March 15, 2007
On successive days this month, the Securities and Exchange Commission and the Department of Justice announced major enforcement actions alleging insider trading in connection with merger and acquisition activity. These actions, coupled with a strong market for mergers and acquisitions, expressed public concern about trading activity by some market participants, and adverse academic commentary about the efficacy of so-called "10b5-1" plans, all suggest a renewed focus by both agencies on alleged insider trading.
The Actions. On March 1, the United States Attorney for the Southern District of New York unsealed ten indictments and criminal informations charging thirteen people with conspiracy, securities fraud, wire fraud, commercial bribery, false statements, and other offenses. All of the charges arose out of two schemes, one to misappropriate and trade on information of impending stock ratings changes by the research department of a major investment bank, the other to misappropriate and trade on information regarding forthcoming actual and potential merger and acquisition activity by clients of another major investment bank. 1 On the same day, the SEC filed suit against eleven individuals and three self-styled hedge funds seeking injunctions, disgorgement of ill-gotten gains, and civil money penalties. The SEC alleged that the scheme netted more than $15 million in illegal profits. 2
The following day, the SEC sought, and obtained, a temporary restraining order freezing assets of certain unknown purchasers of call options for the common stock of TXU Corporation, alleging in its complaint that one or more persons purchased 8,020 call option contracts in the week before the announcement of the TXU leveraged buyout and obtained $5.4 million in illicit profits by trading through overseas accounts. 3
Publicly Expressed Concerns. Federal regulators and others have also expressed concern that certain investors have been seeking and relying upon material non-public information in making trading decisions. Most recently, SEC Director of Enforcement Linda Chatman Thomsen, citing recent academic literature suggesting that corporate officers using 10b5-1 plans may be achieving results that suggest abuse of the rule, announced an intention to investigate this area as well. 4
The Environment. The recent enforcement actions and public statements come in the midst of a market environment that is, in many respects, similar to the 1980s when the SEC and Department of Justice brought prosecutions against executives of Wall Street firms and of other major corporations for insider trading. Merger activity is again active, and the size of some of the transactions is such that acquirers often consist of a consortium of bidders financed by more than one financial institution. Thus, information about the proposed transaction may be more dispersed than was typical in the past. Moreover, the market surveillance departments of the New York Stock Exchange and of NASDAQ have increased their oversight in this area.
The Consequences. Penalties for securities offenses have increased significantly since the 1980s. Securities fraud now carries a twenty-year prison term that, when coupled with the Federal Sentencing Guidelines (even in the post-Booker advisory form), means the likelihood of incarceration for a convicted offender is substantial. Since 1988, the SEC has had the authority to seek and obtain civil money penalties of up to three times the profit obtained or loss avoided by the trade. The SEC also routinely seeks orders barring persons adjudged liable for insider trading from future service as an officer or director of a public company, or as an associated person of a brokerage firm or an investment adviser.
For public companies, insider trading investigations also carry substantial costs. Evidence of insider trading can cause companies to make disclosure of corporate events sooner than planned, can disrupt the market for a company’s stock, and can force a company into the distracting process of responding to the regulators’ need for information. For brokerage firms and other market participants, alleged leaks are harmful to reputation and create potential exposure. 5
What Should Companies Do Now?
In light of this environment, several prudential measures may be in order.
1. Remind officers, directors, and employees of the company’s insider trading and disclosure policies. Reemphasize the importance of trading "windows" as a way to protect the corporation and its employees. Education and prevention can help avoid later difficulties.
2. Consider a new look at existing Rule 10b5-1 plans. Rule 10b5-1 was adopted by the SEC in 2000 to allow corporate officers and directors to sell stock in an orderly manner without fear of insider trading liability. Rule 10b5-1 plans continue to have great value. But the safe-harbor depends on the careful construction of the plan and continued adherence to it.
3. When engaged in a major corporate transaction, remind the participants of the importance of maintaining confidentiality, keep information on need-to-know basis, and keep track of which persons have been informed of the transaction and when.
4. For brokerage firms and investment advisers, consider reinforcing ethical screen, watch list, and control room procedures. None of the brokerage firms victimized in the recent Guttenberg cases were criticized by the regulators, and the complaint alleges elaborate measures, such as the use of disposable cell phones and codes, to conceal the sources of information. Faithful adherence to compliance processes will demonstrate a firm’s commitment to adequate controls.
5. Be thorough, careful, and prompt in responding to requests for information by regulators regarding suspected insider trading. Public companies and brokerage firms are almost always victims of insider trading, rather than suspected offenders. But erroneous information may lead regulators to draw the wrong inferences. Thus, requests for a chronology of events or other information about a transaction must be taken seriously and handled with great care.
1. Office of the United States Attorney for the Southern District of New York, Press Release No. 07-051 (March 1, 2007), available at http://www.usdoj.gov/usao/nys/
pressreleases/March07/ubsinsidertradingpr.pdf (last visited March 15, 2007).
2. SEC v. Michael S. Guttenberg, et al., No. 07 CV 1774 (S.D.N.Y.)(PKC), March 1, 2007.
3. SEC v. One or More Unknown Purchasers of Call Options for the Common Stock of TXU Corp., No. 07C1208 (N.D.Ill. March 2, 2007).
4. Remarks at the 2007 Corporate Counsel Institute, March 8, 2007, available at http://www.sec.gov/news/speech/2007/spch030807lct2.htm (last visited March 15, 2007).
5. Brokerage firms and investment advisers are required by law to have policies and procedures reasonably designed to prevent the misuse of material, non-public information. Under the Insider Trading Securities Fraud Enforcement Act of 1988, corporations may, in some circumstances, have liability for insider trading by employees.
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