Mid-year Report on Insider-Trading Enforcement

The mid-year report on insider-trading prosecutions at the Securities and Exchange Commission shows the agency is making good on its promised crackdown: Investigations are still coming at a brisk pace, and prosecutors are using broader legal theories to catch more possible offenders.

The SEC disclosed 19 insider-trading enforcement actions against 33 defendants in the first half of 2008, compared to 20 actions against 48 defendants in the first half of 2007.

Steskal

“There hasn’t been any let up by the SEC this year,” says Christopher Steskal, a former federal prosecutor and now partner at the law firm Fenwick & West. He says he now spends about 25 percent of his time on insider-trading issues, compared to 10 percent last year. “The cases brought this year show that the SEC has continued to target Wall Street professionals and so-called gatekeepers who trade on inside information,” he says.

The SEC’s renewed push against insider trading began in 2006. Commission officials talk about the crackdown often; at the Compliance Week 2008 conference in June, SEC Enforcement Director Linda Chatman Thomsen warned that her division will not let up any time soon and is targeting senior executives more often.

Ellsworth

Larry Ellsworth, a former SEC enforcement lawyer and now partner at the law firm Jenner & Block, expects the number of insider-trading cases brought this year to be as high as last year, if not higher.

“Every decade or so, the SEC has to go back to the future and re-teach the lesson about insider trading,” he says. “The way they send the message is by bringing a lot of cases and sending people to jail. We’re in one of those eras again.”

Ellsworth says today’s cases have more foreign flavor because insider trading, like fraud generally, is increasingly global in nature. “There are more cases involving foreigners or Americans with foreign accounts or accomplices, and there’s more cooperation with foreign authorities than there was a decade ago,” he says.

Indeed, Thomas Gorman, former senior counsel in the SEC’s Enforcement Division and now a partner at Porter Wright Morris & Arthur, says the SEC’s focus on insider trading is “part and parcel with what’s going on around the world.”

Gorman

“There’s a whole global markets phenomenon with insider trading,” says Gorman. “Regulators around the world have stepped up their enforcement.”

Even in the European Union, where insider-trading enforcement has historically been lax, regulators have been cracking down on abuses. Britain’s Financial Services Authority brought its first-ever criminal charges over insider dealing earlier this year, and has launched a number of investigations into suspect trading.

“Most SEC insider trading cases rely on circumstantial evidence—they have to connect the dots.”

— John Sturc,

Partner,

Gibson, Dunn & Crutcher

Observers expect 2008 to remain busy on the domestic insider-trading front as well. Steskal notes that in the first half of this year, the SEC brought enforcement actions against a former PricewaterhouseCoopers auditor and a former Ernst & Young partner for trading on inside information. Many cases in 2007 and 2008 also focused on trading activity ahead of a merger or acquisition, he adds.

“If we see a decline in the number of enforcement actions toward the end of the year or next year, it will not be because the SEC is no longer focusing on insider trading, but rather because of a market-wide slowdown in M&A activity,” Steskal says.

Pushing the Envelope

Most recent insider-trading cases involve standard theories of enforcement. Gorman, however, contends that a few cases “push the edge of the envelope factually.” For example, he says, the complaint in SEC v. Robert W. Tedder filed in June “raises questions about quality of the proof.”

The complaint alleges that two employees at Aviall Inc., an avionics company in merger talks with Boeing, engaged in insider trading in 2006 as rumors of a deal ran through the company and Boeing executives were seen strolling around Aviall’s premises. The two employees tipped off several others that a merger was imminent—and Boeing did indeed acquire the company that year—but Gorman says the duo never gained actual inside information; they merely pieced together the picture ahead of a formal announcement.

UNLAWFUL CONDUCT

The following excerpt from SEC vs. Robert Wayne Tedder, et al. details the alleged insider dealing conducted by Aviall and defendants.

Between late January and early March 2006, senior executives of Boeing and

Aviall discussed a possible merger of the two companies. The due diligence process

commenced in mid-March 2006 and continued through April 2006. During the month of April, Boeing and Aviall negotiated the specific terms of the merger agreement. The directors of both companies approved the merger on Sunday, April 30, 2006. On the morning of May 1, before the markets opened, Boeing and Aviall publicly announced that their companies had signed a definitive merger agreement whereby Boeing would acquire Aviall in an all cash merger for $48 per share.

Shortly after the merger announcement, the Philadelphia Stock Exchange alerted

Aviall to suspicious trading in Aviall options. In response, the company conducted an internal inquiry in May 2006, which included interviews of Robert Tedder and Carr. At the conclusion of the internal inquiry, the company terminated Robert Tedder and Carr for violating the Code of Conduct.

During the several weeks prior to the public announcement of the acquisition, a

number of internal events occurred that raised expectations among Aviall employees that a significant event involving the company would occur in the near future. These included:

A trading blackout for Aviall’s upper management, which did not include

Robert Tedder or Carr, that remained in place for an extended period from

year-end 2005 through May 2006 (“extended trading blackout”);

A March 8, 2006 tour by Boeing executives of Aviall’s Dallas headquarters,

including the corporate offices and adjoining warehouse, led by Aviall’s CEO

(“Boeing tour”);

Closed-door meetings in April 2006 involving Aviall’s in-house counsel and

several Aviall management employees;

Unusual requests by upper management for data and documents, often in

conjunction with offsite meetings by upper management;

An April 11, 2006 e-mail from Aviall’s CEO concerning a conference call

among Aviall’s board of directors, outside counsel, and the company’s

financial advisers to discuss the status of the due diligence process and draft

merger agreement, with the purchaser referred to only by the code name

“Andre,” was sent inadvertently to 122 Aviall employees across the country,

including Dallas warehouse employees, who should not have received it

(“inadvertent e-mail”);

Internal rumors that Boeing would acquire Aviall and that the acquisition was

imminent.

Each of the Defendants was aware of one or more of these factors when they purchased Aviall securities.

Source

SEC vs. Robert Wayne Tedder, et al. (2006).

“It seems like [the SEC] is reaching to put the factors together,” says Gorman, who notes that none of the defendants have settled the charges.

Sturc

John Sturc, however, a former associate director of enforcement at the SEC and now with the law firm Gibson, Dunn & Crutcher, does not believe such cases are all that unusual. For example, he says, even if classical insider-trading theory wouldn’t apply, the SEC could still sue the defendants under misappropriation theory.

“Most SEC insider-trading cases rely on circumstantial evidence—they have to connect the dots,” he says. “The primary weakness in all insider trading cases is trying to develop evidence that shows they were in possession of the info at the time they traded. Bringing insider-trading cases on circumstantial evidence is very common for SEC.”

Gorman says the SEC is also working on developing a new “fairly aggressive” legal theory involving the use of a combination of inside information and industry knowledge to trade in the stock of a company in the same industry.

While no cases have been brought on that basis yet, Gorman says they could be forthcoming. He says he’s aware of a case in which the staff sent a Wells notice—a warning notice to the target of an investigation that enforcement is imminent—on that basis. The SEC ultimately called off any action for other reasons, he says, but prosecutors did believe that a breach of duty had happened.

One area where enforcement officials have sounded warnings that they’re looking hard at for possible insider-trading abuses is 10b5-1 plans, under which executives buy or sell a fixed amount of company stock under a pre-established plan, presumably to avoid insider-trading allegations. The SEC made it known that it was scrutinizing possible abuses of the plans following the publication of a December 2006 academic study that found that trades by executives participating in 10b5-1 plans outperformed trades by non-participants.

Another likely hunting ground for insider-trading cases is “front-running,” where brokers place their own orders for a stock just before placing orders from clients, which would push up the share price. The SEC has also established a working group to investigate insider trading at hedge funds.

Ellsworth says the SEC has also put issuers “on notice” that it may extend to them obligations currently imposed only on regulated entities for failure to maintain or enforce anti-insider-trading policies and procedures. That warning came in the form of a March report under Section 21(a) of the Securities Exchange Act of 1934 about an investigation into whether the Retirement Systems of Alabama violated federal securities laws by purchasing shares of The Liberty Corp. on the basis of material, non-public information concerning a prospective acquisition of Liberty.

“The report emphasizes that companies may be found liable as control persons if insider trading occurs and they don’t have sufficient controls to prevent it,” says Ellsworth. “While the statute specifically says that’s the law for brokerages, the SEC is saying here that they may expand that to issuers.”