If you are under investigation by the SEC for insider trading, you are likely to have many questions and, understandably, serious concerns. I decided to write this article to answer many of the basic questions those under investigation for insider trading typically have, as well as to provide insight into the process by which the SEC conducts its investigations and, finally, to offer some general thoughts on how to best protect your interests during the SEC investigatory process so as not to be charged. Having spent years investigating numerous insider trading cases for the SEC when I served as Senior Counsel in its Division of Enforcement, I learned how the SEC obtains its leads, investigates its cases, negotiates settlements and prosecutes its cases. Having now worked in private practice for the last decade defending individuals in insider trading cases, I have seen these cases from both sides of the table, and have thus developed a keen insight into this area of law.
The following are some of the more frequently asked questions and answers concerning SEC insider trading investigations.
What is Insider Trading?
Insider trading, at its core, is buying or selling a security while in possession of material, non-public information about that security. While there is no statutory definition of “insider trading” under the Federal Securities Laws, the Courts through case decisions over the years have developed two theories of insider trading: (1) classical insider trading, and (2) the misappropriation theory.
The classical insider trading theory applies to company insiders who learn of the material (important), non-public information in the course of their employment, and thus owe a fiduciary duty to the company and its shareholders not to use the information for their personal benefit. A “classic” example of the classic insider trading theory is the corporate CEO who, while playing golf at the country club, tips his best friend about a better than expected quarterly earnings report that will be soon released by the company with the expectation that his friend will trade in the company’s stock and profit from the information, and that he (the CEO) will personally benefit from providing the tip, whether financially and/or personally. The CEO is the “tipper” and his friend the “tippee”. If the CEO’s friend, in turn, tips a friend of his and the friend trades, the CEO’s friend has now become a remote “tipper” and his friend a remote “tippee”. The CEO is legally responsible for all profits, or losses avoided, by all “downstream” tippers and tippees.
The misappropriation theory generally applies to outsiders of the company who typically learn of the subject material, non-public information in the course of their employment, and who owe a fiduciary duty to someone other than the company itself not to use the inside information for their personal benefit. An example is a lawyer at a law firm who represents a party to a corporate takeover who learns of the transaction in the normal course of his duties and who then trades in the target company’s stock. By virtue of using the inside information to trade for his own personal benefit, the lawyer has breached his fiduciary duties to his law firm and its client, and has acted deceptively in connection with a securities transaction.
The reality is that insider trading, while at first blush a very simple concept to grasp, is actually very complicated and nuanced – a true “grey” area. The Federal Courts, as much as they may have tried, and try, to bring clarity to this area of the law, often tend to make the law even more confusing and unclear. This fact, however, often provides ammunition in defending insider trading cases, as it makes the SEC’s task in investigating and successfully prosecuting these typically circumstantial cases even more difficult.
What are the Consequences of Insider Trading? Can I Really go to Jail?
There are both civil and/or criminal consequences that may flow from an insider trading charge. Insider trading can give rise to civil liability under the federal securities laws, as well as to criminal liability under the relevant federal criminal laws — yes, you can go to jail. It is important to know that the SEC, a civil federal law enforcement agency, does not possess criminal powers. While it has the ability to refer cases to the criminal authorities for investigation and ultimate prosecution, it alone cannot criminally prosecute an individual.
The SEC possesses certain civil remedies in an insider trading case, which consist of a court ordered injunction against future violations of the anti-fraud provisions of the federal securities laws, disgorgement (the return of all profits realized or losses avoided), including pre-judgment interest on that amount, and a civil penalty, which in a settled case is usually the amount of the disgorgement. For those individuals who hold a securities brokerage or investment advisory license, the stakes are even further raised — potential remedies could involve a suspension or permanent bar from the securities industry in all capacities.
There is also criminal exposure. While most SEC insider trading cases do not get referred or otherwise prosecuted by the federal criminal authorities, some do. (For an analysis on the recent wave of criminal insider trading prosecutions involving hedge fund managers on Wall Street, you can listen to my interview on the Voice of Russia on this subject, which is on my website: www.securitiesfrauddefense.net). Insider trading is a criminal offense and is punishable by incarceration. Thus, in defending any insider trading investigation, even when it solely involves the SEC and there is no indication that the criminal authorities are involved and/or interested, SEC defense counsel must always be vigilante in protecting the client’s interests by ensuring that no steps are taken in the SEC case that could potentially, without some underlying strategic rationale, increase the likelihood of a referral to the criminal authorities by the SEC, or make the case less defensible in the event the criminal authorities take interest.
Where Does the SEC Get its Leads on Insider Trading Cases?
The SEC has many and varied sources of leads for its insider trading investigations. These include, but are not limited to, market professionals, anonymous calls, press reports, disgruntled employees, and whistleblowers. Perhaps the most critical source of insider trading investigation leads, however, originate from market surveillance, either from the SEC’s own proprietary technology, or from FINRA, a self-regulatory organization, which provides reports and referrals to the SEC.
How Does the SEC Conduct Its Insider Trading Investigations?
The SEC generally follows the same protocol when investigating insider trading cases. Upon receipt of a tip or referral, the SEC will typically review the targets’ trading records and become familiar with the time-line of events leading up to the corporate announcement that triggered the trading. Quite often, the SEC will then make what is known as an “ambush call” – an unannounced telephone call to the target trader to ask why he traded in the particular stock. The SEC makes this ambush call with two attorneys present (one to take notes) and often aggressively seeks to lock in the story of the trader when he is not only unrepresented by legal counsel, but also is totally unprepared for, and often taken off-balance by, this out-of-the blue inquisition. This technique is often quite effective for the SEC as most individuals will talk and, in certain circumstances, either lie or take untenable positions that will come back to haunt them.
In the event the target trader’s story is unpersuasive, the SEC will then typically
seek either voluntary cooperation, or will obtain subpoena power to compel the individual to appear for sworn testimony and to produce certain documents. The SEC will often subpoena the following documents from an individual: (1) trading records, (2) bank records, (3) diaries and day planners, (4) telephone records, cell phone records and text messages, (5) electronic mail and (6) any documents that may explain the reason for the purchase or sale of the subject stock. After receipt and review of these records, the SEC will then compel the trader to appear for sworn testimony (questions and answers under oath) at an office of the SEC, during which time the trader will be asked about all facets of his securities trading history, relationships (if any) with corporate insiders or those who may have possessed advance news of the corporate event, the reason(s) for buying or selling the security and whether he talked to (tipped) anyone else about the securities transactions. Legal counsel is permitted to attend the sworn testimony session with his client, and is able to ask questions of his client, object to preserve privileges, seek clarification where appropriate and, most critically, protect the client’s interests during the testimony.
Beyond speaking with the trader, the SEC will likely speak to others during their investigation, including financial advisors for the trader, corporate insiders and those who knew of the inside information and had a relationship, either business or personal (or both), with the trader. Additionally, SEC will often obtain from the company whose stock was traded a detailed written chronology that lays out in detail the history of the subject transaction, specifying who knew about the inside information, when they knew it, how they learned of it, and to whom they disclosed the information. The SEC will analyze this document and compare it with the list of those individuals or entities that traded in the stock prior to the announcement to establish a short list of those who received, or likely received, tips of the material, non-public information and traded upon it.
Once the SEC has completed taking testimony and has obtained and reviewed all relevant documents, it will then engage in the process of making charging decisions – who should or should not be charged. Quite often, the SEC staff will bring in SEC trial counsel for her evaluation and assessment of the strengths and potential risks of the case. In the event the SEC staff determines not to bring charges and assuming a subpoena has been issued to the target trader, the SEC should (but does not always) send a letter to the target trader’s legal counsel advising that the SEC does not presently intend to recommend charges, but that it could at a later time. This “hedged” position is as good as it gets from the SEC and is the best (and really only official) indication that no charges are likely to be filed.
If the SEC staff concludes that it has sufficient evidence to prove an insider trading charge, it will then issue what is known as a Wells Notification – usually a written letter advising that it intends to recommend fraud charges against the target trader and seek disgorgement, pre-judgment interest, a civil penalty and an injunction against future violations of the anti-fraud provisions of the Federal Securities Laws, namely section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder. The target trader then has an opportunity to respond to the proposed charges, either in a written and/or oral submission, explaining why the SEC is wrong in its assessment of the case. This “Wells” process is designed give the target a chance to convince the SEC staff that they got it wrong before a complaint is filed in Federal Court, a press release is issued and the target’s name is infamously splashed across the Internet and the SEC’s Website causing irreparable personal, business and reputational harm. I have had success at the Wells stage in convincing the SEC staff not to pursue charges, although it is a tough task, particularly after considerable resources have been invested in the investigation and because of the highly fact-intensive, circumstantial nature of insider trading cases in particular.
If the SEC staff is not persuaded at the Wells stage, and the case is not settled, the SEC staff will seek authority from the SEC Commission, which is typically granted, to file a complaint in Federal Court. The target trader then becomes a named defendant in the case and, like any other litigant before a court, has the ability to defend the case, take depositions, seek documents and records from the SEC, and have the case heard by a jury. While certainly a stressful and expensive proposition to battle an agency of the Federal Government, insider trading cases (absent recordings or other direct compelling evidence against the defendant) are very difficult for the SEC to prove at trial, even with the applicable, lesser civil burden of proof (preponderance of the evidence), and thus it is not surprising that there have been some notable wins by traders and/or tippers in these SEC insider trading litigated cases.
Do I Talk to the SEC or Assert My Fifth Amendment Constitutional Right Against Self-Incrimination During the Investigation?
Whether you talk to the SEC – voluntarily or pursuant to a SEC Subpoena in formal testimony — or opt to assert your Constitutional Fifth Amendment Right against self-incrimination, is typically one of the most, if not the most, critical, strategic questions that must be decided during a SEC insider trading investigation. While every individual has the right to exercise his Fifth Amendment Right to refuse to answer questions on the grounds that it may tend to incriminate him, there is a potential significant cost for doing so in a SEC inquiry. Unlike in the criminal context, the SEC is legally entitled to take a negative inference, both in court and during the investigatory stage, if an individual asserts the Fifth Amendment. Practically, this means that if you are the focus of an insider trading investigation and you assert the Fifth Amendment, you will likely be facing an SEC enforcement lawsuit. In other words, if you take the Fifth, odds usually are that you will be charged. The consequences of this decision become even greater for securities licensed professionals (financial advisors and investment advisors, for example) who may also face suspensions or permanent bars from the securities industry as a result of facing SEC insider trading charges.
On the other hand, if one speaks and makes false statements to the SEC during the course of an official SEC investigation, it can be a criminal offense. The decision, therefore, whether or not to talk to the SEC or assert the “Fifth” is a highly complex, factually intensive evaluation that legal counsel and client must make together, taking into account several considerations, both legal and practical.
Be Careful – Very Careful — During an SEC Insider Trading Investigation
Those under investigation by the SEC need to be very careful about what they do, with whom they speak and the subject matter about which they speak during an SEC insider trading investigation. The SEC will investigate and seek discovery about communications, orally and/or electronically, the target has had with other relevant witnesses after the trading took place, as well as after the SEC initiated its investigation and began making telephone calls and issuing subpoenas. Thus, there are a few guidelines a target should be sensitive to when under investigation to ensure that he does not unwittingly commit what I call “process violations” during the course of an SEC investigation – meaning violations of law (i.e. obstruction of justice, witness tampering or perjury) that are collateral to the underlying insider trading being investigated. For a more in depth read on this subject, I refer you to my published article entitled “When the SEC Comes Knocking: What to do When Faced with an SEC Enforcement Investigation”, which is available on my website: www.securitiesfrauddefense.net.
The following considerations should not be construed as legal advice, as each case is unique, but rather should be viewed as general observations to which a target should be sensitive while an SEC investigation is ongoing.
First, generally speaking, the target trader should not speak with anyone except their attorney about the investigation. Conversations with counsel are, with minor exception, legally protected communications under the attorney-client privilege. This is not the case for conversations with others, particularly including those who may have participated in the insider trading transaction and/or may have knowledge of it. Those conversations are fair game for the SEC and, inevitably, the substance of those conversations will be the subject of questioning by the SEC, particularly those that occurred after the trading took place. Typically, there is no upside to disclosing the substance of these conversations and, quite often, the content of the conversations are either incriminating, may appear to be incriminating, or may suggest efforts to either alter or influence testimony – a basis for an obstruction of justice charge. Quite often, the best course of strategy is simply to stop talking (except to your legal counsel). Silence is usually golden.
Second, all documents should be preserved, not altered or destroyed. This includes paper documents as well as electronic communications. In testimony, the SEC will also question in detail the target about whether a diligent search of his records has been made, what type of search was made, and whether any documents called for by the subpoena have been altered, destroyed or otherwise disposed of. Improperly destroying or deleting relevant and material documents is potentially criminal and may lead to criminal charges. Lying to the SEC about altering, destroying or otherwise disposing of relevant documents called for the SEC Subpoena is also criminal.
Incredibly, there have been several cases where individuals who were under investigation by the SEC for insider trading went to jail — not for insider trading — but rather for “process violations” made during the course of the insider trading inquiry.
What the SEC Considers in Assessing the Strength (or Weakness)
of a Potential Insider Trading Case
In evaluating the relative strengths and weaknesses of a potential insider trading case, the SEC will closely examine the following:
- How strong is the evidence establishing a link between the target trader and a source of the inside information? In other words, what evidence does the SEC possess to establish that the target trader either was tipped by an insider, a remote tipper or misappropriated the information for his own personal gain? This is the most critical of considerations by the SEC in assessing a potential case. While absent direct proof like an incriminating tape recording of the trader, a damaging electronic communication or a cooperating witness, which are rare in SEC cases (with the exception of the recent wave of criminal insider trading prosecutions), the SEC usually must rely upon circumstantial evidence to establish this link. In so doing, it will evaluate, among other factors, the timing of telephone calls and other forms of communication between the trader and those who possessed the material, non-public information, as well as physical meetings between those individuals that may have taken place prior to the trading.
- What was the proximity in time between the trading and the public announcement? The closer in time typically supports a stronger inference that the trader received timely and accurate inside information, whereas the larger in gap in time between the two events may, depending upon when the inside information became known, make a case more difficult for the SEC to prove.
- Had the trader previously traded in the stock, or whether this was a one-time event? A history of trading in the stock may make it more difficult for the SEC to prove its case, as a trading history provides alternative theories as to the reasons for the subject trades. Did, for example, the target trader historically buy or sell the stock in advance of quarterly earnings attempting to speculate on rumors or stock bulletin board chatter, and/or was his history of trading based upon research and long-standing knowledge of the company’s fundamentals? In either case, the trader then may have a rational, credible and legal basis upon which to explain his trading.
- How much money did the trader put at risk on the trade? Quite often, the more invested relative to the trader’s financial means, the stronger the inference by the SEC that the trade was based upon material, non-public information. For example, an individual with a liquid net worth of $3.5 million who purchases $5,000.00 of the subject stock makes for a much less compelling case than an individual with a $50,000.00 liquid net worth who buys $50,000.00 of the stock, and then utilizes margin to purchase even more.
- In what securities account(s) were the trades made? If the subject trades are placed in an account not in the name of the trader, or through an entity for which the trader does not appear on the papers, this will likely cause the SEC to believe that there was an attempt to hide the trading and the individual’s identity behind the trade – evidence, in the SEC’s view, of fraudulent intent. This holds particularly true if a new account was opened (not in the trader’s name) for the sole purpose of making the subject trades.
- Were options, calls or puts, used? The SEC will closely examine whether options were utilized, how far out the option expirations were and whether they were purchased in the money or out, and if so, how far out. Again, the more speculative the bet — particularly with an options play that requires a significant move in the stock within a very limited window of time — the more the SEC will view it with a jaundice eye.
- How credible is the trader’s explanation for the suspect trades? When the SEC takes the testimony of the trader, the SEC staff will carefully consider the trader’s explanation as to why he purchased or sold on the particular day(s) that he did. Beyond taking into consideration those factors set forth above in 1-6, the SEC staff will also make a very basic determination of whether they believe the trader, which is often nothing more than a credibility judgment call by the SEC staff.
My Experience Defending SEC Insider Trading Investigations
In my years of experience defending insider trading investigations throughout the nation, I have found that understanding how the SEC investigates its cases, and in particular knowing what it views as critical weaknesses in a potential case, can be the difference between whether an investigation dies on the vine or is taken to the next level and pursued in Federal Court. My job as SEC defense counsel is to highlight those fatal flaws in the SEC’s insider trading theory — whether it be credible alternate explanations for the trading, prior history of the same or substantially similar trading patterns or inconsistencies in the time-line between the leak of information and the trading — to ensure that the investigation is ultimately dropped. Having been an “insider” at the SEC’s Enforcement Division, I obtained the invaluable insight and knowledge that now provides me the ability to successfully defend my clients in SEC insider trading cases.