Insider Trading: Life After Galleon

1. Insider Trading: Life After Galleon K&L Gates Insider Trading Seminar March 3, 2010 Richard M. Phillips Jeffrey L. Bornstein Mark D. Perlow

2. Imagine if you will…

3. Insider Trading Prosecutions – Things Really Have Changed! • The first SEC insider trading prosecution: The 1960 administrative proceeding in the Cady Roberts case • SEC found broker sold stock in several customer discretionary accounts on the basis of inside information that an NYSE listed company was about to cut its dividend

4. Insider Trading Prosecutions – Things Really Have Changed! (Cont.) • The SEC fined the broker $3,000 and suspended him for 20 business days from the brokerage industry • Next morning, the broker found a long line of prospective customers lined up in front of his office. • From the broker’s point of view, it was a good investment

5. The Galleon Prosecutions – 50 Years Later • Criminal charges brought against 22 persons for alleged insider trading violations • Allegations focused on hedge fund managers/traders • Also involved alleged issuer and consultant insiders • 10 guilty pleas to date and more expected • Parallel SEC Enforcement Actions

6. The Disastrous Consequences for Defendants – Criminal • Up to 20 years imprisonment • Fines up to $5 million or twice the gain • Criminal forfeiture of profits • Example: assume a single trade with profits of $500,000 • Under Sentencing Guidelines, even for a first time offender, and assuming a prompt guilty plea: • Prison for up to 37 to 46 months on the low end • Could be up to 70 to 87 months (depending on various factors)

7. The Disastrous Consequences for Defendants – Civil • Disgorge “ill-gotten gains” • Pay monetary penalties up to three times the amount of those gains • Defendants lost their jobs and their hedge funds are out of business • SEC bars against future employment in the securities industry • Under pending legislation, bar will include the hedge fund industry

8. Galleon Illustrates a New Proactive DOJ-SEC Enforcement Strategy • Historically, insider trading prosecutions not considered to be easy cases • Key issue is whether defendant knowingly traded on inside information rather than on independent investment decision • Usually little or no documentary evidence; only circumstantial evidence • Vague line between good, hard digging for information and illegal inside information • Juries often skeptical of whether it was a real crime • Penalties imposed by judges used to reflect same attitude

9. The Traditional SEC Investigative Methods • Investigations were almost always reactive, not proactive • Often based upon indications of a sudden increase in volume or in price in a particular stock or other unusual trading activity • Focus on relationships among those who traded • Conducted lengthy investigation to decide whether to take enforcement action • Subpoenaed trading records, emails, and other documentary evidence • Interviewed witnesses and took formal testimony on the record • Referred egregious cases to the U.S. Attorney • In last 10 years, closer cooperation between US Attorney and SEC, especially if false statements, obstruction of justice etc. are present

10. The New Galleon Investigative Model • Aggressively pro-active investigation • Early cooperation between SEC and U.S. Attorneys • Unprecedented use of wiretaps by U.S. Attorney working with the FBI • Conducted covert investigation • By media accounts, continued for over 2 years • Used evidence of bad acts to coerce individuals to act as informants • Informants wore concealed wires to record conversations with others • The result: A domino effect of successive indictments and additional cooperating witnesses leading to 22 indictments and possibly more to come

11. New SEC Cooperation Policy • New SEC policy announced last month • The U.S. Attorney has long used the carrot of lighter sentences to entice “cooperating” defendants • Substantial Assistance can and usually does lead to reduced jail time • The SEC traditionally has not rewarded cooperation • Since the Madoff debacle, the SEC revamped its Enforcement Division under leadership of ex-U.S. Attorneys • New Cooperation Policy very important from an enforcement perspective • Could result in a “rush to cooperate” characteristic of many criminal prosecutions • May result in companies “self-reporting” • First one in usually gets the greatest leniency

12. New SEC Enforcement Structure • Sweeping change announced by SEC enforcement division – a new market abuse unit • Primarily focused on detecting and prosecuting insider trading • Using extensive database of trading activity and relationships among people and firms to try to detect trading patterns • Individuals involved could then be targeted for wiretapping and other investigatory techniques • New government enforcement efforts highlight need for effective compliance with rigorous controls and employee sensitivity to what constitutes illegal insider trading

13. Insider Trading Enforcement Actions Are Going Global • Regulators in the UK and Hong Kong, historically lax, have recently been prosecuting, winning convictions, and talking tough SEC/prosecutor language, not their former "light touch" approach. To increasing extent, UK and US regulators cooperate closely with each other • EU Market Abuse Directive to all member nations, requiring them to ban insider trading in similar terms to US law

14. What is “Insider Trading”? • Supreme Court has held insider trading violates SEC Rule 10b-5 if there is: • purchase or sale of securities • based on material, “non-public” information • breach of fiduciary duty or duty of trust or confidence owed to issuer, shareholders or any other source of information • proof of scienter (intent to defraud/deceive; recklessness may suffice) SeeChiarella v. United States, 445 U.S. 222, 228 (1980), Dirks v. SEC 463 U.S. 646 (1983) and United States v. O’Hagen, 521 U.S. 642, 655-56 (1997) • Applies to private transactions as well as transactions in public markets

15. Trading “based on” inside information (cont.) • Split of Authority whether mere “possession” of material, non-public information is sufficient • 9th and 10th Circuits – actual use • 2nd Circuit – possession • Some courts: proof of possession shifts burden to defendant to show non-use • Advisers Act requires insider trading controls even if not a prerequisite to insider trading violation

16. Trading “based on” inside information (cont.) • SEC adopted rules attempting to resolve controversy in its favor • Defendant need only be “aware” of material non-public information at time of trade Rule 10b5-1(b) • Firm has burden to prove no trading on basis of inside information if someone in firm possesses such information by showing: • Individual making the investment decision not aware of information, and • Firm has implemented reasonable policies and procedures to ensure that individuals making investment decisions would not use inside information Rule 10b5-2

17. What is “Insider Trading”? (cont.) • The Classical Theory – • Officers, directors and employees commit breach of fiduciary duty, and engage in fraud on shareholders in violation of Rule 10b‑5, if without disclosure to counterparties, they trade on material, non-public information • Extends to “temporary insiders” such as attorneys, accountants and other outside service providers who temporarily assume fiduciary duty to the company SeeDirks, 463 U.S. at 646 • Misappropriation Theory – • Extends insider trading definition to trades based on material non-public information for personal benefit in breach of duty of trust and confidence owed to source of information See O’Hagen, 521 at U.S. 652

18. Example of Classical vs. Misappropriation Theory • Classical: director, officer or constructive insider trading on news that their company is about to be acquired • Misappropriation: trading based on non-public information from supplier to company

19. Tippee and Tipper Liability • Tippers can be liable for Tippee’s trades • Key Issues • Knew or should have known that Tippee is likely to trade • Personally benefited from the Tippee’s trade • Personal benefit need not be financial • Includes gifts and other benefits to friends or family • Even reputation benefit is sufficient Dirks, 463 U.S. at 662. • Tippee also liable if he or she knew or should have known that information was derived from confidential source

20. What is “materiality”? • Information that a reasonable investor would believe alters significantly the total mix of publicly available information. Basic v. Levinson, 485 U.S. 224 (1988) • Information that reasonable investor would consider important or reasonably certain to have substantial effect on price of securities. TSC Industries, Inc. v. Northway, 485 U.S. 224, 240 (1976)

21. What is “materiality”? (cont.) • Common Defense--Mosaic Theory of Materiality • Information not material where a “skilled analyst with knowledge of the company and the industry may piece together seemingly inconsequential data together with public information into a mosaic which reveals material, non-public information” • See State Teachers Retirement Board v. Fluor Corp., 654 F.2d 843, 854 (2d.Cir. 1981), citing Elkind v. Liggett & Meyers, Inc., 635 F.2d 156,165 (2d.Cir 1980)

22. Materiality – Factors to Consider: • Specificity of the information and probability it is accurate • Significant facts not publicly available • Magnitude of potential impact on a company’s business • Importance attached to information by those who knew it • Whether the information relates to a change in earnings or other trends • Whether the information diverges from analysts’ expectations • SeeGanino v. Citizens Utilities Company, 228 F.3d 154, 163 (2d.Cir. 2000); SEC v. Baush & Lomb, Inc., 565 F.2d 810 (2nd Cir. 1977)

23. Materiality – Factors to Consider: (cont.) • The practical Real World Test for materiality. regarding information concerning publicly traded securities: • Would public disclosure of the information significantly affect market price and/or trading volume? • Test often applied in hindsight

24. What does “non-public” mean? • Non-Public = Not published or disseminated publicly • Open Questions: Is public access without significant dissemination sufficient? • Publication on company website is sufficient but what if website is more obscure? • Major fire in company’s main facility visible to public only from lightly traveled country road? • Overheard conversation on BART or in the grocery store? • Market reaction is best test for determining adequate dissemination

25. What is “scienter”? • “Scienter” is a mental state “embracing an intent to deceive, manipulate, or defraud” • Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 at n. 12 (1976) • Reckless behavior may be enough • If it involves “an extreme departure from the standards of ordinary care . . . which presents a danger of misleading . . . that is either known to the defendant or is so obvious that the [defendant] must have been aware of it” • See e.g., SEC v. McNolte, 137 F.3d 732 (2d.Cir. 1998) • But SEC and courts sometimes speak in terms of simple negligence = “knew or should have known”

26. Recent CasesPIPE Enforcement Actions and the Cuban Case • Several recent SEC actions against hedge funds and others for insider trading alleging sales of stock just prior to public announcement that issuer will make PIPE offering • What is a PIPE offering? -- Private offering of restricted securities of public company to large investors with agreement to promptly register securities and permit public resale of PIPE securities • PIPEs are faster, less cumbersome and expensive than public offerings but public announcement of offering often depresses market for issuer’s outstanding securities

27. Recent Cases (cont.) • Knowledge of PIPE offering before public announcement offers opportunity to profit by selling or selling short publicly traded securities before announcement • But confidentiality uniformly required of investors who are solicited to participate in PIPE offering • In PIPE enforcement actions, SEC alleged that defendants breached their obligation of confidentiality by selling outstanding stock in advance of public announcement • SEC generally successful in insider trading portion of PIPE enforcement action complaints

28. Recent Cases (cont.) • But consider recent Cuban decision where court dismissed insider trading case involving PIPE offering. SEC v. Cuban, 634 Fed. Supp. 2d 713 (2009) • SEC complaint in Cuban seemed to be slam dunk. Cuban, when invited to participate in proposed PIPE offering, agreed to keep confidential refusing to participate but acknowledging “Well, now I’m screwed. I can’t sell” • Nevertheless, several hours later, before public announcement, Cuban sold all of his shares. Next day after public announcement, stock dropped 10.2%; Cuban avoided $750,000 of losses

29. Recent Cases (cont.) • Texas federal district court rejected view that breach of an agreement to keep confidential is sufficient for insider trading violation. Court held that defendant must also promise not to trade • If sustained on appeal, Cuban case could be very significant. Would have precluded the insider trading allegations in PIPE cases

30. Recent Cases (cont.) • Cuban case also undermines SEC Rule 10b-5-2 stating duty of trust or confidence includes: • agreement to maintain the information as confidential • history or practice of sharing confidential information with reasonable belief that it should be kept confidential • Information obtained from spouse, parent, child or sibling • Express agreement to refrain from trading before public disclosure of information regarding a PIPE offering solves problem but in many situations, agreement not practical • Decision, if affirmed, given current climate of public opinion, might induce Congress to clarify through legislation ever elusive scope of insider trading liability

31. Recent Cases (cont.)Default Credit Swaps • The SEC has stated many times that it is looking to prosecute insider trading in default credit swaps which it considers to be “securities” • Recently SEC took enforcement action against traders who bought credit default swaps on a company's subordinated debt after obtaining non public information that it was going to issue dilutive senior debt. SEC v. Rorech, et., SEC Litigation Release No. 21023 (S.D.N.Y.) May 5, 2009; 2009 SEC LEXIS 1466

32. Recent Cases (cont.)Computer Hackers: No Duty of Confidentiality • Insider trading liability requires at least an implied duty of confidentiality between trader and the source of non-public information. No duty can be implied where information is stolen through computer hacking or other thievery. • For this reason, New York federal district court dismissed SEC insider trading case against computer hacker who traded on information illegally obtained through hacking. SEC v. Dorozhko, 606 F. Supp. 2d 321 (S.D. N.Y. 2008) • On appeal, Second Circuit reversed finding a simple fraud not by relying on insider trading analysis but on the language of Section 10(b) and Rule 10b-5 prohibiting conduct which “operates as fraud.” SEC v. Dorozhko, 606 F. 3d 42 (2009)

33. Post Galleon: What Evidence Will Prosecutors Rely On? • Cooperating witnesses • Circumstantial evidence to prove “use” or possession • Including telephone records, bank records, brokerage statements, emails, instant messages, historical trading patterns, analyst reports • Experts usually do an event study to ascertain reasons for stock price/volume changes • Focus not only on profits made but also losses avoided • Intercepted phone calls and consensual recording of conversations -- the real strength of the government’s case in Galleon

34. The Common Excuses/Justifications: They Seldom Work • It’s just industry “color” or water-cooler talk • The information is no different than what an analyst might get from a company • Everyone is doing it • I trade based on a complex trading strategy • I did not make any money on that trade • I do not use the phone • My trades are small

35. Prudent Steps to Take to Protect Your Firm • Insider trading compliance poses unique challenge • Mostly oral conduct – Difficult to monitor • Poorly defined, vague rules • Automated detection programs may be of limited usefulness • Strong temptations versus fiduciary integrity • Easy profits versus remoteness of penalties (if you’re caught) • Primary protection is building a law abiding culture

36. Prudent Steps to Take to Protect Your Firm (cont.) • Prohibit quid pro quo payments for information • Reliance on non-public information from officers or employees of companies always dangerous even if no payment • Also exercise caution regarding information received from brokers – make sure they are not using inside or otherwise confidential information • In cases even of slightest doubt, require employees to consult with Compliance or Legal staffs before trading or disclosing to other staff members

37. Prudent Steps to Take to Protect Your Firm (cont.) • Active compliance program • Develop system to regularly monitor Watch and Restricted Lists, examine trading activity and seek explanations for unusual trades • Maintain effective information barriers within firm • Regular training and educational efforts • Build sensitivity to what may be inside information • Stress importance of maintaining confidentiality • Emphasize awareness of consequences of using inside information to trade • Educate your employees about SEC Reg F-D • restricts conversations with company officers or employees regarding non-publicly disseminated information

38. Is there Life after Galleon? • Yes and plenty of money to be made • But it pays to be vigilant and compliant • The stakes are too high otherwise