Thursday, March 15, 2007
The SEC is unleashing its insider trading cases with near abandon, filing and settling a case against the former CFO of a company who was working there as a consultant when he got wind of an impending takeover. Melvyn C. Goldstein was CFO of Del Laboratories, Inc. until he retired in 1997, and he returned at the end of the quarters to help out the finance department (see SEC complaint here). In 2004, he figured out that Del was in the process of being acquired by another company, and he bought shares a week before the announcement, realizing a $38,000 profit. As part of the settlement, he will disgorge his profits and pay a one-time penalty plus interest, totaling $81,498.31, according to the Litigation Release (here). The SEC Enforcement Division's current push on insider trading cases means that they will pursue even the small ones. (ph)
Saturday, March 10, 2007
Two former CEOs will be headed to court in March to face charges related to their tenure at the top of large, publicly-traded companies. First, Lord Conrad Black, former CEO and controlling shareholder of newspaper publisher Hollinger International, Inc. -- now the Sun-Times Media Group -- faces charges along with three former company executives related to looting the company. The indictment (here) alleges mail and wire fraud, money laundering, and perhaps most ominously for Lord Black, RICO related to a series of deals in which he received substantial payments that the government alleges essentially stolen from the company. The trial is set to start on March 14 in U.S. District Court in Chicago, and may last up to three months. A Bloomberg story (here) provides a good overview of the case.
Out in Denver, former Qwest CEO Joseph Nacchio faces 42 counts of insider trading related to his sales of company stock that netted him over $100 million shortly before the share price collapsed. While Qwest had significant accounting problems, federal prosecutors brought an insider trading case rather than a broader securities fraud case of the type seen in the Enron and WorldCom prosecutions. The allegations against Nacchio focus on his knowledge that Qwest's financials were deteriorating over the five months of 2001 when he sold the shares. Insider trading charges will avoid much of the accounting minutiae that has bogged down other trials. One aspect of the defense has been the claim that Nacchio was privy to secret intelligence contracts that could bolster Qwest's revenue, and there has been an ongoing issue with discovery under the Classified Information Procedures Act, as discussed in a Denver Post story (here). Like most securities fraud cases, including insider trading prosecutions, the issues in the trial set to start March 19 in the U.S. District Court in Denver revolve around Nacchio's intent, whether his trading was motivated by knowledge of impending financial problems at Qwest, so that he sold to avoid substantial losses. (ph)
Friday, March 9, 2007
Able Laboratories, Inc., which made generic drugs, collapsed in 2005 due to improper manufacturing procedures at its New Jersey facility, and now a former vice president and three former chemists at the company have been charged. The three chemists agreed to plead guilty to conspiracy to distribute adulterated and misbranded drugs, while Shashikant C Shah, who was Vice President of Quality Control, Quality Assurance and Regulatory Affairs, entered his plea to conspiracy to commit insider trading and selling the adulterated/misbranded drugs. The SEC also filed a civil insider trading case against Shah, and its Litigation Release (here) describes his trading:
The Commission's complaint alleges that on eight separate occasions from August 2003 through December 2004, Shah acquired an aggregate of 58,000 shares of Able's common stock by exercising employee stock options, and in each case sold the securities either immediately thereafter or within a few days. According to the complaint, at the time he engaged in these transactions, Shah was aware that Able was concealing from the U.S. Food and Drug Administration (FDA) problems with the quality control testing of Able products that resulted in the public release of drugs failing to meet established quality control standards. Shah reaped $909,000 in ill-gotten gains as a result of his unlawful trading. In May 2005, Able's common stock price fell more than $18 per share, or 75%, in one trading day, after Able discovered faulty testing practices of the type Shah had known about, and the company suspended all product shipments. Able's stock price continued to fall in the ensuing months, and the company eventually declared bankruptcy in July 2005, selling substantially all of its assets five months later.
Prior to its collapse, Able Laboratories employed 500 people and manufactured generic drugs to treat cardiac and psychiatric problems. (ph)
Friday, March 2, 2007
Having been roundly criticized on Capitol Hill for perceived softness on insider trading, the SEC and U.S. Attorney's Office for the Southern District of New York announced a set of indictments and civil fraud charges related to two insider trading schemes, involving a total of thirteen defendants, that allegedly netted over $8 million in total profits. The trading involved tipping from insiders at securities firms, including information from an attorney at Morgan Stanley's compliance office -- the very place at the firm charged with preventing the misuse of confidential information. The Morgan Stanley trading involved information about pending corporate deals in 2004 and 2005, and the lawyer, Randi Collotta, was charged along with her husband, Christopher, who is also a lawyer. The other set of trading involved tipping by Mitchel Guttenberg, an executive in the institutional client department at UBS, who sold information about stock analyst upgrades and downgrades before their announcement. A press release (here) from the Southern District of New York prosecutors provides a handy table listing the various conspiracy and securities fraud charges, and four defendants have pleaded guilty. Nothing quite gets the attention of Wall Street -- and Congress -- like a good insider trading saga, and this one will certainly draw notice with two major investment firms involved. (ph)
Wednesday, February 28, 2007
The SEC brought an emergency action against a Hong Kong company, Blue Bottle Ltd., and its named owner, Matthew C. Stokes, for alleged insider trading. The SEC's complaint (here) asserts that Stokes (or others) obtained advanced information about company announcements by hacking into computer networks to view press releases and other documents shortly before the information was released into the market. They are accused of trading in advance of the information by buying or shorting the securities of twelve companies to take advantage of the effect of the news on the stock prices, reaping profits of approximately $2.7 million. The trading took place in January and February 2007, and it appears that Stokes is only a front name on the account. The SEC Litigation Release (here) describes the most lucrative trading before the release of negative earnings news:
[W]ith respect to the defendants' trading in Symantec, the complaint alleges that on January 12, 2007 at approximately 1:03 p.m. EST, the defendants began buying 10,000 SYMC Jan07 20 put contracts, which represented 20 percent of the total trading in that security for the day. Those contracts were out-of-the money when purchased. Later that same day, at approximately 1:37 p.m. EST, the defendants began buying 500 SYMC Jan07 22.5 put contracts, which represented 41 percent of the total trading in that security for the day. All of the put contracts were to expire on January 20, 2007. Essentially, buying the put options was a bet by the defendants that the price of Symantec stock would decrease. The Commission further alleges that on the next trading day, January 16, 2007, at 7:48 a.m. EST, Symantec issued a downward revision of its third quarter 2007 earnings and revenue forecast. Shortly following Symantec's announcement, the defendants began selling the put contracts, amassing a profit of $1,030,471.
Not a bad profit on an investment made for only a couple days, at most. From the SEC complaint, it appears that approximately $1.6 million is still in the U.S., while about $1 million has joined Elvis in leaving the building. The Commission likely moved now to keep the money here, and will have to continue its investigation of the source of the well-timed trades through civil discovery. This kind of trading is sure to draw the interest of the Department of Justice. The U.S. District Court for the Southern District of New York froze Blue Bottle's assets and ordered a hearing for March 7, although any individuals who might want to claim the money are unlikely to show up and risk an immediate arrest on criminal charges. (ph)
Friday, February 23, 2007
Just in time for the end of Carnival, two Brazilians settled an SEC insider trading civil suit arising from purchases in the target of an impending tender offer. The defendants are Luiz Gonzaga Murat was the chief financial officer and investor relations director at Sadia S.A., a Sao Paulo frozen food company, and Alexandre Ponzio De Azevedo, who formerly worked for ABN AMRO's Brazilian affiliate. Sadia planned a tender offer for Perdigão S.A., another Brazilian company, and ABN AMRO's investment banking unit advised on the deal. According to the SEC's Litigation Release (here):
[O]n April 7, 2006, representatives of an investment bank met with Murat and another Sadia executive to propose that Sadia make a tender offer for Perdigão. According to the complaint, Murat proceeded to purchase American Depositary Shares ("ADSs") of Perdigão both later the same day and subsequently on June 29, 2006, on the basis of material, nonpublic information concerning the proposed acquisition, and in breach of a duty of trust and confidence he owed to Sadia. The complaint alleges that Murat's holdings totaled 45,900 ADSs of Perdigão by the time Sadia announced the tender offer. On July 17, 2006, the price of Perdigão ADSs increased to $24.50, up $4.25 (21%) from the previous closing price. According to the complaint, Murat had imputed illicit profits of $180,404 from his unlawful trading.
The Commission's complaint against Azevedo alleges that he learned of the possible tender offer on April 11, 2006, in his capacity as an employee of ABN AMRO assigned to the tender offer financing team, and that ABN AMRO later placed Perdigão on a list of securities in which ABN AMRO employees could not trade. According to the complaint, Azevedo subsequently purchased 14,000 ADSs of Perdigão on June 20, 2006, on the basis of material, nonpublic information concerning the proposed acquisition, and in breach of a duty of trust and confidence he owed to ABN AMRO. Azevedo sold 10,500 ADSs on July 17, 2006, one day after Sadia had publicly announced its tender offer for Perdigão. According to the complaint, Azevedo realized illicit profits of $52,290 on the 10,500 ADSs he sold on July 17 and had imputed profits of $14,875 on his remaining 3,500 ADSs.
Murat agreed to pay $184,028 in disgorgement and a civil penalty of $180,404, while Azevedo will pay $68,215.45 and a civil penalty of $67,165.
An interesting aspect of the case is that neither defendant ever set foot in the United States in connection with the transaction, and none of their trading involved an American company or even any communications that passed through the U.S. The jurisdictional hook is the securities of each company, which are traded on the New York Stock Exchange as ADS. Under Section 10(b) of the Securities Exchange Act, the general antifraud prohibition applies to any person who "directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . ." The fact that the securities of the target trade on the NYSE brings the case under the Act, although it is a fair question whether conduct wholly outside the United States with only a tangential connection to this country should be subject to a civil enforcement action by the SEC. The trades were placed in Brazil, and the companies were incorporated and operated there, but the transaction ultimately occurred in New York, bringing it into the SEC's cross-hairs. The case shows the long arm of the insider trading prohibition. (ph)
Friday, February 9, 2007
Federal prosecutors and the SEC filed criminal and civil insider trading charges against a father, two of his sons, and a family friend for transactions in the securities of the company where the father was an executive and later in companies retaining the accounting firms of one son and the friend. The defendants in the criminal case, who entered guilty pleas, are Zvi Rosenthal, who was a vice president of Taro Pharmaceuticals Industries, Inc., his sons Amir and Ayal, and Amir's childhood friend, David Heyman. The SEC suit also alleges insider trading by Oren Rosenthal, Zvi's third son, Amir's father-in-law, and Amir's supervisor. Ayal worked at PricewaterhouseCoopers, and Heyman worked at Ernst & Young. They admitted tipping Amir about pending mergers before the public announcement of the transactions, and Amir in turn tipped his supervisor. The SEC Litigation Release (here) describes the insider trading at Taro Pharmaceuticals:
In its complaint, the Commission alleged that Zvi Rosenthal, a Vice President at Taro, abused his position at Taro by systematically stealing material, nonpublic information concerning 13 separate company announcements, including earnings results and pending generic drug approvals by the Food and Drug Administration. Zvi then traded on the information and passed it on to his family members who then traded in Taro stock and options. Typically, Zvi provided information to his son, Amir Rosenthal who traded in personal accounts he controlled, and in the account of the family- owned and controlled hedge fund, Aragon Partners, LP.
The Commission alleged that the gains and losses avoided total $3.7 million over a period from 2001 to 2005. In addition to managing the family hedge fund -- which seems to be another way of saying he managed the family's investments -- a press release issued by the U.S. Attorney's Office for the Eastern District of New York (here) states that Amir is an attorney in New York City. According to court records, there is an attorney with the same name admitted to practice in New York in 2006 after graduating from a New York area law school. An AP story (here) states that Zvi Rosenthal has a prior fraud conviction, which means his sentence may be higher if the court applies the Federal Sentencing Guidelines' criminal history provisions. (ph)
Thursday, February 8, 2007
The SEC filed a civil insider trading case against Donald A. Erickson alleging that he bought call options in Magnum Hunter Resources, Inc. (MHR) while the company was negotiating a possible merger. At the time of the trading in January 2005, Erickson was a director and chairman of the company's audit committee. In that role, he was responsible for ensuring that MHR had the requisite internal controls, and so likely was aware of the prohibition on insider trading. According to the SEC's Litigation Release (here):
In its complaint, the Commission alleges that in late December 2004, Donald A. Erickson, while serving as audit committee chairman and a director of MHR, purchased MHR call options during the time MHR was exploring a possible merger or sale of the company. The complaint alleges that Erickson was briefed regularly on the status of negotiations and participated in key decisions regarding the Cimarex deal. The complaint also alleges that in mid-January 2005—just two trading days before the public announcement of the merger, and one day after he attended a board meeting addressing the status of negotiations with Cimarex—Erickson exercised his call options and acquired 30,000 shares of MHR stock. According to the Commission, Erickson purchased and exercised the options based on material, nonpublic information about MHR’s merger negotiations and, ultimately, the Cimarex deal.
The Commission also alleges that Erickson's Form 4 (here) filed in connection with the option purchase was false because it did not disclose the actual date of the transaction, instead listing it as occurring on January 31, 2005, after the announcement of the deal. (ph)
Tuesday, January 16, 2007
The Wall Street Journal reports (here) that the New York Attorney General and the SEC are looking at whether consulting firms that use reports from corporate employees may have been passing inside information about the companies to hedge funds and other traders. The firms, Gerson Lehrman Group and Vista Research, retain large numbers of consultants, including employees of publicly-traded companies, to report on trends in their industries. According to the Journal, the New York AG's office issued subpoenas to the firms and some hedge funds, and the SEC also has requested information from hedge funds that received reports from the consultants.
An interesting question will be whether the information supplied by a corporate employee acting as a consultant will meet the standard of "materiality" for an insider trading case. While the consultants may breach a fiduciary obligation to their employers by sharing private information, especially if they're paid and don't receive permission to do so, it is not entirely clear that the tidbits of information passed on is material to a particular company. A report on industry trends may not pertain to one company any more than another, and aggregating a number of reports from different parts of a company is unlikely to be material until the analyst (or hedge fund) puts it all together. Absent unauthorized disclosure of significant corporate information, the consulting arrangements might be little more than a source of information on a par with government and media reports of consumer trends. The Supreme Court expressed considerable skepticism in Dirks v. SEC, 463 U.S. 646 (1983), about the application of the insider trading prohibition to analysts who gather and interpret information, even when that information comes from a private source.
The presence of the New York AG's office shows that it has not slowed down since Eliot Spitzer moved up to the Governor's office, and the competition with the SEC may be continuing. (ph)
Wednesday, December 6, 2006
The continuing Congressional interest in the SEC's insider trading investigation of money management firm Pequot Capital came up in yet another hearing before the Senate Judiciary Committee. The actual investigation has been closed by the Commission without any securities fraud charges being filed, but the conduct of the investigation and treatment of a former SEC attorney, Gary Aguirre, continues to fascinate Senators Arlen Specter and Charles Grassley. Aguirre was terminated from his position in September 2005, and claims it was the result of issues he raised about alleged political pressure put on the Enforcement Division not to subpoena Morgan Stanley CEO John Mack about his contacts with Pequot at the time of suspicious trading by the firm. Four current and former SEC supervisors testified that there was no political pressure to stop the investigation, but an e-mail (here) from another SEC supervisor at the time of Aguirre's termination said that "[s]omething smells rotten" regarding the failure to pursue the Pequot investigation.
Insider trading investigations can be difficult to pursue if the trades were by a company that engages in thousands of transactions, and the amount of the gain is small compared to the value of the investment fund. The Pequot case is unlikely to be revived because the SEC eventually took the testimony of Mack, who undoubtedly denied tipping. Circumstantial cases are difficult to win, and the investigation on Capitol Hill is facing the same problem when each side points fingers at the other without clear evidence to support the position of either. (ph)
Saturday, December 2, 2006
The SEC is usually quite closed-mouth about its investigations, at least before the filing of a civil enforcement action. When it gets into a fight about enforcing one of its subpoenas, however, the veil is lifted. Unlike grand jury subpoenas, which are presumed valid and can result in a contempt order if the recipient refuses to comply, administrative subpoenas are not self-enforcing and the agency must demonstrate the legitimacy of its investigation and the need for the information. An SEC Litigation Release (here) discusses a subpoena enforcement action filed in the District of Massachusetts seeking to compel David K. Donovan, Sr. and Concetta Donovan to provide documents and for Concetta to testify. The focus of the investigation is their son, David Jr., who worked as a trader at a subsidiary of mutual fund giant Fidelity Investments. The investigation concerns possible tipping by David Jr. to his father and mother about a large pending order at Fidelity, trading that is known as "front running" because the purchaser seeks to get out ahead of the large order that will likely drive up the stock price. According to the Litigation Release (which identifies the father as DKD Sr. and the son as DKD Jr.):
According to the Commission's application and supporting papers, during a period of approximately one month in July and August 2003, DKD Jr. accessed information in FMR Co.'s internal trade database about Covad stock on 44 occasions and thereby learned that FMR Co. was purchasing and intended to continue purchasing substantial amounts of Covad stock for its advisory clients. When DKD Jr. accessed FMR Co.'s internal trade database concerning Covad stock at 7:48 a.m. on August 5, 2003, for example, he would have been able to determine that FMR Co. had pending orders to buy 1,966,400 shares of Covad stock and no pending orders to sell any Covad stock. The Commission alleges that on August 5 and 6, 2003, at least four telephone calls were placed from DKD Jr.'s work number at FMR Co. to his parents' home, and within fifteen minutes of two of those telephone calls, purchases of Covad stock were placed in a brokerage account in Concetta's name. According to the Commission's application and supporting papers, from August 5 through August 7, 2003, a total of 55,000 shares of Covad stock were purchased in Concetta's brokerage account, resulting in profits in the amount of approximately $89,775.
Subpoena enforcement actions are fairly uncommon because the SEC and the recipient usually work out some accommodation without the need to go to court, which slows the investigation considerably. In this case, the Commission is complaining that the Donovans are refusing to provide documents without a valid privilege claim, and that Concetta is claiming physical problems that prevent her from testifying but will not provide any accommodation to allow the testimony to be taken. The law does not recognize a parent-child privilege, as Monica Lewinsky's mother discovered, and it does not sound like Concetta or David Sr. are asserting the Fifth Amendment privilege regarding production of documents or testimony, so the SEC appears to be in a good position to obtain an order to enforce the subpoena. (ph)
Friday, December 1, 2006
The U.S. Attorney's Office for the Southern District of California and the SEC filed criminal and civil insider trading charges against Robert Gallivan for trading in the shares of five California community banks before they were acquired. According to the SEC Litigation Release (here):
Prior to the public announcement of proposed mergers involving Valencia Bank & Trust (announced August 6, 2002), Monterey Bay Bank (announced April 8, 2003), Sun Country Bank (announced April 30, 2003), Mid Valley Bank (announced September 16, 2003) and Harbor National Bank (announced December 1, 2003), Gallivan obtained nonpublic information that each of the five banks was engaged in negotiations to be acquired.
To settle the SEC case, Gallivan paid $106,711, prejudgement interest, and a double penalty of of $213,422. Gallivan also entered a guilty plea to four counts of securities fraud. (ph)
Monday, October 16, 2006
The SEC filed a civil insider trading action against foreign purchasers of call options in CNS Inc., the maker of consumer health products such as the Breathe Right nasal strip, in advance of the disclosure that the company agreed to be taken over by GlaxoSmithKline PLC. The defendants traded through Swiss accounts by purchasing out-of-the-money CNS call options in the week before the announcement of the deal, given them a profit of over $650,000. The SEC Litigation Release (here) quotes from the Commission's complaint:
Between September 27 and October 2, 2006, Unknown Purchasers bought a total of 1186 out-of-the-money CNS call option contracts. These purchases represented approximately 67% to 100% of the daily volume of the various CNS options series on the days purchased.
The Unknown Purchasers' trading coincided with key non-public and confidential events leading up to the announcement that Glaxo would acquire CNS. Specifically, Glaxo was one of several companies contacted by investment bankers on behalf of CNS in August 2006. After Glaxo had executed a confidentiality agreement, Glaxo was invited to submit a binding offer for CNS by September 29, which it did. On October 2, the CNS Board met to review the offers, and Glaxo was informed that it was one of two finalists and that it should submit a best and final offer by October 4.
On Monday, October 9, 2006, before the opening of the New York securities markets, CNS and Glaxo announced the execution of an agreement whereby Glaxo would acquire CNS for a price of $37.50 per share - a 31% premium over the closing price of CNS stock on Friday, October 6. On the date of the announcement, CNS shares closed at $36.72 - a 28.5% increase over the closing price of CNS stock on Friday, October 6.
On October 9 and 10, 2006, following the announcement of the merger between CNS and Glaxo, the Unknown Purchasers sold the CNS options in both accounts and realized net profits of approximately $651,895.
As is common in cases involving foreign purchasers, the SEC sought a freeze order to keep the funds from leaving the United States, which was granted by the U.S. District Court for the Eastern District of Pennsylvania.
The trading in CNS call options is similar to a recurrent pattern of insider trading, particularly by foreign purchasers. In August 2005, the SEC filed against then-unknown purchasers of Reebok call options before a takeover by Adidas, a case that turned out to be part of a much larger insider trading network. More recently, in June 2006, the Commission filed suit against defendants in Argentina who purchased Maverick Tube call options before an announced takeover by Tenaris. What made the trades particularly suspicious is that the options were out of the money at the time of the purchases and had fairly short expiration dates, making them especially risky -- unless the purchaser knew that the price of the company would increase significantly due to a pending extraordinary announcement. Given the frequency with which these types of insider trading cases occur, particularly when it involves overseas purchasers, it is starting to sound like repeat episodes of Desperate Housewives. (ph)
Saturday, October 7, 2006
Allegations that senior management in the SEC's Enforcement Division quashed an insider trading investigation largely came to naught as the Commission decided not to file any civil insider trading charges in the case. Former SEC staff attorney Gary Aguirre alleged to the Senate Judiciary Committee that after he sought to take the deposition of Morgan Stanley CEO John Mack in connection with an investigation of possible insider trading at a hedge fund run by Pequot Capital Management, upper-level managers in Enforcement refused to permit the testimony and then fired him two days after giving him an outstanding performance appraisal (see earlier post here and Aguirre's statement to the Judiciary Committee here). With the glare of publicity, the SEC relented and authorized taking testimony from Mack, who was thought to be a potential source of the information about an impending transaction. As expected, the renewed investigation had little effect on the final outcome as Pequot received notice from the Enforcement Division that it will not recommend the filing of charges against the firm or any individuals. Consistent with SEC practice, the staff maintained that the investigation remains open -- essentially on the off chance that manna from heaven in the form of a confession from some unknown participant emerges. The circumstances surrounding Aguirre's dismissal remain under investigation, but it's unlikely that anything further will come out about the case. An AP article (here) discusses Pequot's disclosure that the SEC investigation into its trading is complete. (ph)
Wednesday, September 27, 2006
The SEC filed a civil insider trading case against Graham Lefford for using confidential information he gleaned from faxes about a pending deal to buy a company. The faxes were sent to the summer house he managed that was owned by Robert Sillerman, the creator of American Idol, who bought a shell company, Sports Entertainment Enterprises, Inc. (SPEA), to use it as a vehicle for licensing Elvis Presley products. Other media reports describe Lefford as the butler at Sillerman's South Hampton summer home. According to the SEC's complaint (here), Lefford signed an agreement with Sillerman to maintain the confidentiality of all business and financial information he learned while managing Sillerman's summer home in South Hampton. The SEC Litigation Release (here) states:
Lefford found out about Sillerman's acquisition of SPEA from one or more of the several deal-related documents that were faxed between Sillerman's office in Manhattan and his South Hampton residence that summer. Within minutes of faxing Sillerman's signed authorization for the SPEA acquisition back to Sillerman's office, Lefford bought 5,000 shares of SPEA stock at 12 cents per share. The price of SPEA stock shot up by over 9,000% after Sillerman's acquisition of SPEA and the Presley deal were both announced in December 2004, and Lefford made $48,525 in total profit on his $600 investment when he later sold all his SPEA stock.
While the total gain is rather small, the investment return is something that certainly catches the eye, and may have triggered the SEC's interest in pursuing the matter. The confidentiality agreement likely relieves the Commission from having to prove that the master-servant relationship, to use the traditional terminology, creates a fiduciary duty between Lefford and Sillerman to keep the information confidential. Lefford denies that he traded on material nonpublic information and is fighting the action at this point.
The same day the SEC filed the complaint, the Senate Judiciary Committee held a hearing on whether the SEC and Department of Justice are bringing enough insider trading cases. There have been a number of deals recently, many of them involving going-private transactions, in which there was suspicious trading in advance of the announcement, particularly in call options. SEC Enforcement Division Director Linda Thomsen explained in her prepared statement (here) that suspicious trading is not necessarily illegal insider trading, or at least proving it can be very difficult.
It is important to understand how difficult it is to build an insider trading case. They are unquestionably among the most difficult cases we are called upon to prove, and despite careful and time-consuming investigations, we may not be able to establish all of the facts necessary to support an insider trading charge. The challenge is not to establish facts that show suspicious trading—the surveillance records alone are often sufficient to establish that much. The real challenge is to establish that a particular individual was in possession of material non-public information and in fact traded on it in breach of a duty, and to establish those facts based on admissible evidence that can withstand challenge at trial.
Piecing together an insider trading case can be a complex and painstaking process. It is rare to find a “smoking gun;” virtually all insider trading cases hinge on circumstantial evidence. It is quite common for insider traders to come up with alternative rationales for their trading—rationales that the staff must refute with inferences drawn from the timing of trades, the movement of funds and other facts and circumstances. And because many insider trading cases involve secret communications between two people – the tipper and his tippee – assembling compelling circumstantial evidence is often difficult. In some cases, such as when a corporate insider trades on company information or when an outsider steals nonpublic information, there are no communications at all to use as evidence at trial, but only the facts of the wrongdoer’s access and trading. Building an insider trading case based on circumstantial evidence can be frustrating, risky and time-consuming. Because of these challenges, we also have to accept that a number of the insider trading investigations we open may not result in a filed enforcement action—not for any lack of diligence on the part of the staff, but for lack of evidence.
Pressure from Congress will likely trigger more investigations and perhaps even more cases, although that could result in more questionable prosecutions and civil enforcement actions. Insider trading may be easy to spot, but as Thomsen points out that does not necessarily mean it is easy to prove. (ph)
Thursday, August 31, 2006
Maybe he didn't think he was doing anything wrong, or perhaps just fell asleep at the switch, but one expects more from a CFO, so whatever caused Tom Mitchell to buy a piddling amount of stock in a company has turned out not to be worth the hassle. Mitchell was CFO of Ferguson Enterprises, a large plumbing distributor, and bought 1,454 shares of Noland Company in 2005 while Ferguson was considering making a tender offer for Noland. He bought the shares in his account and those of two sons, so if he was trying to cover his tracks he didn't do a very good job. Interestingly, Ferguson passed on the acquisition, but another company did buy Noland, and the sale of the shares netted Mitchell a profit of $35,214. He settled the SEC civil fraud case and agreed to disgorge his profits and pay a one-time penalty.
An interesting aspect of the case is that the profits were not derived from the inside information on which Mitchell traded, but on a different transaction about which he does not appear to have had any knowledge, except perhaps that Noland was "in play." The fraud in insider trading occurs when the fiduciary trades on the material nonpublic information, not when a profit is realized, so the violation of the antifraud provisions of the securities laws occurred regardless of the outcome of the trade. Mitchell may have been able to make a good argument that his profits were not from the violation, however, but just the luck of having traded on information that never came to fruition and then holding the shares as an investment. Perhaps good in theory, but probably not worth fighting over in a case that settled for less than $75,000. Accident or mistake, the trading certainly doesn't make the former CFO look good. The SEC Litigation Release (here) describes the settlement. (ph)
Wednesday, August 30, 2006
The Sixth Circuit affirmed the insider trading, conspiracy, obstruction, and false statement convictions of former Ohio State University business school professor Roger Blackwell (United States v. Blackwell here), and the case contains an important, if rather obvious, lesson in what a defendant should not do during testimony of a crucial witness. Blackwell was convicted of tipping a number of family members, friends, and colleagues about an impending purchase by Kellogg of Worthington Foods while Blackwell was a member of Worthington's board. The NASD and then the SEC began an investigation of suspicious trading in Worthington stock, and Blackwell and his wife, Kristina Stephan-Blackwell, denied tipping anyone. Blackwell, Stephan-Blackwell, and her parents testified in the Commission investigation. In fact, however, Stephan-Blackwell tipped her parents, and after she and Blackwell split up in 2003, she contacted the government and worked out an immunity deal. Not much later, another tippee, a friend of Blackwell's, worked out a similar arrangement, at which point the government indicted Blackwell and others.
At trial, Stephan-Blackwell was a key witness for the government, and during her testimony Blackwell allegedly mouthed "I hate you" to her. As recounted in the Sixth Circuit's opinion, this little tidbit appears to have been observed by three jurors and the judge, along with Stephan-Blackwell, and the government was allowed to cross-examine Blackwell about what he purportedly mouthed because the court viewed it as witness intimidation. Blackwell denied having done so, but the damage was done to his case. While Blackwell denied having tipped anyone, and offered a rather dubious "leakage theory" for how the purchasers decided to buy Worthington in advance of the Kellogg deal, the jury convicted him, perhaps in large part because he was not believable. An article published about the trial noted that the jurors who say they saw what Blackwell mouthed believed that it "destroyed his credibility" -- which is certainly not surprising. While there is something to be said for looking your accuser in the eye, communicating your feelings about her is not a particularly good idea.
The Sixth Circuit also affirmed the six-year sentence imposed on Blackwell even though he did not profit directly from the transactions in Worthington stock. (ph)
Friday, August 18, 2006
Two senior executives of DHB Industries, Inc., a supplier of body armor to the U.S. military, were arrested on insider trading, securities fraud, and conspiracy charges, and the SEC filed a civil suit alleging securities fraud. The former officers are Dawn M. Schlegel, DHB's CFO, and Sandra L. Hatfield, the chief operating officer, and the charges were filed by the U.S. Attorney's Office for the Eastern District of New York. The charges involve both accounting fraud and the sale of DHB securities that resulted in a profit of over $8 million. According to the SEC Litigation Release (here), the two defendants:
[R]egularly overstated the value of DHB's inventory by fraudulently increasing inventory quantities, labor costs, overhead costs, and the amount of raw materials used in DHB's products. The complaint alleges that together Hatfield and Schlegel also transferred millions of dollars of expenses from cost of goods sold to research and development costs to materially increase the company's gross profit. The complaint further alleges that Schlegel falsely inflated DHB's $60 million charge against earnings taken in the third quarter of 2005 to mask her and Hatfield's fraudulent conduct. Schlegel is alleged to have lied to DHB's auditors and provided fake inventory schedules and other documents to conceal the fraud.
The complaint also alleges that during the period of their fraudulent conduct, Schlegel and Hatfield collectively profited by over $8.2 million from the cashless exercise of warrants and sale of over 400,000 DHB shares. Schlegel and Hatfield sold these shares at the end of 2004 at the height of DHB's stock price and before the public knew about the misrepresentations in DHB's filings and public statements.
Last year, the military ordered the recall of one of the company's body armor products due to quality issues. Former CEO David Brooks, whose daughter's $10 million bat mitzvah party featured legendary rockers Steven Tyler and Joe Perry of Aerosmith, left the company on July 10 "pending the outcome of federal, state, and internal investigations" while DHB settled shareholder suits (press release here) Because federal prosecutors did not file any charges against Brooks at the same time as they did against Schlegel and Hatfield, it may be that he is cooperating in the investigation. Brooks made over $190 million from the sale of DHB stock in 2004, so he is a likely target of the grand jury investigation. (ph)
Wednesday, July 26, 2006
The SEC amended its complaint in the insider trading case that grew out of suspicious call option purchases of Reebok before its announced takeover by Adidas in August 2005 by adding three new overseas defendants, all with ties to Croatia: Bruno Verinac, Antun Dilber, and Anto Krsic. The case began with trading by a person identified as a retired seamstress in Croatia, and has grown into a large-scale insider trading ring involving tips from workers at the printer for BusinessWeek, an analyst at Merrill Lynch, and a member of a federal grand jury in New Jersey investigating Bristol-Myers Squibb. The three new defendants, along with three others already named, traded through accounts at Direktanlage.at AG, an Austrian bank. According to the SEC litigation release (here):
The complaint also identifies additional insider trading by the Direktanlage Traders based on newly-obtained information, bringing the total illicit gains netted by the insider trading ring to over $6.8 million. In total, the Direktanlage Traders netted over $445,000 of these illicit gains in trades placed in 17 different securities through Direktanlage based on material, non-public information stolen by a former investment banker employed at Merrill Lynch & Co., Inc., and two former employees at a printing plant where BusinessWeek magazine is printed.
A number of individuals have been charged criminally in the Southern District of New York, and the case is one the most widespread insider trading cases seen in years. (ph)
Sunday, July 23, 2006
John Mack, CEO of investment bank and broker Morgan Stanley, agreed to an SEC request that he testify in its probe of possible insider trading by hedge fund manager Pequot Capital Management, where he served briefly as chairman before becoming CEO of the investment bank a second time in 2005. The Commission investigation became a bit of a cause célèbre when Gary Aguirre, a former SEC staff attorney in the Enforcement Division, alleged that higher-ups in the Division blocked his effort to have Mack testify as part of the insider trading investigation.
Aguirre's allegations surfaced as part of a Senate Judiciary Committee hearing into hedge fund regulation, or perhaps better the lack thereof, in which his written statement (here) described, without naming names, the scope of the investigation: "By May 2005, one of the insider trading matters dwarfed all others: the hedge fund’s trading in two companies just before the announcement of a cash tender offer by one for the other at a 50% premium over the last trading price. The hedge fund profited by $18 million in 30 days. The evidence suggested that the hedge fund’s CEO acted on an unlawful tip in directing the hedge fund’s trades. But the question remained: who tipped him?" Aguirre believed it was the CEO of a major investment bank, i.e. Mack, and sought to issue a subpoena for his testimony. According to Aguirre's statement: "A high-powered attorney, Mary Jo White, bypassed the normal protocol of discussing the investigation with the assigned staff attorney. Instead, she went directly to Enforcement Director Linda Thomsen, despite the fact Director Thomsen had no prior involvement in the case. For the first time, senior staff left me out of meetings when they discussed the case." Lo and behold, the subpoena was not issued and, although Aguirre received a two-step pay increase as part of his annual review, he was terminated a little over a week later. SEC Chairman Cox has ordered the Commission's Inspector General to review Aguirre's termination, and now Mack will come in to testify.
Will Mack's testimony change the course of the investigation? I think it's highly unlikely his statement will make a difference now, or would have earlier in the case. Mack has maintained consistently that he never tipped Pequot, and SEC cases are rarely made by witness admissions unless there is powerful circumstantial evidence showing abnormal contacts and sudden, aggressive trading. Pequot is a hedge funds that makes large stock bets, and Mack is a long-time investor in the firm with close ties to its management, so any contacts with them are unlikely to be unusual. There are few "Perry Mason" moments in SEC depositions (or anywhere else for that matter), and a person of Mack's stature starts out with a high degree of credibility, so assertions that "we don't believe his denials" are unlikely to carry the day in seeking authorization to file an insider trading action against Mack and Pequot. Absent someone on the inside of Pequot who could testify about tipping -- and it's unlikely the Commission has heard from such a person -- then Mack's testimony probably will be the end of the investigation. A Bloomberg story (here) notes that he will be accompanied by Morgan Stanley's general counsel, Gary Lynch, former head of the Enforcement Division, so this will not be an unprepared witness who may be surprised by the staff's questions. I suspect the case will end quietly and the transactions will leap back into lucrative obscurity. (ph -- in the interest of full disclosure, I worked at the SEC when Lynch was head of Enforcement, but not all mistakes in hiring were his fault, especially of lowly staff attorneys)