Few events in life trigger immediate panic like receiving a SEC subpoena or getting an unannounced call from the staff of the SEC’s Market Abuse Unit asking about a particular stock trade you made, whether recently or years ago.
These investigations typically originate with an invisible trigger: an automated algorithm at FINRA or the SEC that flags a well-timed, profitable trade shortly prior to a major corporate announcement, whether it be an acquisition, merger or a surprise quarterly earnings result. In my experience both as a former sec enforcement attorney when I investigated insider trading cases, and now as a sec defense lawyer having defended such investigations over the last 25 years, I have found that short-term options trades, especially when they are structured significantly out-of-the money, are particularly susceptible to being flagged by the algorithm.
While algorithms can certainly detect suspicious trades, as well as highly suspicious trading patterns, it has its limits. Meaning it cannot — alone — prove that illegal insider trading actually took place. Rather, it merely provides a lead for the SEC Enforcement Division to potentially investigate. The SEC thus still must prove by clear and convincing evidence that the trade was made while in possession of material, non-public investigation obtained in breach of a duty, as opposed to being a legitimate, bona fide investment decision based upon market considerations, like stock price, prior trading history, industry events and/or valuation considerations.
The consequences flowing from an SEC insider trading inquiry can often be life changing. In insider trading enforcement actions (all of which are public), the SEC Commission routinely seeks the return of any profits made or losses avoided (known as disgorgement), prejudgment interest, a civil penalty up to three times the disgorgement amount, an officer and director bar (whether permanently or for a period of time) and a permanent injunction against future violations of the federal securities laws. Professional reputations are likely to be shattered, and high-level executive positions may be lost. Still worse, the SEC can refer the case to the Department of Justice (DOJ) for criminal investigation and ultimately, criminal prosecution, which may result in jail time.
The Defense Strategy: Dismantling the SEC’s Prosecution Theory
To successfully prosecute an insider trading enforcement action, the SEC must prove that the trader possessed Material Non-Public Information (MNPI) when he executed the targeted trade(s) in breach of a fiduciary duty and with the intent to deceive or defraud (known as scienter).
A defense strategy comprises three rigorous phases:
- The Forensic Email and Text Review: As SEC defense counsel, it is critical to understand what the paper trail of communications about the trading, to the extent it exists, looks like. Why? Because the SEC will likely gain access to the same electronic and digital data, and thus it is critical to reconstruct what it will see and thus know. Such a review necessarily involves a comprehensive internal review of all relevant communications, including social media channels, emails, and text messages, often spanning months to years. The objective is to reconstruct what the trader knew, if anything, and when he knew it.
- Establishing a Basis for a Legitimate Rationale for the Targeted Trades: Carefully reviewing and analyzing personal brokerage statements to understand trading history is critical in establishing whether the subject trade was, or was not, potentially problematic. Given that an algorithm’s scope is often narrow and focused upon an isolated transactional event within a finite time period, it cannot account for prior trading history that may be perfectly consistent with the trade currently under the SEC’s microscope. For example, if the trader had a history in speculating on earnings announcements in the same company’s stock, sometimes guessing right and making money, and others getting it wrong and losing money, and absent any persuasive evidence that he possessed MNPI, the SEC’s case is likely dead.
- Thorough SEC Testimony Preparation: SEC investigative testimony is often a grueling, multi-hour under oath interrogation where every word is recorded subject to penalty of perjury. Yet, it is arguably the most critical phase of the investigation where the SEC staff can assess the trader’s credibility, often in person. I therefore put each of my clients through rigorous mock sessions where I assume the role of a SEC enforcement attorney (the role I played in real life when I investigated potential insider trading as a SEC staff attorney and thus know how to do it well), ensuring the client can clearly and credibly articulate the rationale for his trades, as well as anticipate and competently respond to the SEC’s likely, difficult questions.
The Resolution: Total Vindication
If the strategy is successful, the SEC Division of Enforcement concludes its investigation and formally issues a “no-action” letter. You can see multiple examples of my “no-action” letter successes for my clients on my website here: https://www.securitiesfrauddefense.net/recent-successful-results/. Several are insider trading investigations. In those cases, the probe was closed, and the financial impact to the client was $0 in penalties and $0 in disgorgement. Most importantly, because the investigation was closed during the non-public phase of the investigation, the matter never became public, and thus reputations and professional licenses were saved.
Key Insights for Individuals Facing Regulatory Insider Trading Scrutiny
If your trading activity becomes the focus of an SEC or DOJ inquiry, remember this:
- The SEC Is Often Beaten by Careful and Thorough Preparation: As explained in detail above, algorithmic suspicions are not evidence, merely a lead. A strategic defense that presents supported, credible exculpatory narrative can effectively kill an investigation before it gains destructive momentum.
- Never Go It Alone: Speaking directly to SEC investigators without experienced defense counsel is the most common way an individual inadvertently compromises, often irreparably, his defense. SEC staff are generally smart, sophisticated, and experienced, and will use your words against you in a subsequent civil prosecution. They can also share the information you provide, including incriminating statements, to the DOJ for use in a criminal prosecution.
- Rely on former SEC enforcement lawyers: Defending against the SEC requires a deep understanding of how enforcement attorneys think, how they build their case, and how they investigate. Former SEC defense lawyers, armed with such insight, are thus in a better position to effectively defend an insider trading investigation and successfully cause it to be closed without enforcement action.
If you are under SEC investigation, or have just received a SEC subpoena, call David Chae now toll-free at 800-760-0912 for a confidential consultation to start the process of formulating a defense strategy to protect your legal rights and financial interests.
