Insider Trading & Whistleblowers
RISK MANAGEMENT AND LOSS PREVENTION
Metropolitan Club , NYC
February 9, 2011
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INSIDER TRADING, WHISTLE BLOWERS,
RISK MANAGEMENT AND LOSS PREVENTION
Doug Hirsch, Partner, Head of Litigation & Advisers Operations Practice
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Topics for Discussion
Insider Trading & Whistleblowers
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Definitions & Theories
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Caselaw
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Procedures to Prevent
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SEC Enforcement
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Dodd Frank Act, Whistleblowers Program & the SEC
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Solutions
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About the Speaker
Doug Hirsch
551 Fifth Avenue
New York, NY 10176
Douglas Hirsch is the head of the Litigation Practice and the
Advisers Operations Practice. This dual role gives him a unique
perspective on litigating financial services issues and counseling
financial services clients. He represents investment advisers in
all phases of their operations, from drafting and counseling
in connection with service provider agreements and
employment agreements to representing them in
connection with SEC enforcement proceedings and
litigating fraud and breach of fiduciary
Duty cases.
Mr. Hirsch also counsels clients in connection with
potential exposure under a variety of agreements, including
operating agreements, ISDA agreements and marketing
agreements. Mr. Hirsch’s 20 years of litigation experience has
encompassed a broad range of trials, appeals class action
litigations and arbitrations.
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What is Insider Trading?
Classic Theory - trading by an “Insider” (1) in violation
of Section 16 of the Exchange Act (Short Swing Profits,
Violation of Filing Requirements, Short Sale Violations,
Trades Against The Box); or (2) using non-public
material information in breach of a fiduciary duty owed
to the company or shareholders for direct or indirect personal
benefit with the intent to deceive. An “Insider” is
generally defined as an officer, director or 10% beneficial
owner and attorneys, accountants, consultants and
others who temporarily become fiduciaries.
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Tippee Liability – Variation of
Classic Theory
A tippee assumes a fiduciary duty to the shareholders of a corporation
not to trade on material nonpublic information only when the insider
has breached his fiduciary duty to the shareholders by disclosing the
information to the tippee and the tippee knows or should know that
there has been a breach. Dirks v. SEC, 463 U.S. at 660.
The insider breaches his fiduciary duty when he receives a “direct or
indirect personal benefit from the disclosure”. 463 U.S. at 663
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Misappropriation Theory
Under the misappropriation theory, a person violates section 10(b)5
“when he misappropriates confidential information for securities
trading purposes, in breach of a duty owed to the source of the
information”. U.S. v. O’Hagan, 521 U.S. 642, 652 (1997).
In a misappropriation case, the source of the information does not owe
a fiduciary duty to the issuer of the security or its shareholders and
therefore, cannot be prosecuted under the classic theory of insider
trading.
An example is the employee of Barron’s or the WSJ who trades in
advance of the publication of an article. The employee does not owe a
duty to the issuer of the security but has breached a duty of trust or
confidence owed to his employer.
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Common Misconceptions About
Insider Trading
Section 10(b)5 does not prohibit trading upon material non-public
Information. The courts have repeatedly rejected the parity of
information theory. No liability is created simply because one party
to a trade has material non-public information that the other party
does not. U.S. v. Chestman, 947 F.2d at 565.
Fiduciary duties or duties of confidentiality cannot be unilaterally
imposed. For example, an officer of a company could not prevent
someone from trading the stock of the company by unilaterally
divulging material non-public information to the person. U.S. v.
Chestman, 947 F. 2d at 567.
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Caselaw
United States v. Chestman, 947 F.2d 551 (2nd Cir. 1991) – no misappropriation
theory liability where wife told husband of pending tender offer for her family
business and told husband it was confidential and husband told broker who then
traded on the information. Court held no fiduciary business relationship existed
between the husband and wife. However, Williams Act violation.
United States v. Kim, 184 F.Supp.2d 1006 (N.D. Cal. 2002) – no misappropriation
theory liability where a CEO advised a member of his club that he could not make
a meeting due to his company’s pending merger negotiations, and the other CEO
traded upon said information. Their relationship was held to be “peers” that
socialize with one another, not a fiduciary relationship.
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Caselaw
SEC v. Cuban, 634 F. Supp. 2d 713 (N. D. Tx 2009) - The District Court held that no misappropriation
theory liability existed where Cuban merely agreed to keep information about an upcoming PIPE
offering confidential but never agreed not to trade on said information. No fiduciary relationship.
“The agreement, however, must consist of more than an express or implied promise merely to keep
information confidential. It must also impose on the party who receives the information the legal duty to
refrain from trading on or otherwise using the information for personal gain. With respect to
confidential information, nondisclosure FN6 and non-use are logically distinct. A person who receives
material, nonpublic information may in fact preserve the confidentiality of that information while
simultaneously using it for his own gain. Indeed, the nature of insider trading is such that one who
trades on material, nonpublic information refrains from disclosing that information to the other party to
the securities transaction. To do so would compromise his advantageous position. See O'Hagan, 521 U.S.
at 656, 117 S.Ct. 2199 (“The misappropriation theory targets information of a sort that misappropriators
ordinarily capitalize upon to gain no-risk profits through the purchase or sale of securities.”).”
The Fifth Circuit reversed the district court and held that Cuban’s statement to the CEO “Well, now I’m
screwed. I can’t sell”, could be interpreted as an agreement not to trade the shares. The court also held
that the question of whether a relationship of trust and confidence existed between Cuban and the
Company was a fact sensitive inquiry that could not be resolved on a motion to dismiss. SEC v. Cuban,
620 F.3d 551 (5th Cir. 2010).
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Caselaw
SEC v. Rorech - The SEC alleges that Mr. Rorech told Mr. Negrin during two unrecorded cellular
telephone calls on July 14 and July 17, 2006, (1) that Deutsche Bank would recommend to VNU’s
financial sponsors that VNU issue the holding company bonds and (2) that at least one of Mr.
Rorech’s customers already had placed an order for $100 million of the holding company bonds.
Mr. Negrin purchased CDS. After announcement that VNU holding company would issue bonds, the
value of the CDS increased and Mr. Negrin realized a 1.2 million dollar profit.
Court held that the information was neither material nor confidential. For purposes of the securities
laws, information is deemed “material” if there is “a substantial likelihood that the disclosure of the
omitted fact would have been viewed by the reasonable investor as having significantly altered the
‘total mix’ of [available] information.” Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988)
The Court noted that another hedge fund manager who was aware that VNU may issue bonds
actually sold CDS. Court also noted that Deutsche Bank did not treat such information as
confidential.
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Primary Global Research & Galleon
PGR December 16th Arrests
• James Fleishman – Sales manager for PGR. It is alleged that Fleishman arranged for
clients to speak with PGR consultants knowing that consultants would
provide confidential information.
• Mark Anthony Longoria – employed by AMD as a supply chain manager. It is alleged that
his AMD employment agreement prohibited from disclosing AMD confidential information.
• Walter Shimoon – employed by Flextronics International, Ltd. as a senior director of
business development. Flextronics is a supplier to Apple. The government alleges that
while acting as a consultant to PGR, Shimoon provided clients with confidential sales
forecasts and new product features in violation of the confidentiality provision of his
employment agreement.
• Galleon – Use of wiretaps is legal in connection with a securities fraud case
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Procedures to Prevent and Detect
Insider Trading
• Distribute written guidelines and definitions of what constitutes insider trading. Make
employees attest that they have read the materials.
• Chinese Walls – limit the flow of non-public information to those on a need to know
basis. Physical or informational barriers – restricting access to information, separating
functions.
• Review of employee personal trading – restricting employee trading and/or monitoring
employee trading are effective ways to prevent insider trading. Force all employees (and
perhaps their immediate family members) to use the adviser’s brokerage firm.
• There should be at a minimum, a restricted list. Advisers should also consider watch lists
and rumor lists of securities. A watch list is a list of securities in which trading is closely
monitored and limited. A rumor list is a list of securities that become the subject of
rumors.
• Exception reports
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New Enforcement Tools
Fostering Cooperation – The Division of Enforcement is now authorized to use various tools to
encourage individuals and companies to report violations and provide assistance to the agency.
These tools include:
Cooperation Agreements – Formal written agreements in which the Enforcement Division agrees to
recommend to the Commission that a cooperator receive credit for providing substantial assistance
such as full and truthful testimony
Deferred Prosecution Agreements – Formal written agreements in which the Commission agrees to
forego an enforcement action against a cooperator if the individual or company agrees to cooperate
fully and to comply with express prohibitions during a period of deferred prosecution
Non-prosecution Agreements – Formal written agreements, entered into under limited
circumstances in which the Commission agrees not to pursue an enforcement action in exchange for
full cooperation and compliance with express undertakings.
Policy Statement – SEC issues written guidelines detailing how it will go about evaluating whether to
credit cooperation
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Dodd-Frank Act Expands SEC’s
Enforcement Power
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Special Protection for “Whistleblowers”
Substantially Increased Penalties
Ease of Issuing Subpoenas and Investigations
Expanded Causes of Action
SEC Budget Doubles by 2015
Registration Requirements
Swifter Timeline for Enforcement Actions
Power to Limit Arbitration Clauses
SEC’s Current Enforcement Priorities
Solutions
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SEC’s Whistleblower Program Under Dodd-Frank
Basic Outline of Program
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SEC must pay “whistleblower” making a “voluntary” submission of
“original information” derived from “independent knowledge” leading to
enforcement action recovering > $1 million.
“Voluntary” means that the whistleblower came to the SEC with the
information prior to a subpoena, examination or request for information.
No “independent knowledge” if information is learned through performing
legal audit, compliance audit or supervisory responsibilities – unless
company fails to disclose to SEC in reasonable time or acts in bad faith.
Whistleblower gets 10-30% of money collected in any related civil &
criminal case.
Participants in wrongdoing not absolutely barred from collecting reward.
SEC is required to pass rules fleshing out statute by 4/15/11.
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SEC’s Whistleblower Program Under Dodd-Frank
Special Protection for “Whistleblowers”
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Confidentiality: Can report anonymously with lawyer.
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Identity must be disclosed to the SEC by the time the
Whistleblower seeks the award.
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Employer unlikely to learn identity unless & until it is charged
by SEC, and only then during discovery in enforcement
proceedings.
Protection Against Retaliation: Private right of action for
retaliation, with remedies of reinstatement, payment of 2x back pay
and other relief.
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SEC’s proposed rule attempts to balance
internal reporting with employee’s financial
incentive to report immediately to the SEC.
“We emphasize, however, that our proposal not to require a whistleblower to utilize internal
compliance processes does not mean that our receipt of a whistleblower complaint will lead to
internal processes being bypassed. We expect that in appropriate cases, consistent with the
public interest and our obligation to preserve the confidentiality of a whistleblower, our staff
will, upon receiving a whistleblower complaint, contact a company, describe the nature of
the allegations, and give the company an opportunity to investigate the matter and report back.
The company’s actions in these circumstances will be considered in accordance with the
Commission’s Report of Investigation Pursuant to Section 21(a) of the Securities Exchange
Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency
Enforcement Decisions.”
Pg. 34-35 of SEC Release No. 34-6323?
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SEC’s Whistleblower Program Under Dodd-Frank
Example From SEC’s Prior Insider Trading Bounty” Program
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Pequot Capital Insider Trading Case (July 2010): Ex-wife of Pequot
executive finds email on family hard-drive showing that at prior job (Microsoft) he
grilled co-workers for inside information & gave it to Pequot founder, Arthur
Samberg.
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SEC reopened insider trading investigation into Pequot.
SEC orders Pequot to pay $28 million ($10 million penalty & $18 million disgorgement):
investigation causes Pequot to Shut Down.
SEC awards ex-wife $1 million bounty (statutory maximum of 10% of penalty) – highest
ever awarded pursuant to Bounty Program.
Pequot shows SEC will be aggressive and give maximum rewards under
Whistleblowers Program
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Whistleblower designed to remedy defects in Bounty Program by requiring SEC to pay
larger reward of all money collected.
Bounty Program gave SEC discretion to pay only up to 10% of civil penalties.
In more than 20 years, SEC paid only a handful of Bounties.
Can Shorts Double Dip?
• Can a short seller report its analysis of company wrongdoing to the SEC and
recover a whistleblower bounty under Dodd Frank as well as profit in its
short position? Possibly.
• U.S., ex re Brickman & Greenlight – using publicly available information,
Greenlight concludes that BLX did not comply with underwriting standards
and defrauded the government out of tens of millions of dollars by writing
loans that would default and collecting origination fees.
• Court holds that Greenlight’s “analysis” did not constitute original
information under the False Claims Act and could not recover FCA reward.
• Dodd Frank is different than FCA because it defines “Original Information”
to include “analysis”.
• Proposed SEC Rule defines whistleblower as natural person – major hurdle.
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SEC’s Whistleblower Program Under Dodd-Frank
Suggestions for Updating Internal Compliance
Programs
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Re-emphasize that employees have a contractual duty to report
wrongdoing internally.
Highlight that failure to report internally may be participation in
or aiding/abetting the wrongdoing.
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Grounds for sanctions, including termination from job.
Note that reporting wrongdoing can lead to promotion, higher
salary or other benefits.
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Counteracts financial incentive to be “Whistleblower” instead
of reporting internally.
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Solutions
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Tailor compliance manuals to particular business needs
Adopt and implement insider trading procedures
Ensure that marketing materials contain appropriate disclosures
Document a review of all cross trades (including rebalancing)
Document pre-approval of personal trades in a manner consistent with
internal policies and review trades for potentially improper trading
Maintain detailed records of the valuation of assets
• Disclose how you will value hard to value assets
• Disclose the use of side pocket accounts
Review proxy voting records to ensure votes have been cast in accordance
with procedures and in the best interest of investors
Retain thorough and organized records of all transactions, brokerage
statements, and financial reports
Purchase and Maintain Professional Liability Insurance
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THANK YOU
For More Information Contact:
Douglas Hirsch
Sadis & Goldberg LLP
212.573.6670
dhirsch@sglawyers.com