Insider Trading: Overview and Recent Developments. Presented By: Bridget Rohde, Dominic Picca, and Chris Hildenbrand

Transcription

1 Insider Trading: Overview and Recent Developments Presented By: Bridget Rohde, Dominic Picca, and Chris Hildenbrand November 17, 2011

2 Agenda Introduction Rules and Theories Who is a Potential Insider? DOJ/SEC Targets Crimes, Violations, and Punishment Recent Insider Trading Cases Hypothetical Scenarios Lessons Learned Questions & Comments 2

3 Introduction Presentation Objective Success in the financial world typically requires a competitive advantage. This presentation looks to identify which advantages are permissible and which are not. It also aims to address how a company can protect itself against insider trading. 3

4 Introduction Introduction Insider Trading: What is it? From Ivan Boesky to Raj Rajaratnam, and now Rajat Gupta, we have seen what happens to people who engage in insider trading, alleged or real, and how it can destroy a career and a reputation. How can we determine what type of trading is legal? 4

5 Introduction Key Definitions Insider: Ranges anywhere from a director, officer, or shareholder of 10% or more in the company, to someone with no direct fiduciary duty to the company. We will examine this in more detail in the coming slides. Fiduciary duty: A requirement for discretion and confidentiality, based on a party s involvement in a case or deal. Material information: Information that is substantially likely to influence a reasonable investor. Nonpublic information: Information that has not been publicly disseminated. 5

6 Agenda Introduction Rules and Theories Who is a Potential Insider? DOJ/SEC Targets Crimes, Violations, and Punishment Recent Insider Trading Cases Hypothetical Scenarios Lessons Learned Questions & Comments 6

7 Rules and Theories Section 10(b) Rule 10b-5 Section 10(b) of the Securities Exchange Act of 1934 makes deceptive activity pertaining to the purchase or sale of a security unlawful. Rule 10b-5 implements that idea. The rule does not explicitly refer to insider trading. Instead, it lays a broad groundwork to cover a wide range of insider trading activity. It is intentionally vague, which allows the rule to be flexible and adaptable. Courts from the Supreme Court on down have repeatedly stated that 10(b) is interpreted expansively to be flexible. 7

8 Rules and Theories Rules and Theories Section 10(b) Rule 10b-5 Rule 10b-5 reads, in part: It shall be unlawful for any person, directly or indirectly (a) to employ any device, scheme or artifice to defraud, (b) to make any untrue statement of a material fact or to omit to state a material fact (c) [or] to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. (Emphasis added.) 8

9 Rules and Theories Basic Theories There are two commonly accepted theories as to what an insider is: 1. Classical/traditional theory: When a corporate insider (director, officer, significant shareholder, broker, attorney, accountant, consultant) trades on material, nonpublic information regarding a company to which s/he owes a fiduciary duty. 2. Misappropriation theory: When a person trades on material, nonpublic information that s/he has obtained from someone who has a fiduciary duty to the company. 9

10 Rules and Theories Affirmative Defenses and Other Considerations In 2000, the SEC introduced Rules 10b5-1 and 10b5-2. Rule 10b5-1 provides several affirmative defenses of liability, such as: Ø Having entered into a binding contract to purchase or sell the security before having heard about the information. Ø Having instructed another person to purchase or sell the security before having heard the information. Ø Having adopted a written plan for trading securities before having heard the information. 10

11 Rules and Theories Affirmative Defenses and Other Considerations Rule 10b5-1 also covers the ethical wall Ø If procedures were in place that insulated someone who was trading from material non-public information known to someone else within the entity, the entity would have a defense to insider trading. Note that the use of an ethical wall is a concept that will probably only have credence with the SEC with the largest of funds. 11

12 Rules and Theories Duty of Trust Rule 10b5-2 provides a non-exclusive definition of circumstances in which a person has a duty of trust or confidence for purposes of the misappropriation theory. It applies when: Ø s/he agrees to maintain information in confidence; Ø when the people communicating have a history of sharing confidences; Ø and/or when a person obtains information from a family member. 12

13 Agenda Introduction Rules and Theories Who Is A Potential Insider? DOJ/SEC Targets Crimes, Violations, and Punishment Recent Insider Trading Cases Hypothetical Scenarios Lessons Learned Questions & Comments 13

14 Who Is A Potential Insider? Potential Insiders Clear Examples Officer Director Significant shareholder ( 10% share) Lawyer (both on and off a case) Accountant Broker Consultant 14

15 Who Is A Potential Insider? Potential Insiders Not So Clear Examples Family members Romantic interests Nearly anyone can be an inside trader if the government can prove that the person knowingly accepted inside information from a source with a fiduciary duty and traded on that information. 15

16 Who Is A Potential Insider? Potential Insiders Keep in Mind A person doesn t have to trade on information to be considered an insider. If a person with a fiduciary duty passes on information, s/he is liable. Even people with no fiduciary duty to a company who pass on information that they know is from a fiduciary source are considered insiders. A person who trades on inside information and does not profit is also considered an insider. 16

17 Who Is A Potential Insider? Tipper/Tippee Liability Under the federal securities laws, insiders are prohibited from providing tips of material, nonpublic information to outside persons. From Dirks: A tipper is someone who discloses material, nonpublic information to another individual. A tipper is exposed to insider trading liability for: 1. Communicating this material information and breaching his/her fiduciary duty, even if s/he did not personally use the information in any trading activity; and 2. If s/he received a personal benefit as a result of the disclosure. A tippee is someone who trades on the basis of the material, nonpublic information received from the tipper. A tippee is held liable if s/he had reason to believe that the tipper had breached a fiduciary duty in disclosing the information; thereby assuming this duty. 17

18 Who Is A Potential Insider? Tipper/Tippee Liability In Dirks, the Supreme Court set forth the personal benefit test for tippers in classical insider trading cases to determine liability. The court identified three types of personal benefit that a tipper might receive from making a tip: 1. A pecuniary benefit (including kickbacks and profit-sharing arrangements); 2. A reputational benefit that will translate into future earnings; or 3. A gift of confidential information to a trading relative or friend. To determine tipper liability under the classical theory, courts uniformly require proof of personal benefit, as established in Dirks. However, under the misappropriation theory, district courts have not been consistent in their rulings when deciding whether personal benefit to the tipper is necessary for proof of liability. 18

19 Who Is A Potential Insider? Regulation FD In 2000, the SEC enacted Regulation Fair Disclosure, which prohibits an issuer from disclosing material nonpublic information to certain individuals or entities, specifically securities market professionals such as stock analysts, or holders of the issuer s securities, unless the issuer makes public disclosure of that information. The focus of Regulation FD is on whether the issuer discloses material nonpublic information, not on whether an analyst, through some combination of persistence, knowledge, and insight, regards as material information whose significance is not apparent to the reasonable investor. SEC (17 CFR Parts 240, 243, and 249) 19

20 Who Is A Potential Insider? Expert Network Firms After 2000, an industry of expert network firms began to grow. Expert network firms seek to link investors with industry experts for a fee, as a supplement to traditional sources of research, which is legal as long as the information being passed along is not material and not confidential. Investors pay these expert network firms to match them with a consultant, who is typically an employee of a public company and is paid by the expert network firm to meet with and speak to the investor. Ø The SEC acknowledges that an investor can assemble pieces of nonpublic and immaterial information into a mosaic that reveals a material conclusion, which is usually provided by outside experts. Ø An obvious exception to this would be if the information revealed was whether a company would make its numbers in its next earnings release. Yet, sometimes, it s not as clear whether or not something comes within the Mosaic Theory. 20

21 Who Is A Potential Insider? Expert Network Firms Expert Network firms are a key focus of insider trading investigations that have targeted the employees of these firms as part of a federal probe into hedge funds, technology companies, investment banks and consulting firms. One firm in particular, which connected investors with the employees of public companies (also known as experts ) to provide them with insight into specific markets, has recently been the subject of six different cases by the SEC. Several consultants or experts for this firm received hundreds of thousands of dollars in purported consulting fees after sharing inside information with the firm and its clients, without the knowledge of their employers. 21

22 Who Is A Potential Insider? Consulting Outside Advisors for Research Support Using an outside advisor like a consultant or fact finder to research deals or opportunities can potentially create insider trading exposure unless certain policies and procedures are in place. What should you do if you use a consultant or fact-finder to research potential deals and/or opportunities? Ø Do due diligence on the company prior to signing a contract. Ø Lay out an agreement with strict requirements regarding using legitimate sources of information. Ø Do periodic checkups with the company to make sure they re enforcing their requirements. 22

23 Who Is A Potential Insider? Consulting Outside Advisors for Research Support As part of your due diligence, you should check what the outside advisor s rules are on confidential material. Example requirements are: Ø A contract that sources of information of the outside advisor must sign requiring confidentiality. Ø If they are unsure of their confidentiality requirements, the sources must check before providing advice and expertise. Ø Blocking certain sources from giving investment advice if they have a duty to a company that your fund invests with. 23

24 Agenda Introduction Rules and Theories Who Is A Potential Insider? DOJ/SEC Targets Crimes, Violations, and Punishment Recent Insider Trading Cases Hypothetical Scenarios Lessons Learned Questions & Comments 24

25 DOJ/SEC Targets Hedge Funds The DOJ/SEC tends to target specific financial sectors or fraudulent practices for scrutiny. This occurred in the past with the investigations into options back-dating and accounting fraud. Ø Now, in the wake of numerous scandals involving hedge funds, special focus has been placed on hedge funds and expert network firms. In 2009, Robert Khuzami, the Director of the SEC s Division of Enforcement, stated at a press conference: We at the SEC are committed to pulling back the curtain on hedge fund operations and taking a close look at their activity [ ] developing a variety of initiatives to do that involving greater specialization and expertise, improved technological tools to track and analyze trading, better coordination among regulators and law enforcement. Ø Since August 2009, 51 hedge-fund managers and other employees have either been convicted or pled guilty to insider trading charges as part of a broad crackdown by federal prosecutors. 25

26 DOJ/SEC Targets Galleon Group Galleon Group, one of the world s largest hedge funds before it collapsed in the wake of its founder s arrest, illustrates the focus on this issue. Ø Since October 2009, more than two dozen people were arrested and convicted in the Galleon investigation, culminating in Raj Rajaratnam s recent 11 year prison sentence (the longest ever for insider trading). Ø Rajaratnam allegedly made up to $75 million between 2003 and 2009 at Galleon by using a network of friends, former classmates, and other tipsters at various companies and investment firms to get lucrative secrets about public companies including Google, IBM, Hilton Hotels and Goldman Sachs, before they were announced publicly. In October 2011, Rajat K. Gupta, former managing director of McKinsey & Co., surrendered to the FBI on criminal charges of leaking inside information to Rajaratnam. 26

27 DOJ/SEC Targets Galleon Group The Galleon Management case is considered the largest ever hedge fund insider trading case, involving an extensive network of alleged tippers and tippees, and appears to be the first insider trading investigation to use wiretaps to obtain evidence. Ø As we have seen, the definition of an insider is not limited to a corporate insider who trades on his/her own company. Ø Rajat Gupta is accused of leaking information that he learned at Goldman board meetings in 2008 regarding a $5 billion investment in the bank by Warren Buffett s Berkshire Hathaway Inc., and Goldman s first ever quarterly loss as a public company, to Rajaratnam. Currently free on a $10 million bail, Gupta has pleaded not guilty to all charges and faces a trial on April 9, The Galleon case includes a number of insiders removed from Wall Street, including a consultant, a lawyer, corporate executives, and family members. 27

28 DOJ/SEC Targets The Government s Approach to Stopping Insider Trading SEC Tools: 1. New units under Robert Khuzami Ø Asset Management Unit Ø Market Abuse Unit 2. Use of data-mining software Since late 2009, federal prosecutors in Manhattan have charged 55 individuals with insider trading, resulting in 51 convictions or guilty pleas. 28

29 DOJ/SEC Targets SEC s Initiative In early 2010, the SEC announced a series of new procedures intended to strengthen its enforcement program. According to the SEC, the purpose of these new procedures is to encourage the provision of timely, thorough, and useful information. These procedures include: 1. Specific considerations for determining whether, how much, and in what manner to credit cooperation; 2. Use of cooperation agreements, deferred prosecution agreements, and non-prosecution agreements to reward substantial assistance with its investigations; and 3. A streamlined process for submitting immunity requests to the Department of Justice. 29

30 DOJ/SEC Targets Department of Justice s Initiative On November 19th 2009, Attorney General Eric Holder announced that President Barack Obama had established by Executive Order a Financial Fraud Enforcement Task Force which aims, inter alia, to enhance coordination and cooperation among federal, state, local, tribal, and territorial authorities responsible for investigating and prosecuting significant financial crimes and violations. This task force model has been used to combat organized crime and drug-trafficking. 30

31 DOJ/SEC Targets The Government s Investigative Tools Analysis of information Business records obtained by relevant entities Court-authorized pen registers and telephone tolls records Consensually recorded conversations between cooperating witnesses and others Court-authorized wiretaps Ø According to the U.S. Attorney for the Southern District of New York, Preet Bharara, the Galleon case represents the first time that courtauthorized wiretaps have been used to target significant insider trading on Wall Street. 31

32 DOJ/SEC Targets Consensual Recordings: Wiretaps Are Key Tools Insider trading is like betting on a game when you already know the outcome. But if you traffic in inside information, there's always a chance the person you conspire with is working for us. If you talk on the phone, we may be listening. Insider trading provides an illegal competitive edge over honest players in the hedge fund business. Our job is to ensure a level playing field through enforcement and deterrence. FBI Assistant Director Joseph Demarest (November 5, 2009) 32

33 Agenda Introduction Rules and Theories Who Is A Potential Insider? DOJ/SEC Targets Crimes, Violations, and Punishment Recent Insider Trading Cases Hypothetical Scenarios Lessons Learned Questions & Comments 33

34 Crimes, Violations, and Punishments An Insider Trader Is Typically Charged with One or More Crimes or Civil Violations: Securities fraud Mail fraud Wire fraud Money laundering Obstruction of justice Tax offenses 34

35 Crimes, Violations, and Punishments Penalties/Sentencing If convicted, penalties can include: Ø Prison time: up to 20 years per violation. Ø Fines: up to $5 million or twice the gain from the offense. Ø Suspension or revocation of license. Ø Bar from serving as a director or officer of a company that trades securities. Ø Unofficial penalty: tarnished reputation. In district courts, the judge s sentencing depends in part on: Ø The amount of money that has been lost through the fraud. Ø The defendant s cooperation with the federal government. 35

36 Agenda Introduction Rules and Theories Who Is A Potential Insider? DOJ/SEC Targets Crimes, Violations, and Punishment Recent Insider Trading Cases Hypothetical Scenarios Lessons Learned Questions & Comments 36

37 Recent Insider Trading Cases Significant Cases SEC v. Cuban, 620 F. 3d 551 (5th Cir. 2010) ~District court s decision is reversed and remanded; more than a plausible basis that Cuban understood he was not allowed to trade on the confidential information revealed to him.~ SEC v. Rorech, 720 F. Supp. 2d 367 (S.D.N.Y. 2010) ~Credit Default Swaps do qualify as a security-based swap under SEC regulations, thus expanding the SEC s ability to police the derivatives market.~ US v. Chiesi (2011) ~Chiesi convicted of passing on tips from executives at technology companies to hedge fund managers; leaked information about IBM which earned her hedge fund $1.7 million.~ US v. Goffer (2011) ~Goffer sentenced to 10 years in prison after facing numerous counts of securities fraud and conspiracy to commit securities fraud, and for bribing two Manhattan attorneys $30,000 for inside tips on M&A deals.~ US v. Rajaratnam (2011) ~Hedge fund billionaire, Rajaratnam, is sentenced to 11 years in prison, fined $10 million, and ordered to forfeit $53.8 million, after trading on confidential corporate information.~ 37

38 Agenda Introduction Rules and Theories Who Is A Potential Insider? DOJ/SEC Targets Crimes, Violations, and Punishment Recent Insider Trading Cases Hypothetical Scenarios Lessons Learned Questions & Comments 38

39 Hypothetical Scenarios Issues What is the source of the information? Is the information nonpublic? Is the information material? Was the information obtained in breach of a duty owed to either the source of the information or the issuer? 39

40 Hypothetical Scenarios Scenario 1 A portfolio manager ( PM ) is traveling on a train and overhears a conversation in front of him regarding Company A s pending earnings release, indicating that Company A expects to beat Street estimates by a wide margin. PM has no relationship to Company A. Later that afternoon PM initiates a position in Company A. 40

41 Hypothetical Scenarios Scenario 2 In a small group meeting with buy-side analysts, the CEO of ABC Corp. indicates that the company is considering a variety of strategic alternatives, including potential acquisitions in its space. Analyst returns to her office and, after reviewing her extensive research file regarding the industry, decides that consolidation is likely in the industry, and initiates positions in several smaller companies in ABC Corp. s space that she believes would be the most likely candidates for such consolidation. Several weeks later ABC Corp. announces its acquisition of XYZ Corp., one of the new positions Analyst initiated after her meeting with CEO. 41

42 Hypothetical Scenarios Scenario 2 - Variation At ABC s annual meeting, CEO indicates that ABC and XYZ are exploring ways to integrate their businesses. Analyst calls Friend at ABC, who states that, based on an internal report he prepared for the VP of Business Development regarding the industry, he can confirm what CEO said at the meeting. 42

43 Hypothetical Scenarios Scenario 3 Analyst has covered the auto industry for many years and has an exhaustive understanding of the industry, including creative trends. Among other things, Analyst knows that when Company A is preparing to release a new sports car model it always scales up its purchases of competition tires. In the course of his channel checks into the industry, Analyst learns from one of his sources at Tire Manufacturer that Company A has recently ratcheted up its competition tire purchases. Analyst decides to initiate a position in Company A. Several weeks later Company A announces the introduction of a new Roadster, and the reaction is very positive, causing a spike in the shares of Company A. 43

44 Agenda Introduction Rules and Theories Who Is A Potential Insider? DOJ/SEC Targets Crimes, Violations, and Punishment Recent Insider Trading Cases Hypothetical Scenarios Lessons Learned Questions & Comments 44

45 Lessons Learned What Your Company Can Do Determine if information is material and nonpublic Understand your status, even if you are not a classical insider Design insider trading policies for your company Provide training for these policies on a regular basis Monitor for compliance 45

46 Lessons Learned What Your Company Can Do Set up practical safeguards to ensure that inside information isn t being used to trade on, and implement explicit no-trade agreements When in doubt, consult legal counsel to determine if certain corporate tips could lead to insider trading Make a hold or watch list for any stocks that might lead to insider trading charges, to keep traders from trading on inside tips Create specific guidelines regarding outside advisors, and check their guidelines 46

47 The End Questions? Comments? 47