a period of time bidders toured the properties.
Gary and Cliff are alleged to have had inside information which is the predicate for the trading. According to the SEC’s complaint Gary, a vice president and chief mechanical officer who reported to the COO, had inside information because: 1) In early March before the deal the CFO asked him to prepare a comprehensive list of company equipment; 2) he was aware of a number of unusual people touring the property and he “believed” they were investment bankers for a possible sale; 3) employees asked him if the company was up for sale and they would lose their job; and 4) he arranged a monitored rail trip for the Fortress executives in a special rail car reserved for visitors. Cliff observed similar events. One defendant settled with the Commission. The others are litigating the case.
In other cases the Commission is also pushing the edges of what constitutes insider trading. In both Cuban and Onubu, discussed earlier in this series, the actions centered on whether the recipient of material non-public information had a duty not to trade. Cuban is in litigation. In Onubus the Commission tried the case and lost on a directed verdict. See also SEC v. Berlacher, Civil Action No. 07-3800 (E.D. Pa. Filed Sept. 13, 2007)(PIPE case against a hedge fund operator where the SEC lost at trial on question of if there was a confidentiality agreement as discussed earlier in this series).
Finally, a settled case which centers on the question of duty is SEC v. Levinberg, Case No. 10-CV-777 (S.D.N.Y. Filed Feb. 2, 2010). The complaint is in this case is based on the acquisition of Scopus Video Networks, Ltd., an Israel company with a U.S. subsidiary whose shares are traded on NASDAQ, by Harmonic, Inc. The deal was announced on December 22, 2008.
In 2008 Scopus approached Gilat Sateellite networks, Ltd. about being acquired. Scopus furnished the company confidential information which was labeled as such. No confidentiality agreement was entered into. Although the transaction never went forward Scopus pursued a deal through December 2008.
Between October 31, 2008 and December 17, 2008 Mr. Levinberg purchased 102, 172 shares of Scopus. At the time his employer, Gilt, had an insider trading policy. After the announcement that Scopus was being acquired by another company, the share price increased by 41% giving the defendant a profit of $187,996.48. Mr. Levinberg settled the SEC’s action, consenting to the entry of a permanent injunction and agreeing to disgorge his trading profits along with prejudgment interest and pay a penalty equal to the trading profits.
Next: Insider trading, Part B, market professions, executives and friends and family.