The recent spate of news stories concerning allegations of insider trading by a sitting Congressman, consultants at political intelligence firms and traders at hedge funds has brought insider trading into public view again. A charge of insider trading can have serious criminal and civil consequences for the accused. In fact, frequently, the accused will face parallel investigations by both the U.S. Attorney’s Office and the U.S. Securities and Exchange Commission (SEC). In addition, local state authorities are increasingly pursuing securities fraud prosecutions, including insider trading cases.
The proscriptions against insider trading are primarily designed to prevent corporate insiders from unfairly taking advantage of, and profiting from, their access to material non-public information. Insider trading is prohibited by Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78j (the Exchange Act), Rule 10b-5, 17 C.F.R. Section 240.10b-5 and other statutes.
However, a knowledgeable defense attorney can make a difference in an insider trading case. This article will review both the legal aspects of an insider trading case as well as the techniques investigators use to uncover and investigate insider trading.
How Are Insider Trading Cases Uncovered?
Securities regulation in the United States has various components. At the top of the regulatory structure is the SEC, which maintains nationwide jurisdiction to investigate and enforce the federal securities laws. However, the SEC relies heavily on the securities industry’s self-regulatory efforts. Accordingly, all of the stock exchanges in the United States maintain active market surveillance and enforcement divisions. Similar surveillance and enforcement groups are in place at the Financial Industry Regulatory Authority (FINRA), which regulates securities traded over the counter on the Nasdaq electronic system. These industry groups are known as self-regulatory organizations (SRO’s).
Most insider trading cases are uncovered by sophisticated computer systems that are employed by the stock exchanges and by FINRA to monitor trading in the nation’s securities markets. The computer systems constantly monitor volume and price movements of all publicly traded stocks. When there is a price movement in a particular stock that exceeds predetermined parameters, an alert is generated. The staff of the SRO will then monitor that stock to see if any unusual news announcements are made by the company. When there is an unusual amount of trading prior to a major news announcement the stage is set for an insider trading investigation.
The SRO’s will first obtain trading records to determine who was trading in the company’s stock immediately prior to the announcement. Immediate red flags will arise if any of the company’s officers or directors traded in the company’s stock. The names of senior officers and directors are easily obtained from the company’s public filings with the SEC.
Next, the SRO’s will determine whether any of the individuals who traded are associated with broker-dealers. This is an important step of the process because the SRO’s only have jurisdiction over their own members and not the general public. If none of the individuals who traded are associated with member firms, the SRO will make a referral of the matter to the SEC for further investigation.
The SEC’s Role
By the time a referral is made to the SEC, the SRO’s have typically done a thorough analysis of the suspicious trading. The individuals who made the largest trades will be identified and their brokerage account statements will be provided to the SEC at the time of the referral.
Usually the individuals who are subject to the SRO investigation will have no idea that their trading is being investigated. At the time the SEC receives the referral from the SRO, a preliminary investigation is opened. During the preliminary stages of an investigation, the SEC does not have subpoena authority and cannot compel the production of documents or testimony from individuals or publicly traded companies. Therefore, during the early stages of the investigation the SEC will rely on voluntary cooperation. In the event that voluntary cooperation is not forthcoming, the SEC can issue subpoenas once it has obtained a Formal Order of Investigation from the five commissioners in Washington, D.C.
The SEC attorney assigned to the preliminary investigation will attempt to determine whether any of the individuals who traded prior to the news announcement by the company had access to the information before it was made known to the public. Typically, the SEC attorney will prepare a letter to the company whose securities are the subject of the inquiry that lists the names of all individuals that traded and asks whether the company recognizes any of the names. Often, the company will recognize certain names on the list and inform the SEC of their relationship to the company. Such individuals could be associated with the company’s law firm, accounting firm or investment banking firm. Such responses by the company can save the SEC many hours of work uncovering relationships with the company that may not otherwise be apparent.
Frequently, the first indication that an individual will receive that he is the subject of an insider trading investigation is a phone call from the SEC attorney. In that phone call, the SEC attorney will ask that the individual answer questions regarding his trading activities. The SEC will also inform the individual that their participation in the phone call is voluntary and the attorney will then attempt to proceed with the interview. Although many people begin to answer questions then and there on the phone, the much more preferable course is to decline to participate in the phone interview until an attorney can be consulted. Answering questions in the first phone call from the SEC can be damaging because the subject of the investigation will be quite alarmed at receiving a call from the SEC and, as a result, inadvertent admissions may be made. If requested, the SEC will agree to reschedule the phone interview at a later time with the subject’s attorney on the phone.
The Defense Attorney’s Initial Steps
When consulted by a client who has received a request to answer questions from the SEC, the defense attorney must quickly gain a complete understanding of the trading that the individual engaged in as well as what motivated that trading. The defense attorney must also know what the trader’s relationship is to the company and whether the trader possessed any non-public information prior to trading. In the event that the client states that there were reasons that he traded that did not involve inside information such as analyst reports or a favorable news article about the stock, copies of such documents should be obtained. It is also important to find out if the trader placed trades in any other accounts that the SEC may not know of yet such as accounts in the name of family members or in the name of affiliated corporations.
In addition, the defense attorney should also determine whether the SEC’s investigation is still in the preliminary stage or whether it has become a formal investigation through the issuance of a Formal Order of Investigation. In the event that a Formal Order has been issued, the defense attorney should request a copy of the formal order prior to allowing his client to be questioned. The Formal Order will contain citations to the statutes that are at issue as well as contain other information related to the investigation that could be helpful. To obtain a copy of the Formal Order, a letter must be sent to the staff attorney requesting the formal order and making certain representations about how the formal order will be used (i.e. agreeing not to use the formal order to obstruct the SEC’s investigation). The precise language of the representations will be provided by the SEC staff attorney.
Red Flags the Defense Lawyer Should Be Alert For
There are certain facts that will be detrimental to the client and, if they are present, will influence the decision of whether to voluntarily answer questions. If trades occurred in accounts other than the client’s own individual account, such as family members’ accounts or corporate accounts, then such trading will be seen by the SEC as an attempt to conceal the client’s trading, particularly if the accounts are not readily associated with the client, i.e. using accounts of family members with a different last name. If the trader purchased or sold options on the stock instead of the stock itself this will be a major red flag because options allow the trader to leverage his investment and will generate substantially more in profits when the stock moves in the anticipated direction. Finally, the defense attorney should be familiar with the client’s past trading patterns to determine whether the trades under investigation are consistent with past practices. Facts to look for are whether the client ever traded the particular stock before, whether the amount of securities bought or sold is consistent with past trades and, if options were used, whether the client had ever traded options in the past.
The purpose of the defense attorney’s review is to determine how much exposure the client has. Although the immediate concern may be deciding how to handle the SEC, the defense attorney must always be aware that there is a real possibility that the SEC will refer the matter to the U.S. Attorney’s Office for criminal charges. In the event that the trading has an innocent explanation that is credible, the attorney may well approve of the client answering the SEC’s questions. If, however, the client’s trades appear suspicious to the defense attorney the best course of action would be to decline to answer the SEC’s questions. In the event that a subpoena is ultimately issued, the client will have the ability to assert his fifth amendment right against self-incrimination.
The Law of Insider Trading
In order to effectively analyze a client’s potential exposure in an insider trading case, the defense lawyer must be familiar with the elements that must be established in order to prove insider trading. The vast majority of insider trading cases consist of circumstantial evidence and the failure of the prosecutor to establish one of the elements will result in the case being dismissed. Insider trading is generally defined as purchasing or selling securities while in the possession of material, non-public information in violation of a duty not to trade.
The Purchase or Sale of Securities
The first element that must be established is an actual purchase or sale of securities. Insider trading can be broken down into two categories: 1) buying securities prior to a good news announcement by a company, such as unexpectedly high earnings or a promising merger; or 2) selling securities prior to a bad news announcement, such as the receipt of an FDA rejection letter as was allegedly involved in the ImClone and Martha Stewart matter. In order for an insider trading prosecution to succeed, there must be an actual purchase or sale of securities. The government may not allege that a defendant refrained from trading securities as a result of inside information. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S.Ct. 1917 (1975). Generally, this element is not in dispute because the monthly account statements and trade confirmations will establish whether or not a security was purchased or sold.
The “In Possession of” Requirement
Trading while “in possession of” material non-public information is the second element. The SEC has consistently taken the position that insider trading has occurred when the trader had possession of material non-public information, even when there were other factors that may have been more important in his trading decision. The SEC’s position is that it does not matter whether the trader used the non-public information in making his trading decision, so long as he had possession of the information insider trading has occurred. However, some courts have rejected this position and have required that the SEC prove that the trader actually used the non-public information in making his decision to trade. See U.S. v. Smith, 155 F.3d 1051 (9th Cir. 1998); SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998). In the Second Circuit, the government only has to prove possession of non-public information, not use of such information.
The third element that must be proven is that the non-public information was “material.” The U.S. Supreme Court has held that information is “material” if there is a substantial likelihood that a reasonable investor would consider it important in making investment decisions. TSC Industries, Inc. v. Northway, Inc, 426 U.S. 438, 449 (1976). In discussing the materiality standard, the U.S. Supreme Court has stated “[w]hat the standard does contemplate is a showing of a substantial likelihood that, under all the circumstances, the . . .[information] would have assumed actual significance in the deliberations of the reasonable [investor]. Put another way, there must be a substantial likelihood that the [information] would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.” Id.
Whether the defense attorney can argue that the non-public information is not material will depend on the facts of each case. It is important to note that merely because the price of the stock went up or down after the disclosure of the information is not enough to show materiality because the price change can be due to other factors, such as the overall movement of the stock market on a particular day. The defense attorney should examine news articles and analyst reports to see whether the information alleged to be material was viewed as such by market participants. Frequently, an expert witness can be brought in to testify that the information at issue was not viewed as material by market participants.
This is the final element that must be established by the government. Occasionally, a defense attorney can show that the information at issue was in fact public due to rumors and leaks from the company or others. However, in most cases it is conceded that the information at issue is non-public.
The Misappropriation Theory
An attorney handling an insider trading case will quickly come across the body of law dealing with the “misappropriation theory.” The classical theory of insider trading deals with the fairly straight forward circumstance of a corporate officer trading on inside information that he gleamed during the course of his job. Such trading violates the corporate officer’s duties to the corporation. In fact, courts have ruled that illegal insider trading has not occurred when a person does not have a duty not to trade on material non-public information. These types of cases generally involve bystanders overhearing conversations of corporate insiders and then trading on the information learned. Because the bystander has no duty to the corporation or anyone else, he may trade on the information without running afoul of the prohibitions against insider trading. Essentially, the bystander does not become a corporate “insider” merely by overhearing non-public information.
However, between these two extremes of a bystander with no duty to the corporation and a corporate officer with a clear duty to the corporation stood a whole group of people such as printers, lawyers and others who were involved in non-public transactions that did not necessarily have a duty to the company whose securities they traded. To address this group of people, the courts developed the misappropriation theory. The misappropriation theory covers people who possess inside information and who are prohibited from trading on such information because they owe a duty to a third party and not the corporation whose securities are traded.
The use of the misappropriation theory in insider trading cases was approved by the U.S. Supreme Court in the case U.S. v. O’Hagan, 117 S.Ct. 2199 (1999). In that case, Grand Metropolitan PLC (Grand Met) retained the law firm of Dorsey & Whitney to represent it in a tender offer for the common stock of Pillsbury Company. The defendant, O’Hagan, a Dorsey & Whitney partner who did not work on the transaction, purchased call options for Pillsbury stock and, in addition, purchased shares of the stock. Shortly after these purchases, Grand Met publicly announced its tender offer and the price of Pillsbury stock rose dramatically. O’Hagan sold his call options and his stock at a profit of more than $4.3 million. An SEC investigation resulted in a 57-count indictment alleging, inter alia, that O’Hagan defrauded his law firm and its client, Grand Met, by misappropriating for his own trading purposes material, non-public information regarding the tender offer. Note that O’Hagan owed no duty to Grand Met, the company whose securities he traded. The Supreme Court held that a person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information (such as a law firm), even when the source of that information is not the company whose securities are traded, may be held liable for violating § 10(b) of the Exchange Act and Rule 10b-5.
Winning an insider trading case involves knowledge of both the law of insider trading as well as the particular trading engaged in by your client. By carefully analyzing each of the elements of insider trading, a defense attorney can often make a strong argument that the prosecution has failed to meet its burden on one or more of the elements. It is important to keep in mind that insider trading cases are almost always circumstantial and to the extent that an accused can produce documents or other evidence that other legal reasons lead him to trade securities, then such proof will go a long way towards defeating the prosecution.
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