Tag: Thomas O. Gorman

Don’t Lie to the Feds When Caught for Insider Trading

The “classical theory” of insider trading targets “a corporate insider’s breach of duty to shareholders with whom the insider transacts[, and the] misappropriation theory outlaws trading on the basis of nonpublic information by a corporate ‘outsider’ in breach of a duty owed not to a trading party, but to the source of the information.” See United States v. O’Hagan, 521 U.S. 642, 651-53 (1997). The extra element that the government must prove in a criminal insider trading case, beyond what it is required in a civil action, is that the defendant acted “willfully.” 15 U.S.C. § 78ff.

The Securities and Exchange Commission is limited to fines and injunctions, but when the Department of Justice gets involved they will be seeking jail time for insider trading. Although their enforcement authority mostly overlaps, the DOJ exercises their jurisdiction sparingly. After all, the DOJ generally gets the case when the SEC refers the case to them.

Don’t lie to the SEC when they are investigating an insider trading case against you. It makes them angry and more likely to refer the case for criminal prosecution. You can always be quiet.

Case in point is the indictment filed against Peter Talbot and Carl Binette in connection with trading in the stock of securities for Safeco Corporation. Talbot worked at Hartford Investment Management Company. He saw some co-workers putting in long hours and concluded they were working on a potential acquisition. Talbot snooped around the company’s network and found files from those co-workers identifying Safeco as the target of the acquisition. Talbot told his nephew, Binette.

Talbot instructed Binette to buy call options on Safeco stock for $37,260,85 in a newly opened brokerage account. A week later, a competitor announced it was acquiring Safeco, sending up the stock price. The two sold their call options and realized a 1653% profit of $615,833.06.

The SEC looked closely at Binette because of all the red flags in that account. Binette was a 28 year old finance manager at a car dealership. It would certainly be odd that he would suddenly plop down over $30,000 on a speculative investment. It turns out he had borrowed $10,000 from his home equity line, $10,000 from his aunt, and $10,000 from each of his supervisors.

Binette lied to the SEC about whether he had spoken to anyone else about the Safeco securities. That’s obstruction of justice. That’s what landed in jail. In this case, it sounds like they have good case for actually proving insider trading against Binette and Talbot, something they failed to do for Martha.

Binette even claimed that the trades were based on a dream. That’s another big red flag for the SEC. I could imagine a few chuckles coming from the SEC investigators when they heard that terrible excuse.

It’s  also likely to land him in jail, instead of merely returning his ill-gotten gains and paying a fine.

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What Do You Get For Cooperation with the SEC?

Rebecca Files

  • More likely to get sanctioned.
  • Reduction of $30.3 million in penalties when you initiate your own investigation.
  • Reduction of $609,000 in company penalties for each week earlier the statement is announced the public.
  • Reduction of $112,000 in personal penalties for each week earlier the statement is announced the public.

We in the compliance field have often heard from federal regulators that cooperation will get you benefits. Although when asked how much, it’s merely a “trust us” reply. Back in the beginning of 2010, the SEC launched a new enforcement cooperation initiative. The SEC’s 2001 Seaboard Report lists several criteria that SEC staff evaluate before making enforcement decisions, including whether ―the company cooperated completely with the appropriate regulatory and law enforcement bodies‖ and whether ―the company promptly, completely, and effectively disclosed the existence of the misconduct to the public [and] to regulators

I figured some academic would spend the time to sit down and see how much benefit really accrues when you cooperate. Rebecca Files of the University of Texas at Dallas did just that.

Dr. Files dove into a set of the 2443 press releases announcing an earnings restatements compiled by the General Accounting Office (GAO 2003, 2006a,b) during the 1997-2005 time period. She ended up culling the list down to 1,249 for a variety of reasons. Of those, 127 received a formal sanction by the SEC.

Individuals were sanctioned in 115 of the 127 cases, paying an average of $3.9 million in fines. Companies were sanctioned in 109 of the cases with an average fine of $35.5 million.

When the company had independently investigated their restatements, they paid an average of $30.3 million less in penalties than those that did not.

Dr. Files concludes that the end result is mixed. “[C]ompany-initiated investigations significantly increase the likelihood of an SEC enforcement action, but decrease firm-level penalties associated with a sanction. … Regarding forthright disclosures, I find somewhat mixed results. Headline disclosure of a restatement increases the likelihood of an SEC sanction, suggesting that SEC staff is influenced by the visibility of press release disclosures when choosing its enforcement targets. However, individuals pay significantly smaller fines when the restatement is disclosed prominently in a press release or on a Form 8-K or amended filing. Placing restatement information in a Form 8-K or amended filing also significantly reduces the likelihood of an SEC sanction, but only in the post-2001 period. Consistent with the Seaboard Report, timely disclosure of a restatement reduces the likelihood of being sanctioned and results in lower individual and firm penalties.”

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Fund Manager Fraud for Exceeding Leverage Limits

It turns out that failing to adhere to your investment guidelines can not only get you sued by your investor, it can get you sent to jail.

Mark D. Lay ran a hedge fund whose sole investor was the Ohio Bureau of Worker’s Compensation. The fund agreement had a non-binding 150% leverage guideline. Lay apparently relied on the non-binding nature of it and had 2/3 of the trades in excess of 150 leverage and over 20% of those trades involved leverage over 1000%. Lay ended up losing $214 million of the $225 million invested by the Bureau.

Apparently Lay not only greatly exceeded the leverage guidelines, he also lied about his excess.

Lay was convicted investment advisory fraud, conspiracy to commit mail and wire fraud, and two counts of mail fraud. Those convictions earned him a 12-year sentence at the Federal Correctional Institution in Fort Dix, N.J. and an order to repay nearly $213 million from the loss and forfeit $590,526 of the $1.7 million in fees the bureau paid.

Lay lawyers tried get him out of the investment advisory fraud by claiming that the Bureau was not a client. They argued that the Bureau was merely an investor in the fund and that Lay advised the fund. It was this handling of deeming an investor in the fund as the “client” that caught my attention.

Lay’s legal team used the Goldstein v. SEC case to argue that the SEC is precluded form treating fund investors as clients. The Sixth Circuit Court of Appeals did agree with that argument. The found that the SEC could not treat all investors in a fund as clients, but they could treat some as clients under the Investment Advisers Act.

In this case, the Bureau was already a client under a different investment management agreement. So a client relationship was already established. Also, the Bureau was the only investor in the fund. This is an atypical fund relationship.

The case points out that investors in a fund may still be clients of the fund manager under the Investment Advisers Act.

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Do Prosecutions Stop Insider Trading?

We generally assume that the prosecution of crime acts as a deterrence to others who may think about committing the crime. One of the key factors in fraud is opportunity. If the wrongdoer thinks they can not get away with the violation, they are less likely to commit the violation.

At least that is the theory. Social scientists have been looking at this strategy for a long time, with sometimes mixed results. My guess is that the deterrent effect will vary from crime to crime and deterrence strategy to deterrence strategy.

What about insider trading?

The UK’s Financial Services Authority has published a metric on insider trading. They look at the level of abnormal pre-announcement price movements (APPMs) in the share price of a company.

“The level of APPMs for the takeover data set has remained stable over the past few years including for 2009. The level of APPMs for the FTSE 350 data set remained at a low level in 2009.”

The data does not show any improvements. The data set is on the small side so it is hard to judge significance. The FSA program is also new. The program begin during a period of great turmoil in the financial markets.

On the other hand, the FSA’s new enforcement activity of criminal prosecutions and large fines did not affect the amount of abnormal pre-announcement price movements. If this robust enforcement activity is supposed to have a deterrent effect, it does not obviously appear in the data.

Perhaps robust enforcement activity catches more bad guys but does not reduce the bad activity.

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Questions and Answers with Robert Khuzami

After the news conference announcing the Rearrangement of its Enforcement Program, the Securities and Exchange Commission offered a group of bloggers the chance to ask questions to Robert Khuzami, the Director of Enforcement. (It must have felt like Obi-Wan stepping into the cantina full of low-life scoundrels.)

The blogging participants:

Mr. Khuzami let us know that the specialized units and cooperation initiatives came out of the self-assessment they conducted last year. Now that the heads of the new units have been made, those heads will start filling out their ranks.

Bruce started off questions by asking for more information on the new Office of Market Intelligence. This unit is combining two existing units, Market Surveillance and Internet Enforcement. It sounds like this will be a big source of information flow for the SEC with lots of complaints and charges coming in one place, getting filtered and sent to the right people for the appropriate action.

I asked about the creation of the new specialized units which are great for expertise, but may push information into silos. Mr. Khuzami pointed out that one of the current problems is that information is currently too diffuse across the SEC. There is a going to be hybrid approach. Not everything is going to end up in these units. He thinks expertise is very important. These units are going to be national in scope, so the people will spread out across the regional offices.

Laura Richman wanted to know if the SEC Commissioners are going to be comfortable with the new cooperation protocols. The enforcement division can only make a recommendation. It’s up to the Commission to decide whether to prosecute or settle. (This is unlikely to give the warm fuzzies to someone who is thinking about acting as a whistleblower or a company cooperating with an issue.)

Todd Sullivan was surprised that the cooperation initiatives were not already available to the SEC. Mr. Khuzami pointed out that criminal prosecutions have used cooperation strategies for a long time. It’s a new concept to civil proceedings.

Cate wanted to know if the SEC could develop the experience or tools to differentiate between proprietary trading versus market making. The SEC wants better information.

Francine wanted to know if the SEC will step up its enforcement actions against the accounting firms. Timeliness is key. If there is a long time between the misconduct and the prosecution, then there is a lost opportunity to stop others by setting an example.

Mr. Khuzami pointed out the SEC has been through a tough year but his group wants to use their professional skills and do good work. He thinks the Division is coming together and moving forward in a positive direction.

I want to thank Mark Story, the SEC’s Director of New Media, for inviting me to the press conference and Rob (I think I can call him that now) for taking the time to talk with us.

Insider Trading Enforcement

sec-seal

Either the Securities and Exchange Commission has stepped up its enforcement of insider trading or it’s doing a better job of publicizing its enforcement.

Earlier this week, the SEC announced its case against Raj Rajaratnam and his New York-based hedge fund advisory firm Galleon Management LP.

On September 23, they charged Reza Saleh with insider trading in connection with Dell’s tender offer for Perot Systems. These charges were filed just two days after the date of the merger.

Last month, the SEC brought charges against Melissa Mahler for insider trading activity that happened in 2004. Ms. Mahler made the stupid mistake of lying to the feds about whether she had purchased the shares. That turns the insider trading case from a civil case to a criminal case. It’s also easier to prove, since all the feds can pull up the brokerage statement showing that she had purchased the shares.

There is also the SEC’s insider trading case against Mark Cuban. Even though the initial charges were thrown out in district court, they are appealing that decision to the Fifth Circuit Court of Appeals.

According to reports there are 10 More Insider Trading Arrests Coming Against Securities Professionals.

Perhaps the SEC is finding insider trading cases to be some easy wins? After being raked over the coals, maybe they see insider trading enforcement as an area that can get them some good publicity?

As we heard on The Wire: “We want dope on the table for the six o’clock news.”

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The 2008 Year in Review from Securities Docket

This panel joined Securities Docket’s Bruce Carton to look back at the most important and interesting developments in 2008, and offer their predictions for 2009.

Kevin started off noting that the number of securities class action lawsuits in 2008 is a 33% increase over last year and the highest since 2004. He sees the increase as a result of the credit crisis, starting with the sub-prime loan programs and them spreading.

Kevin predicted that 2009 will see even more securities class action lawsuits.

Tom focused on SEC enforcement actions. He started with the Siemens FCPA case. He then mentioned the Faro Technologies case involving payments in China (Admin File No. 3-13059, June 5, 2008). Last he mentioned the UnitedHealth Group option back-dating case. Of course the big case is the Madoff scandal.

Tom expects to see a big re-shaping of the SEC and its enforcement division.

Francine looked at auditor litigation. Either the public accountants fell down while acting as the watchdogs against fraud on the public or that it is that they were also duped by management. The Big 4 has escaped sub-prime exposure so far but will likely get hit in Madoff. She sees BDO Seidman as having significant exposure from the Banco Espiritu Santo judgment. All of the Big 4 are subject to wage/overtime suits. Deloitte has sued their former vice chairman for insider trading.

Francine predicts that a Big 4 firm will take a significant hit for failing to make a “going concern” opinion prior to a big failure.

Walter sees the federal government’s bailout amplifying the effect of the financial markets meltdown. This was not just a Wall Street problem; it is now a taxpayer problem. Walter also expects to see more criminal prosecutions against individuals. He points out that the cutting edge risk methods blew up. CDSs and CDOs caused explosive damage. Also low-tech methods failed. The personal relationships of Madoff still failed investors. peopel are looking for lessons as to whether more regulations would have prevented the financial meltdown.

Walter predicts another AAA rated firm will have its executives indicted or be revealed as insolvent.

Bruce sees the Madoff case as the biggest development in 2008. He also sees the SEC getting worked over by Congress. The SEC admitted that they ignored credible evidence about Madoff.

Bruce predicts 90% of big law firms will begin to use Twitter for public relations.

A public vote found that Tom’s prediction was most likely to happen (41%) with Kevin following close behind (40%).