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Insider Trading: Life After Galleon


K&L Gates Insider Trading Seminar March 3, 2010 Richard M. Phillips Jeffrey L. Bornstein Mark D. Perlow Imagine if you will Insider Trading Prosecutions Things ... – PowerPoint PPT presentation

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Title: Insider Trading: Life After Galleon

Insider Trading Life After Galleon
KL Gates Insider Trading Seminar March 3, 2010
  • Richard M. Phillips
  • Jeffrey L. Bornstein
  • Mark D. Perlow

Imagine if you will
Insider Trading Prosecutions Things Really Have
  • The first SEC insider trading prosecution The
    1960 administrative proceeding in the Cady
    Roberts case
  • SEC found broker sold stock in several customer
    discretionary accounts on the basis of inside
    information that an NYSE listed company was about
    to cut its dividend

Insider Trading Prosecutions Things Really Have
Changed! (Cont.)
  • The SEC fined the broker 3,000 and suspended him
    for 20 business days from the brokerage industry
  • Next morning, the broker found a long line of
    prospective customers lined up in front of his
  • From the brokers point of view, it was a good

The Galleon Prosecutions 50 Years Later
  • Criminal charges brought against 22 persons for
    alleged insider trading violations
  • Allegations focused on hedge fund
  • Also involved alleged issuer and consultant
  • 10 guilty pleas to date and more expected
  • Parallel SEC Enforcement Actions

The Disastrous Consequences for Defendants
  • Up to 20 years imprisonment
  • Fines up to 5 million or twice the gain
  • Criminal forfeiture of profits
  • Example assume a single trade with profits of
  • Under Sentencing Guidelines, even for a first
    time offender, and assuming a prompt guilty plea
  • Prison for up to 37 to 46 months on the low end
  • Could be up to 70 to 87 months (depending on
    various factors)

The Disastrous Consequences for Defendants
  • Disgorge ill-gotten gains
  • Pay monetary penalties up to three times the
    amount of those gains
  • Defendants lost their jobs and their hedge funds
    are out of business
  • SEC bars against future employment in the
    securities industry
  • Under pending legislation, bar will include the
    hedge fund industry

Galleon Illustrates a New Proactive DOJ-SEC
Enforcement Strategy
  • Historically, insider trading prosecutions not
    considered to be easy cases
  • Key issue is whether defendant knowingly traded
    on inside information rather than on independent
    investment decision
  • Usually little or no documentary evidence only
    circumstantial evidence
  • Vague line between good, hard digging for
    information and illegal inside information
  • Juries often skeptical of whether it was a real
  • Penalties imposed by judges used to reflect same

The Traditional SEC Investigative Methods
  • Investigations were almost always reactive, not
  • Often based upon indications of a sudden increase
    in volume or in price in a particular stock or
    other unusual trading activity
  • Focus on relationships among those who traded
  • Conducted lengthy investigation to decide whether
    to take enforcement action
  • Subpoenaed trading records, emails, and other
    documentary evidence
  • Interviewed witnesses and took formal testimony
    on the record
  • Referred egregious cases to the U.S. Attorney
  • In last 10 years, closer cooperation between US
    Attorney and SEC, especially if false statements,
    obstruction of justice etc. are present

The New Galleon Investigative Model
  • Aggressively pro-active investigation
  • Early cooperation between SEC and U.S. Attorneys
  • Unprecedented use of wiretaps by U.S. Attorney
    working with the FBI
  • Conducted covert investigation
  • By media accounts, continued for over 2 years
  • Used evidence of bad acts to coerce individuals
    to act as informants
  • Informants wore concealed wires to record
    conversations with others
  • The result A domino effect of successive
    indictments and additional cooperating witnesses
    leading to 22 indictments and possibly more to

New SEC Cooperation Policy
  • New SEC policy announced last month
  • The U.S. Attorney has long used the carrot of
    lighter sentences to entice cooperating
  • Substantial Assistance can and usually does lead
    to reduced jail time
  • The SEC traditionally has not rewarded
  • Since the Madoff debacle, the SEC revamped its
    Enforcement Division under leadership of ex-U.S.
  • New Cooperation Policy very important from an
    enforcement perspective
  • Could result in a rush to cooperate
    characteristic of many criminal prosecutions
  • May result in companies self-reporting
  • First one in usually gets the greatest leniency

New SEC Enforcement Structure
  • Sweeping change announced by SEC enforcement
    division a new market abuse unit
  • Primarily focused on detecting and prosecuting
    insider trading
  • Using extensive database of trading activity and
    relationships among people and firms to try to
    detect trading patterns
  • Individuals involved could then be targeted for
    wiretapping and other investigatory techniques
  • New government enforcement efforts highlight need
    for effective compliance with rigorous controls
    and employee sensitivity to what constitutes
    illegal insider trading

Insider Trading Enforcement Actions Are Going
  • Regulators in the UK and Hong Kong, historically
    lax, have recently been prosecuting, winning
    convictions, and talking tough SEC/prosecutor
    language, not their former "light touch"
    approach. To increasing extent, UK and US
    regulators cooperate closely with each other
  • EU Market Abuse Directive to all member nations,
    requiring them to ban insider trading in similar
    terms to US law

What is Insider Trading?
  • Supreme Court has held insider trading violates
    SEC Rule 10b-5 if there is
  • purchase or sale of securities
  • based on material, non-public information
  • breach of fiduciary duty or duty of trust or
    confidence owed to issuer, shareholders or any
    other source of information
  • proof of scienter (intent to defraud/deceive
    recklessness may suffice)
  • See Chiarella v. United States, 445 U.S. 222,
    228 (1980), Dirks v. SEC 463 U.S. 646 (1983) and
    United States v. OHagen, 521 U.S. 642, 655-56
  • Applies to private transactions as well as
    transactions in public markets

Trading based on inside information (cont.)
  • Split of Authority whether mere possession of
    material, non-public information is sufficient
  • 9th and 10th Circuits actual use
  • 2nd Circuit possession
  • Some courts proof of possession shifts burden to
    defendant to show non-use
  • Advisers Act requires insider trading controls
    even if not a prerequisite to insider trading

Trading based on inside information (cont.)
  • SEC adopted rules attempting to resolve
    controversy in its favor
  • Defendant need only be aware of material
    non-public information at time of trade Rule
  • Firm has burden to prove no trading on basis of
    inside information if someone in firm possesses
    such information by showing
  • Individual making the investment decision not
    aware of information, and
  • Firm has implemented reasonable policies and
    procedures to ensure that individuals making
    investment decisions would not use inside
    information Rule 10b5-2

What is Insider Trading? (cont.)
  • The Classical Theory
  • Officers, directors and employees commit breach
    of fiduciary duty, and engage in fraud on
    shareholders in violation of Rule 10b-5, if
    without disclosure to counterparties, they trade
    on material, non-public information
  • Extends to temporary insiders such as
    attorneys, accountants and other outside service
    providers who temporarily assume fiduciary duty
    to the company See Dirks, 463 U.S. at 646
  • Misappropriation Theory
  • Extends insider trading definition to trades
    based on material non-public information for
    personal benefit in breach of duty of trust and
    confidence owed to source of information See
    OHagen, 521 at U.S. 652

Example of Classical vs. Misappropriation Theory
  • Classical director, officer or constructive
    insider trading on news that their company is
    about to be acquired
  • Misappropriation trading based on non-public
    information from supplier to company

Tippee and Tipper Liability
  • Tippers can be liable for Tippees trades
  • Key Issues
  • Knew or should have known that Tippee is likely
    to trade
  • Personally benefited from the Tippees trade
  • Personal benefit need not be financial
  • Includes gifts and other benefits to friends or
  • Even reputation benefit is sufficient Dirks, 463
    U.S. at 662.
  • Tippee also liable if he or she knew or should
    have known that information was derived from
    confidential source

What is materiality?
  • Information that a reasonable investor would
    believe alters significantly the total mix of
    publicly available information. Basic v.
    Levinson, 485 U.S. 224 (1988)
  • Information that reasonable investor would
    consider important or reasonably certain to have
    substantial effect on price of securities. TSC
    Industries, Inc. v. Northway, 485 U.S. 224, 240

What is materiality? (cont.)
  • Common Defense--Mosaic Theory of Materiality
  • Information not material where a skilled analyst
    with knowledge of the company and the industry
    may piece together seemingly inconsequential data
    together with public information into a mosaic
    which reveals material, non-public information
  • See State Teachers Retirement Board v. Fluor
    Corp., 654 F.2d 843, 854 (2d.Cir. 1981), citing
    Elkind v. Liggett Meyers, Inc., 635 F.2d
    156,165 (2d.Cir 1980)

Materiality Factors to Consider
  • Specificity of the information and probability it
    is accurate
  • Significant facts not publicly available
  • Magnitude of potential impact on a companys
  • Importance attached to information by those who
    knew it
  • Whether the information relates to a change in
    earnings or other trends
  • Whether the information diverges from analysts
  • See Ganino v. Citizens Utilities Company, 228
    F.3d 154, 163 (2d.Cir. 2000) SEC v. Baush
    Lomb, Inc., 565 F.2d 810 (2nd Cir. 1977)

Materiality Factors to Consider (cont.)
  • The practical Real World Test for materiality.
    regarding information concerning publicly traded
  • Would public disclosure of the information
    significantly affect market price and/or trading
  • Test often applied in hindsight

What does non-public mean?
  • Non-Public Not published or disseminated
  • Open Questions Is public access without
    significant dissemination sufficient?
  • Publication on company website is sufficient but
    what if website is more obscure?
  • Major fire in companys main facility visible to
    public only from lightly traveled country road?
  • Overheard conversation on BART or in the grocery
  • Market reaction is best test for determining
    adequate dissemination

What is scienter?
  • Scienter is a mental state embracing an intent
    to deceive, manipulate, or defraud
  • Ernst Ernst v. Hochfelder, 425 U.S. 185, 193 at
    n. 12 (1976)
  • Reckless behavior may be enough
  • If it involves an extreme departure from the
    standards of ordinary care . . . which presents a
    danger of misleading . . . that is either known
    to the defendant or is so obvious that the
    defendant must have been aware of it
  • See e.g., SEC v. McNolte, 137 F.3d 732 (2d.Cir.
  • But SEC and courts sometimes speak in terms of
    simple negligence knew or should have known

Recent Cases PIPE Enforcement Actions and the
Cuban Case
  • Several recent SEC actions against hedge funds
    and others for insider trading alleging sales of
    stock just prior to public announcement that
    issuer will make PIPE offering
  • What is a PIPE offering? -- Private offering of
    restricted securities of public company to large
    investors with agreement to promptly register
    securities and permit public resale of PIPE
  • PIPEs are faster, less cumbersome and expensive
    than public offerings but public announcement of
    offering often depresses market for issuers
    outstanding securities

Recent Cases (cont.)
  • Knowledge of PIPE offering before public
    announcement offers opportunity to profit by
    selling or selling short publicly traded
    securities before announcement
  • But confidentiality uniformly required of
    investors who are solicited to participate in
    PIPE offering
  • In PIPE enforcement actions, SEC alleged that
    defendants breached their obligation of
    confidentiality by selling outstanding stock in
    advance of public announcement
  • SEC generally successful in insider trading
    portion of PIPE enforcement action complaints

Recent Cases (cont.)
  • But consider recent Cuban decision where court
    dismissed insider trading case involving PIPE
    offering. SEC v. Cuban, 634 Fed. Supp. 2d 713
  • SEC complaint in Cuban seemed to be slam dunk.
    Cuban, when invited to participate in proposed
    PIPE offering, agreed to keep confidential
    refusing to participate but acknowledging Well,
    now Im screwed. I cant sell
  • Nevertheless, several hours later, before public
    announcement, Cuban sold all of his shares. Next
    day after public announcement, stock dropped
    10.2 Cuban avoided 750,000 of losses

Recent Cases (cont.)
  • Texas federal district court rejected view that
    breach of an agreement to keep confidential is
    sufficient for insider trading violation. Court
    held that defendant must also promise not to
  • If sustained on appeal, Cuban case could be very
    significant. Would have precluded the insider
    trading allegations in PIPE cases

Recent Cases (cont.)
  • Cuban case also undermines SEC Rule 10b-5-2
    stating duty of trust or confidence includes
  • agreement to maintain the information as
  • history or practice of sharing confidential
    information with reasonable belief that it should
    be kept confidential
  • Information obtained from spouse, parent, child
    or sibling
  • Express agreement to refrain from trading before
    public disclosure of information regarding a PIPE
    offering solves problem but in many situations,
    agreement not practical
  • Decision, if affirmed, given current climate of
    public opinion, might induce Congress to clarify
    through legislation ever elusive scope of insider
    trading liability

Recent Cases (cont.) Default Credit Swaps
  • The SEC has stated many times that it is looking
    to prosecute insider trading in default credit
    swaps which it considers to be securities
  • Recently SEC took enforcement action against
    traders who bought credit default swaps on a
    company's subordinated debt after obtaining non
    public information that it was going to issue
    dilutive senior debt. SEC v. Rorech, et., SEC
    Litigation Release No. 21023 (S.D.N.Y.) May 5,
    2009 2009 SEC LEXIS 1466

Recent Cases (cont.) Computer Hackers No Duty of
  • Insider trading liability requires at least an
    implied duty of confidentiality between trader
    and the source of non-public information. No
    duty can be implied where information is stolen
    through computer hacking or other thievery.
  • For this reason, New York federal district court
    dismissed SEC insider trading case against
    computer hacker who traded on information
    illegally obtained through hacking. SEC v.
    Dorozhko, 606 F. Supp. 2d 321 (S.D. N.Y. 2008)
  • On appeal, Second Circuit reversed finding a
    simple fraud not by relying on insider trading
    analysis but on the language of Section 10(b) and
    Rule 10b-5 prohibiting conduct which operates as
    fraud. SEC v. Dorozhko, 606 F. 3d 42 (2009)

Post Galleon What Evidence Will Prosecutors Rely
  • Cooperating witnesses
  • Circumstantial evidence to prove use or
  • Including telephone records, bank records,
    brokerage statements, emails, instant messages,
    historical trading patterns, analyst reports
  • Experts usually do an event study to ascertain
    reasons for stock price/volume changes
  • Focus not only on profits made but also losses
  • Intercepted phone calls and consensual recording
    of conversations -- the real strength of the
    governments case in Galleon

The Common Excuses/Justifications They Seldom
  • Its just industry color or water-cooler talk
  • The information is no different than what an
    analyst might get from a company
  • Everyone is doing it
  • I trade based on a complex trading strategy
  • I did not make any money on that trade
  • I do not use the phone
  • My trades are small

Prudent Steps to Take to Protect Your Firm
  • Insider trading compliance poses unique challenge
  • Mostly oral conduct Difficult to monitor
  • Poorly defined, vague rules
  • Automated detection programs may be of limited
  • Strong temptations versus fiduciary integrity
  • Easy profits versus remoteness of penalties (if
    youre caught)
  • Primary protection is building a law abiding

Prudent Steps to Take to Protect Your Firm (cont.)
  • Prohibit quid pro quo payments for information
  • Reliance on non-public information from officers
    or employees of companies always dangerous even
    if no payment
  • Also exercise caution regarding information
    received from brokers make sure they are not
    using inside or otherwise confidential
  • In cases even of slightest doubt, require
    employees to consult with Compliance or Legal
    staffs before trading or disclosing to other
    staff members

Prudent Steps to Take to Protect Your Firm (cont.)
  • Active compliance program
  • Develop system to regularly monitor Watch and
    Restricted Lists, examine trading activity and
    seek explanations for unusual trades
  • Maintain effective information barriers within
  • Regular training and educational efforts
  • Build sensitivity to what may be inside
  • Stress importance of maintaining confidentiality
  • Emphasize awareness of consequences of using
    inside information to trade
  • Educate your employees about SEC Reg F-D
  • restricts conversations with company officers or
    employees regarding non-publicly disseminated

Is there Life after Galleon?
  • Yes and plenty of money to be made
  • But it pays to be vigilant and compliant
  • The stakes are too high otherwise