Building on the groundbreaking and sprawling Galleon case filed in 2009, insider trading cases sat at or near the top of the Department of Justice's and the SEC's securities enforcement priorities for the past year. In this paper, we summarize the key new cases in this area and offer our thoughts on their import for the securities industry. Our comments are strictly our own, and do not necessarily reflect the views of our firm or its clients.
1. Primary Global and Benhamou: Expert Networks/Industry Consultants
After Galleon, the government's most significant new insider trading initiative is its focus on expert networks and industry consultants. Generally speaking, expert network firms offer traders and investment managers access to the insights and opinions of experts on industries throughout the world. The government has alleged that one such firm, Primary Global Research LLC—despite assurances on its website that its consultants are forbidden to divulge inside information—paid employees of various public companies to reveal material nonpublic information, including corporate revenues and sales forecasts, to Primary Global's clients.
To date, the Justice Department and the SEC have brought criminal and civil insider trading and related charges against twelve individuals: three Primary Global employees; five consultants associated with Primary Global; the founder and an employee of hedge fund Barai Capital Management; and two former employees of SAC Capital Advisors.1 The Barai employee, who allegedly heard one of the tips, and one of the former SAC employees have pled guilty and are reportedly cooperating with the government. In one made-for-the-movies incident, one of the cooperators allegedly caught a defendant on tape saying that he used pliers to rip apart a USB drive with incriminating evidence and threw the pieces into four different garbage trucks.
In another expert consultant case, the DOJ and the SEC brought tipping charges against a French doctor, Yves Benhamou, who served on the steering committee of a clinical trial for a drug under development by Human Genome Sciences, Inc. (HGSI), while also acting as a paid consultant for an expert network firm.2 The government alleges that Dr. Benhamou revealed some adverse developments in the clinical trial to a hedge fund client (identified in the press as Front Point Partners) of the expert network firm that employed him. Front Point's portfolio manager allegedly avoided $30 million in losses by selling the fund's entire position in HGSI before the information became public. Notably, neither Front Point nor the portfolio manager has been charged.
For trading firms, the most significant issue raised by the expert network cases is under what circumstances, if any, a trader can safely trade on information from an expert network firm or an independent industry consultant. Legally, a tippee cannot be liable for insider trading unless (among other required elements) the tippee "knew or should have known" that the information was obtained in breach of a duty of trust or confidence.3 The SEC has not provided guidance as to when, absent explicit knowledge of a breach, a trader "should know" that the source obtained and/or disclosed the information improperly. Understandably, portfolio managers and traders are concerned about being second-guessed by the SEC or a court, in hindsight, about whether they should have known that a consultant gave them information that the consultant was duty-bound to keep confidential. As a result, some firms have gone so far as to prohibit any use of expert network firms; some require a compliance officer to listen in to any conversation with a paid consultant; and many conduct extensive due diligence on the firms and the relevant experts before using them. Although a firm's specific approach to expert networks will depend on a variety of factors, including its trading strategy, the extent and nature of its use of expert consultants, and its appetite for regulatory risk, every firm should think carefully about these issues, adopt and enforce clear written policies and procedures on the subject, and train its trading personnel on them.
2. Galleon Update: SEC Charges Prominent Corporate Director With Tipping
In the past year, the Galleon case mushroomed into the biggest alleged insider trading ring in history. To date, federal prosecutors have charged 46 people in the case with insider trading, 29 of whom have pled guilty. The trial of Raj Rajaratnam, the founder and managing partner of the Galleon Group, is scheduled to begin tomorrow (March 8, 2011). In addition to its vast scale, the case is remarkable for the government's extensive use of wiretaps and recorded evidence.
In addition, some of the alleged information conveyed to Mr. Rajaratnam appears to approach the line of immateriality. For example, some of the alleged tips involved quarterly earnings information where the reported earnings differed from analysts' expectations by only a few pennies per share. This type of information stands in sharp contrast to the information at issue in many traditional insider trading cases, which tend to involve unannounced mergers, tender offers, or other highly significant events in the life of a company. Mr. Rajaratnam's counsel have contended that his business model was based in part on the "mosaic theory." Under this theory, a trader gathers numerous pieces of information from disparate sources, each of which is immaterial standing alone, but when combined give the trader valuable insights into a company. The Rajaratnam trial will likely be the first opportunity for a thorough consideration of this theory by a court and jury.
The most notable recent Galleon-related development occurred on March 1, 2011, when the SEC filed a tipping charge against Rajat Gupta, the former Managing Director of McKinsey & Company who served on the boards of directors of several prominent companies, including Goldman Sachs and Proctor & Gamble.4 According to the SEC, Mr. Gupta told Mr. Rajaratnam about Berkshire Hathaway's $5 billion investment in Goldman Sachs in September 2008, and about Goldman's financial results for the second and fourth quarters of 2008, before the information was made public. Mr. Gupta also allegedly divulged to Mr. Rajaratnam non-public information concerning P&G's financial results for the fourth quarter of 2008.
Interestingly, taking advantage of new authority conferred on it by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the SEC brought its charge against Mr. Gupta in an administrative cease-and-desist proceeding. Before Dodd-Frank, the SEC could have sought a penalty in an insider trading case (other than against a registered securities firm or professional) only in federal district court. Although a cease-and-desist order is usually viewed as a weaker remedy than a federal court injunction, bringing the case administratively offers the SEC several advantages, including depriving the respondent of the right to discovery and a jury trial, potentially more lenient rules of evidence, and greater control over the appellate process (since the Commissioners hear any appeal of the administrative law judge's initial decision). Perhaps most important, the administrative forum allows the SEC to approve any settlement it might reach with Mr. Gupta, without the oversight of a federal district court judge. This could spare the agency the embarrassment of another judicial rejection of a settlement in a high-profile enforcement action.
3. SEC v. Rorech: Beyond Stocks and Bonds
Last year, a high-profile effort by the SEC to extend its insider trading program to a non-traditional market yielded decidedly mixed results. On June 24, 2010, following a three-week bench trial, a judge in the Southern District of New York dismissed the SEC's first-ever insider trading case based on trading in credit default swaps (CDS).5
In brief, the complaint alleged that a portfolio manager made an unlawful profit of approximately $1.2 million for his hedge fund by trading in CDS on the basis of material nonpublic information about the structure of a proposed high-yield bond offering provided to him by a Deutsche Bank salesman, in supposed breach of the salesman's duty to keep the information confidential. Both the salesman and the portfolio manager were charged with securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.
When the SEC filed the case, senior agency officials heralded it as "strategically important"6 and an example of its new priority focus on "cross-market conduct—that is, utilizing two or more of the equity, fixed income and derivatives markets to engage in wrongdoing."7 But in his 122-page decision, Judge John G. Koeltl rejected the SEC's proof across the board, finding that the information at issue was neither material nor confidential; that in conveying it the salesman did not breach any duty to Deutsche Bank; and that neither defendant acted with an intent to deceive. Most strikingly, the decision gives the impression that the SEC did not appreciate that, during the marketing of a high-yield bond issue, issuers, investment bankers, and institutional investors routinely exchange information about the potential structure of the offering and indications of interest, and do not regard it as confidential. That standard industry custom and practice, as confirmed by several trial witnesses, would appear to have been a fatal flaw in the case from the outset.
The only silver lining for the SEC is that Judge Koeltl rejected the defendants' jurisdictional challenge by broadly construing the definition of "security-based swap agreements" in Section 10(b) to include the CDS at issue. That ruling paves the way for the SEC to bring more CDS-based insider trading cases. Despite the SEC's trial loss in Rorech, it would be a serious mistake for securities firms and funds to assume that they can trade CDS on the basis of material nonpublic information with impunity. Although the SEC can be expected to be more careful in choosing its next CDS insider trading case, especially to meet the breach-of-duty requirement, we believe that case will come.
4. SEC v. Cuban: Do Confidentiality Agreements Implicitly Bar Trading?
On September 21, 2010, the U.S. Court of Appeals for the Fifth Circuit put the kibosh on a controversial ruling by the district judge overseeing the SEC's insider trading case against Mark Cuban, the owner of the Dallas Mavericks basketball team.8 According to the SEC's complaint, in June 2004, the CEO of a company called Mamma.com called Mr. Cuban, elicited an oral agreement to keep what he was going to say confidential, and told Mr. Cuban that the company was planning to raise capital through a private placement of its equity (PIPE offering). Because the offering would be expected to dilute his significant stake in the company, Mr. Cuban allegedly reacted angrily and said, "Well, now I'm screwed. I can't sell." The SEC also alleged that Mr. Cuban later obtained additional confidential details about the PIPE, including that it would be sold at a discount to the market price, from the company's investment bank. Immediately after receiving this information, Mr. Cuban allegedly sold his shares and avoided over $750,000 in losses, as the stock price plummeted after the PIPE was announced the next day.
In 2009, Mr. Cuban, backed by an amicus brief from five prominent law professors, moved to dismiss the SEC's complaint. The district court, in a widely criticized decision, granted his motion, holding that a mere agreement to keep information confidential—which does not explicitly bar trading on the information—is insufficient to establish liability under the misappropriation theory of insider trading. The district court also invalidated SEC Rule 10b5-2(b)(1), which explicitly provides that under the misappropriation theory a duty of trust or confidence exists "[w]henever a person agrees to maintain information in confidence." Regarding Mr. Cuban's alleged statement to the CEO that he "can't sell," the judge found it reflected only Mr. Cuban's erroneous understanding of the law of insider trading.
The Fifth Circuit, ruling narrowly, took issue with that finding. It held that the SEC's allegations supported a reasonable inference that Mr. Cuban had agreed not to trade and that his understanding with the CEO was "more than a simple confidentiality agreement." Although it expressed skepticism at the district court's theory, the appellate court did not decide whether a mere confidentiality agreement would be enough to prove insider trading or whether an explicit trading ban is required. It also did not rule on the validity of Rule 10b5-2(b)(1). Instead, it sent the case back to the district court for discovery and further proceedings.
Thus, it remains an open question whether a third party can lawfully trade on information provided under a confidentiality agreement that does not expressly prohibit trading. Companies that provide nonpublic information to third parties, such as potential investors, business partners, consultants, or vendors, should ensure that their confidentiality agreements expressly prohibit recipients of the information from trading on it. Companies should thus make sure that their confidentiality agreements contain such a provision. And Mr. Cuban's plight in this case (even if he ultimately prevails) is a reminder that any trading on the basis of nonpublic information, regardless of the source of the information, is fraught with risk of incurring the cost and distraction of a lengthy SEC investigation, litigation, and potentially substantial monetary penalties.
5. SEC v. Steffes: Pushing the Limits of Materiality?
In September 2010, the SEC brought an insider trading case that raises some interesting questions concerning materiality and the mosaic theory. In Steffes, two relatively low-level employees allegedly tipped or traded merely on their suspicion that the company that they worked for, Florida East Coast Industries (FECI), was going to be acquired.9 Neither employee was informed that the company was for sale. Rather, according to the SEC, the Chief Mechanical Officer of a FECI subsidiary inferred that the company was for sale because: he was asked to prepare a comprehensive list and valuation of the subsidiary's locomotives, freight cars, trailers and containers; there was an unusual amount of rail yard tours, which he believed were being provided to investment bankers; and, once the tours began, yard employees asked him if the company was being sold. The other employee, a trainman, allegedly discerned that the company was being acquired based on the unusual number of rail yard tours; the use of a tour bus and the presence of people in business attire; and discussions among rail yard employees about the possibility that the company would be sold. None of these facts, taken on its own, would appear to be material, an argument that the defendants are likely to press at every opportunity. The SEC can be expected to counter that, as employees, the defendants had a duty to refrain from trading once they accumulated sufficient non-public information from which a material conclusion could be drawn. Although this case involves no high-profile defendants, it could set an important precedent as the SEC continues to push the envelope of materiality in its insider trading program.
6. In re Merrill Lynch: Alleged Misuse of Customer Order Information
Although not cast as an insider trading case, a recent SEC settlement charged a novel form of misuse of information that is worthy of review here.10 According to the SEC's order, during a two-year period, a Merrill Lynch proprietary trading desk was located on the firm's equity trading floor, where traders on the firm's market making desk received and executed orders for institutional customers. The SEC alleged that on four occasions in 2003 and early 2004 the Merrill Lynch proprietary trading desk traded on information about institutional customer orders provided by market makers. Notably, in each instance, the customer order was allegedly executed from one to 31 minutes before the proprietary trade.
The SEC found that this conduct was inconsistent with Merrill Lynch's general policy, published on its website, prohibiting its employees from discussing client business affairs with any other person, except on a "strict need-to-know basis." The agency charged the firm with violations of three provisions of the Securities Exchange Act of 1934: Section 15(c)(1)(A) (an anti-fraud provision applicable only to brokers or dealers); Section 15(g) (requiring broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material, nonpublic information); and Section 15(b)(4)(E) (failure to supervise).11
Based on the facts alleged in the order, it seems clear that SEC lacked a basis for charging Merrill Lynch or its traders with insider trading. Although the SEC observed that, as a general matter, customer order information can constitute material nonpublic information ("particularly information concerning potentially market moving orders submitted by institutional customers"), it did not allege that any of the information conveyed to the Merrill Lynch proprietary traders was material. Nor did the order state if, or in what circumstances, the agency views information about executed customer orders as nonpublic.
Especially for broker-dealers or investment advisers with proprietary trading desks, the Merrill Lynch settlement reaffirms the importance of erecting effective information barriers between the proprietary and customer-facing sides of the house, as well as strong policies and procedures, training, and surveillance designed to prevent the misuse of material nonpublic information. The SEC's willingness to deploy novel legal theories in the Merrill Lynch matter reflects its hostility towards any seepage of customer order information to personnel outside of the market-making function of the firm, even absent a showing of actual harm to the customer.
Conclusion
Insider trading cases are certain to continue to make headlines in the year ahead. The Galleon, Cuban, and Gupta cases will be tried or settled, and important rulings in the expert network/industry consultant cases are likely. Especially given the relative paucity of significant criminal or SEC actions focused on the perceived causes of the financial crisis, we expect the government's intensive focus on insider trading to yield many new investigations and cases.
Footnotes
1. See United States v. Shimoon et al., 10-MAG-2823 (S.D.N.Y. Dec. 15, 2010); United States v. Barai et al., 11-MAG-332 (S.D.N.Y. Feb. 7, 2011); SEC v. Longoria et al., 10-CV-0753 (S.D.N.Y. Feb. 8, 2011). The SEC action also named Barai Capital Management as a defendant.
2. United States v. Benhamou, 10-MAG-2424 (S.D.N.Y. Nov. 1, 2010); SEC v. Benhamou, 10-CV-8266 (S.D.N.Y. Nov. 2, 2010).
3. Dirks v. SEC, 463 U.S. 646, 660 (1983).
4. In the Matter of Rajat K. Gupta, SEC Admin. Proc. File No. 3-14279 (March 1, 2011). The authors' law firm, Covington & Burling LLP, represents a company in connection with the Galleon and Gupta cases.
5. SEC Chairman Mary L. Schapiro, Testimony Before the House Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises, Jul. 14, 2009, available at http://www.sec.gov/news/testimony/2009/ts071409mls.htm.
6. SEC Enforcement Director Robert Khuzami, Remarks Before the New York City Bar, Aug. 5, 2009, available at http://www.sec.gov/news/speech/2009/spch080509rk.htm.
7. SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010).
8. SEC v. Steffes et al., 10-CV-06266 (N.D. Ill. Sept. 30, 2010).
9. In the Matter of Merrill Lynch, Pierce, Fenner & Smith Inc., SEC Admin. Proc. File No 3-14204 (Jan. 25, 2011), available at http://www.sec.gov/litigation/admin/2011/34-63760.pdf.
10. One of the authors of this paper (Mr. Kornblau) was the Head of Global Regulatory Affairs at Merrill Lynch between September 2005 and February 2009, and oversaw the company's response to the SEC's investigation of this matter during that time. The views expressed in this paper should not be attributed to Merrill Lynch.
11. These charges, and the $10 million penalty assessed against the firm, also encompassed alleged improper mark-ups and mark-downs on certain riskless principal trades with institutional and high net worth customers.
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