Combatting insider trading

September 2014 | COVER STORY | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

Insider trading is significantly more prevalent than many analysts had thought, according to a report from the New York and McGill universities. As many as a quarter of all public company deals may involve some degree of insider trading. Although the rewards for insider trading may be bountiful, the consequences of exposure are serious. Sanctions, including custodial sentences, massive financial penalties, disgorgement and permanent exclusion from the industry, have been meted out to individuals found guilty of insider activity. There are also serious implications for their firms. When an employee, officer or director is accused of insider trading, it can destroy client, investor and public trust in the organisation.

Landmark cases

Prosecuting insider trading is often an expensive and time consuming process, but recently the Securities and Exchange Commission (SEC) has been able to bring a number of high profile cases to court. “The Rengan Rajaratnam and Mark Cuban cases were recent watershed moments for insider trading cases, although both for different reasons,” says Michael Rosensaft, a partner at Katten Muchin Rosenman LLP. “Cuban was an example of the SEC overreaching on its evidence with its star witness astoundingly testifying via videotape. Although Rengan has been touted as important because it was the first insider trading trial loss for US Attorney Preet Bharara, the real importance comes on how determinative a role judges can have affecting the criminal cases before them – not only by dismissing counts, but really setting the atmosphere in the courtroom, which has a direct effect on the jury.”

The conviction of Mr Rajaratnam has been described as a ‘defining moment’ in the US government’s attempts to stamp out insider trading. Not only was he sentenced to 11 years in prison – the longest sentence ever imposed for the crime – he was also ordered to pay a $10m fine and forfeit $53.8m of his own money. The sentence was the culmination of a long and complex investigation into the conduct of his now defunct hedge fund The Galleon Group. As a result of the investigation, a number of Galleon’s other senior employees were handed extensive jail terms. Collectively, these sentences indicate a change in emphasis by the courts. Increasingly, they are inclined to impose much harsher custodial sentences.

Disgorgement has also become an important tool for judges and prosecutors. The recent case of SEC vs Contorinis saw the Second Circuit court endorse an expansive program of disgorgement, allowing the SEC to require the defendant to disgorge funds over which he never had ownership or control.

This decision flies in the face of previous disgorgement rulings. While the SEC has been able to pursue disgorgement, historically it has been restricted primarily to amounts actually received by defendants through their own wrongdoing. The Contorinis case changed that. Mr Contorinis was ordered to disgorge not only the $400,000 in personal gains he made from his alleged insider trading activities, but also the $7.2m in insider trading profits made by Paragon Fund, on whose behalf he traded.

Turning to less successful actions, the loss of the Mark Cuban case has the potential to be rather damaging for the SEC and any future high profile cases it hopes to bring. The Commission’s failure to adequately prepare a convincing case has served to highlight the agency’s struggles in court. According to Nicolas Morgan, a partner at DLA Piper LLP, the recent case of US v Newman et al in the Second Circuit may also prove influential. “At the oral argument back in April, a Second Circuit panel implied that the US Attorney’s office may be mistaken in its belief that a tippee can be guilty of insider trading even if the tippee didn’t know that the tipper, or insider, received a personal benefit,” notes Mr Morgan. “Typically, the government – including the DOJ and SEC – assert that a tippee violates insider trading prohibitions if he knew the information was non-public and that it was disclosed in violation of a fiduciary duty. If the Second Circuit clarifies that a tippee’s knowledge of an insider’s personal benefit is also required, this will have a major impact on civil and criminal insider trading matters across the country.”

Securing prosecutions

Securing a successful prosecution is a complicated and arduous task for regulators. In previous cases, the failure to produce a clear document trail has proved a stumbling block. In light of this, what can steps can authorities take to ensure they achieve more successful prosecutions?

“Given today’s highly-scrutinised environment, accusations of insider trading may be considered an everyday hazard.”

In the last few years the legislative approach has altered across the globe. In 2013, Japanese authorities made revisions to the Financial Instruments and Exchange Act (FIEA) governing insider trading and its related financial penalty system. The changes, which will be enforced and specified by the Cabinet Office Ordinance, have been designed with prevention in mind. According the new rules, fines for insider trading have also increased significantly. Furthermore, any individual found guilty of leaking confidential, non-public information or attempting to encourage another person to trade on such information will be subject to criminal penalties.

In the EU, the European Court of Human Rights (ECHR) has upheld a ruling which decrees that insider trading crimes which have been punished by a regulator cannot also be tried in criminal courts. It is thought the ECHR’s controversial decision could set a precedent across Europe, particularly in Italy where the initial case was heard, as well as in France. The case has been of particular interest to the French financial services authority (AMF). In France, individuals can currently be tried twice for the same offence, as both the AMF and criminal prosecutors can pursue a case.

Generally, introducing new regulations and increasing the resources available to prosecutors has been a key strategy in securing prosecutions. According to Campbell Jackson, a partner at Deloitte in Australia, local regulators are now treating insider trading as a priority. The practice, he believes, is systematic in local financial markets. “The Australian regulator responsible for market supervision – the Australian Securities and Investment Commission (ASIC) – has, in recent years, received increased government funding to specifically resource its enforcement and surveillance activities into insider trading and other forms of market manipulation,” he says. “In addition to investigating reports of market misconduct, ASIC has increased its capabilities to detect potential insider dealing through investing in technology and programs designed to identify irregular trades typically before market announcements. The regulator has a range of enforcement powers to assist in investigating insider dealing cases and to achieve prosecutions, including the power to compel individuals and firms to provide information through formal examinations and production notices, acting swiftly to inquire with firms about irregular trading, and cooperating with other regulators.”

Australian regulators have also moved to tackle the question of communication and evidence. Under the auspices of the Telecommunications (Interception and Access) Act, ASIC is able to apply to the courts for a warrant to intercept the telephone conversations of any individual suspected of insider trading. The Australian authorities have also begun to utilise modern technology to help strengthen cases. Smartphones, laptops and servers can now all be accessed to locate electronic communication. By contrast, US regulators have been surprisingly slow to adapt to technological shifts. Unlike inside traders themselves, who have deftly embraced technological advancements, the SEC has dragged its feet. “Although insider trading investigations are becoming more popular, law enforcement’s investigative techniques have not changed – they are simply employing more of them in the insider trading context,” Mr Rosensaft points out. “Email searches, wiretaps and subpoenaing banks and trading information are typical; but the best source for law enforcement is always a cooperating witness.” Although, the SEC’s reliance on witness evidence cost it in the Mark Cuban case, the Commission is likely to persevere with this tactic in the future.

With insider trading becoming more prevalent and traders utilising more sophisticated methods, the SEC and other agencies have started to develop new legal and regulatory approaches to combatting the problem. However, they have not all been particularly successful in their efforts. According to Mr Morgan, the SEC has been guilty of “consistent overcharging”, and a number of failed cases including SEC v. Obus, SEC v. Moshayedi, SEC v. Schvacho and SEC v. Life Partners Holdings, Inc are indicative of this. “The takeaway from this string of insider trading litigation losses is: beware,” says Mr Morgan. “The SEC appears willing to allege violations of the law that it ultimately cannot prove, which means potential defendants engaged in conduct that is anywhere close to the line may be falsely accused of insider trading. Err on the side of caution.”

Preventative measures

Although regulators are continually reviewing their national and regional approach, much of the battle is waged internally by firms. Companies must therefore ensure they have the right compliance procedures and cultures in place to discourage and report illegal activity. Robust ethical compliance policies, strong IT infrastructure and regular training and education all help to preventing criminal activity. Firms must also ensure ongoing vigilance and continually reinforce a zero-tolerance stance on insider trading. Periodic reminders, spot checks and policy updates are essential to compliance.

Should an employee find himself under investigation, the firm must act quickly. “The organisation will need to take swift steps, often in conjunction and cooperation with the regulator, to determine if the matter is isolated, not recurring and to establish how it occurred,” says Mr Jackson. “Such steps are usually best handled by an internal investigation using an independent firm. There are other practical steps an organisation may take, including directing the employee not to attend work until the matter is fully investigated.” Indeed, segregating the employee from further inside information is often a priority while the investigation unfolds.

Prevention, quite clearly, is better than cure, and a firm’s efforts can be made more effective by establishing an internal compliance watchdog to oversee the company’s stock transactions. If internal processes prove efficient, firms may consider bringing in third parties to assist. An external auditor or law firm can study insider holdings at year end and compare them to the reported transactional history for the year. Some analysts have suggested creating blind trusts would also stop the majority of insider trading.

Shades of grey

Observers speak of the fine line that exists between legal and insider trading – a grey area in legislation that can trip up individuals and their firms who genuinely believe in the legitimacy of their trades. In many respects, any sale of shares by a company executive can be considered insider trading. Executives often have the benefit of confidential information, upon which many of them base their trading activity. It is easy to see, therefore, how the line can become blurred.

Not all are convinced, however. Despite the perception of some executives walking a tightrope, this does not ring true for Mr Jackson. “The line between legitimate trading and insider trading is not as fine as perceived,” he says. “It is really a matter of identifying whether the information used to engage in a transaction is not generally available and, if the information were generally available, that a reasonable person would expect it to have a material effect on the price or value of publicly listed securities. Based on recent cases in Australia, the offenders are commonly professional advisers with knowledge of – or access to – confidential client information which would make a related trade they undertake less likely to be a legitimate one.”

Individuals and firms face potential exposures on a number of fronts and must be aware that the slightest misstep could put them in the spotlight. According to Mr Morgan, much of the danger lies in family trading. “A surprising number of insider trading cases against executives involve trading by friends or family,” he says. “Many of these cases are based on circumstantial evidence involving little more than unusually timed trades, phone records and physical proximity between the executive and the person who traded – even if the executive didn’t, or didn’t intend to, disclose inside information. To avoid the possibility of being falsely accused in this area, executives should remind friends and family not to engage in trading in the executive’s company stock.”

Indeed, given today’s highly-scrutinised environment, accusations of insider trading may be considered an everyday hazard. “The problem for investors is that almost anytime there is a significant event in a company and the investor traded prior to that event, there will be an investigation,” notes Mr Rosensaft. “Establishing robust insider trading policies with clear blackout periods can of course help, but it is becoming almost impossible for an insider to trade without some scrutiny.”

Insider trading will always be an emotive subject, but it is difficult to imagine a business environment where it does not occur in some form. Governments, regulators and companies have all attempted to eradicate insider trading at various points, to little avail. While there may be some cases of success, such as the prosecution of Mr Rajaratnam, they are always likely to be the minority. Insider trading is not a problem that will be eradicated entirely. Firms must therefore take the lead in establishing preventative measures to protect themselves, and bringing to account those who act outside the rules.

Richard Summerfield