Speech by SEC Staff:
The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
Good afternoon. Thank you Belinda for that kind introduction. Also many, many thanks to ASIC for organizing this Summer School and to everyone here for attending. I am delighted and honored to be here. I take our collective presence as a testament to our collective commitment to work together to protect investors and markets.
As I prepared for today's events, I thought about how I would be traveling nearly halfway around the world to get here (and just how long that would take). And I contrasted that with two thoughts — how much longer it took, and how much more difficult it was, for Australia's early settlers to get here on the one hand and, on the other hand, and more to the point of our gathering here, how more quickly and how more easily, information, misinformation, money and securities can now travel that same distance.
I am going to talk about the American experience with insider trading enforcement. Let me preface my remarks by saying that the views expressed are my own, and don't necessarily represent the views of the Securities and Exchange Commission, any individual Commissioner, or any of my colleagues on the Commission staff.
1. Measuring the Limits of Ambition
There is, as you can well imagine, a comparatively thin line that separates initiative and impropriety, moxie and malfeasance. The story of insider trading law in the United States is the story of how and where we draw that line, and that has made its development both illustrative of the American business temperament and highly dramatic. Insider trading lies where ingenuity, aggressiveness and ambition end — and venality, greed and unfairness begin, and charting the borders between these two realms has been a long and delicate process for American courts.
Of all financial crimes, insider trading has a unique hold on the American popular imagination. Other types of schemes are either too complex for people to understand or too mundane to excite them. But insider trading, in its most basic form, possesses all of the elements of great drama. It starts with a secret, a piece of precious knowledge that can make its owner rich. Then comes the betrayal, an individual turning away from duty toward self-enrichment. Throw some complicated personal and family ties into the mix, which, for whatever reason, are almost inevitably present in these cases. And finally, spice up the whole story with some old-fashioned detective work, since it is usually a note, a record of a telephone call, or the painstaking analysis of a mountain of trading records, that breaks the case open. These stories have beginnings, and middles, and ends, and their progress has all the rising and falling action of a good thriller. They are morality plays writ small, filled with greed and hubris. I suspect that's part of the reason why Oliver Stone's 1987 movie Wall Street, a story of a promising young businessman's seduction by insider trading, is as popular today as it was twenty years ago. Whether it's the real Ivan Boesky or the fictional Gordon Gekko, the fall of the mighty has always been one of America's favorite spectator sports.
And although the lure of insider trading crosses all areas of the economic and social spectra, it is often the mighty, the people with the least need and the most to lose, who are drawn into its web. That is the conundrum of insider trading. Blue-collar workers may dream of finding the key to quick riches, but it is those at the top of the corporate or professional ladders who most routinely have access to such valuable information, and who have the alpha personalities needed to put their schemes into operation. Whether it is arbitrageur extraordinaire Ivan Boesky, biotech CEO Sam Waksal or one of the "smartest guys in the room" at collapsed energy giant Enron, our recent legal history is liberally sprinkled with the names of CEOs, law firm partners, and other major players who succumbed to the temptation to turn their access to corporate secrets into unlawful gains for themselves and their friends, family and associates. It is these stories that fascinate so many of us. For better or worse, these become the object lessons that teach us the limits of ambition.
Take, for example, the case of James J. McDermott, Jr., former CEO of Keefe, Bruyette & Woods, at the time probably the pre-eminent investment banking house for clients in the financial services industry. Mr. McDermott ultimately was sentenced to five months imprisonment, ordered to pay over $230,000 in disgorgement and penalties, and was banned from the brokerage industry as a result of tips on impending bank mergers he passed to his lover, an adult film actress and exotic dancer, who, in turn, passed this information on to another boyfriend.1 One of America's most powerful and influential women, Martha Stewart, CEO of the media conglomerate that bears her name, and culturally omnipresent television and print celebrity, ultimately served five months in a federal prison camp after becoming embroiled in an insider trading scandal and subsequent cover-up. Ms. Stewart sold off shares of biotech company Imclone Systems after being tipped by her stockbroker that CEO Sam Waksal, awaiting a U.S. Food and Drug Administration decision on Imclone's marquee drug, was selling his holdings. In a pattern of conduct we've seen all too often, Ms. Stewart's prison time was handed out not for the trading, but for repeated falsehoods she told investigators in trying to cover up her activities.2 Just two weeks ago, the SEC brought a settled enforcement action against four Hong Kong residents who paid more than $24 million in disgorgement and penalties as the result of trading prompted by an insider tip from David Li Kwok Po, a prominent Hong Kong businessman and a member of Dow Jones' board of directors about an upcoming offer for Dow Jones by News Corp.3
It fascinates us to think: why would they do it? We can never fully know their motives (although we can take an educated guess at one of Mr. McDermott's). Clearly, it is not simply the lure of easy money, since people like this are smart, savvy and hard-working go-getters. Their drive and determination, their desire, their willingness to risk, are all qualities we want and need in our corporate leaders. Yet somehow, they went awry, they overreached. Insider trading law, and the actions of those charged with enforcing it, can be seen as an expression of society's ambivalence toward the aggressive corporate culture it values. It is the legal system's response to the question: How do we encourage the development of strong and effective business leadership while simultaneously instilling an equally strong and effective sense of business ethics? Insider trading jurisprudence, at its most thoughtful, embodies this compromise. It is, in microcosm, the struggle of the American psyche between the egalitarian belief in a level playing field for all and the opposing belief that those whose hard work takes them to positions of power are entitled to reap the benefits of their work and position.
2. Insider Trading: The Classical Theory
One of the interesting facts about American insider trading law is that it is not specifically proscribed by an "insider trading" statute or rule. Instead, over the past half century or so, the parameters of illegal insider trading have grown up, by and large, around court interpretations of the general antifraud provisions of Securities Exchange Act Section 10(b) and Exchange Act Rule 10b-5, provisions which, to use shorthand, bar "manipulative or deceptive devices" in connection with securities transactions. Insider trading is just one specialized form of this deception.4 In our insider trading jurisprudence, judicial opinions have created a body of common law crystallized around certain key concepts, which act as guideposts for investors, corporate officers, brokers, lawyers and others, dividing the permissible from the forbidden.
In a nutshell, "insider trading" is the purchase or sale of securities, with scienter (or guilty knowledge), while in possession of material, non-public information in breach of a duty arising out of a fiduciary relationship or other relationship of trust and confidence. Under the so-called "classical" theory of insider trading, a corporate insider (either permanent like an officer or director, or "temporary" like a consultant working on a deal) violates a duty to corporate shareholders to either disclose his intent to trade or to abstain from trading, on the basis of material non-public information. The tippee of a corporate insider assumes the tipper's duty to shareholders if the tippee knows or should know that the tip constitutes a breach of the tipper's duty. This breach of duty to shareholders constitutes the deception necessary for liability under our general anti-fraud statute in a classical insider trading case.
There is more to be said about insider trading theory, but let's stop here for a moment. The theory of which I have just given you a thumbnail sketch developed over time and was solidified in a pair of early-1980s U.S. Supreme Court decisions, the seminal Chiarella5 and Dirks6 cases, both of which demonstrate how the developing law of insider trading used the concept of duty as a fulcrum of sorts to balance the twin virtues of enterprise and loyalty. The defendant in Chiarella worked at a financial printer responsible for printing deal announcements. Using information contained in the announcements, he deduced the identities of takeover targets, and purchased their shares before the final announcements drove up their prices.7 His criminal conviction in the lower court was premised on his failure to either disclose the information to target company shareholders or abstain from trading. The lower court imposed a "disclose or abstain" obligation on all who would come into possession of inside information.8 This the Supreme Court rejected, holding that merely possessing nonpublic information did not make trading illegal. In order to constitute insider trading, the trader must either owe a fiduciary duty or derivatively assume the duty of his tipper. The mere fact that a trader held an advantage, that the trade was "unfair," did not make a trade a fraud under the securities laws.9
The Court's majority opinion acknowledged winners and losers in the ongoing tug of war of the business world. But it also implicitly affirmed the old adage that with great power comes great responsibility; those whose access was gained in the exercise of the shareholders' trust would be prohibited from using that access for personal gain. More to the point, the Chiarella case put into high relief the issue of duty and the question of how the common law of insider trading would deal with those, like Chiarella, who owed no direct fiduciary duty to the issuer or its shareholders. We will see momentarily how the law on this point developed.
Dirks also presents an interesting gloss on classical theory. Raymond Dirks, a stock analyst, was told by a former corporate officer about a massive fraud at the officer's former employer, information which Dirks then relayed to his clients.10 In Dirks, the Supreme Court premised tippee liability on the motives of the tipper, that is to say, the tippee was only under a duty to disclose or abstain when the tipper sought an improper benefit for his information. Where the tipper acts from altruistic, or at least non personal benefit motives, there could be no liability. Once again, duty was key. The Court found that Dirks did not breach a direct or derivative duty; his conduct therefore did not break the law.11
3. Filling the Gaps: Misappropriation Theory and the Tender Offer Rule
Although these two cases greatly helped to solidify the common law of insider trading, there was still problematic conduct that was not yet addressed by the courts. What of the situation where a trader's duty ran not to the issuer or its shareholders, but to others? And what of situations where a trader owed no duty at all? How, if at all, would the law allow law enforcement to reach such conduct?
Classical insider trading theory did not take into account, as Chiarella made clear, the situation in which an individual stole confidential information and illicitly used it to his advantage. How could federal common law handle these matters? By developing a different, but complementary approach. This new approach, the misappropriation theory, bars trading or tipping by those who "misappropriate" material, nonpublic information, based on the breach of a pre-existing relationship of trust and confidence owed by the trader or tipper not to the issuer or its shareholders, but to the source of the confidential information. The "misappropriation theory" therefore covers people who are not corporate insiders, but who seek to profit by stealing sensitive information from those with whom they share, for example, an employment or family relationship.
A classic example of a non-classical insider trading case is the 1986 criminal insider trading case U.S. v. Winans, et al12. R. Foster Winans was a reporter at the Wall Street Journal who contributed to a column called "Heard on the Street." Mr. Winans was charged with operating a scheme through which he would trade in stocks that were to be the subject of upcoming Journal columns, columns that would likely move the market for those stocks.13 The district court, in its opinion, applied the misappropriation theory to Mr. Winans' actions. It held that while Mr. Winans owed no duty to the shareholders of the companies in whose stock he traded, he did owe a duty to his employer, the Wall Street Journal. The court held that Mr. Winans' behavior was a fraud on his employer, from whom confidential information about the timing and content of articles was taken. The court additionally held that Winans' duty to his employer need not be imposed by explicit federal or state law, but could be inherent in the employer/employee relationship itself.14
As time went on it became clear that not all federal courts agreed with the approach taken by the court in the Winans case. Some courts embraced the misappropriation theory; others rejected it. Ultimately the Supreme Court took up the issue and resolved it in the late 1990s in the O'Hagan case.15
O'Hagan involved an attorney whose firm represented a client contemplating a tender offer for the shares of the Pillsbury Company. Using nonpublic information he acquired through his law firm, Mr. O'Hagan loaded up on Pillsbury stock and call options. Pillsbury's securities soared in value after the announcement of the tender offer and Mr. O'Hagan realized a profit of some $4.3 million.16 He was convicted at the trial stage, but that conviction was overruled by an intermediate appellate court which rejected the misappropriation theory.17 The government appealed to the Supreme Court.
In its 1997 opinion, the Supreme Court reversed the appellate court and expressly endorsed the misappropriation theory of insider trading.18 In so doing, the Court held that the misappropriator, despite owing no duty to shareholders of the company whose stock he trades, in fact, is engaged in a fraud in connection with his securities trading. It is just a different type of fraud — a fraud on the party from whom information was stolen, in breach of the misappropriator's duty to the source. It is the breach of this duty that constitutes the "deception" required by the federal securities laws.19
The basic concepts that have evolved over the last half century or so to flesh out the theory of insider trading:
These are the moving parts in this clockwork. The genius of insider trading law, if you are inclined to think in such terms, is its flexibility, its ability to accommodate changing business practices, conditions and situations. For example, just a few short years ago, before the mainstreaming of Internet businesses, who could have imagined that statistics like webpage "hits" or "views" could have big impacts on the earnings of major companies? The use of online disclosures also raises issues of how "public" a piece of corporate information may be today. The varieties of corporate and transactional relationships are also ever-changing, as are the duties they engender. Take, for example, the evolution of the PIPE, private investment in public equity. These PIPE transactions are typically entered into by struggling public companies in need of capital. The equity is typically offered at a discount and when the PIPE becomes public the result is often a decline in the price of the outstanding shares. We have seen instances, where some of those solicited to participate in a PIPE have used that information to short the stock in anticipation of the impact of the PIPE. This behavior is similar to what we have seen for some time in connection with M&A transactions — a party, or a potential party, to a transaction anticipates the market reaction to the transaction and trades ahead of it. And just like we did and do with trading ahead of M&A transactions, we have brought insider trading cases based on trading ahead of PIPEs.
One of the cases that illustrates both how creative insider traders can be and how flexible the law can be in response is SEC v. Sonia Anticevic, et al., filed in 2006 and currently in litigation.21 Two former employees at Goldman Sachs Group were allegedly the hub in a series of insider trading schemes which used various artifices to obtain material, nonpublic information concerning a host of companies. These two are alleged to have co-opted a Merrill Lynch M&A analyst who provided them with tips on upcoming mergers in return for a cut of the anticipated profits. They also enlisted printing plant workers who relayed nonpublic information about imminent Business Week columns prior to publication. One of their more creative ploys was to use an individual serving on a federal grand jury examining allegations of accounting fraud, who agreed to leak information on those proceedings. These two individuals are also alleged to have concocted a number of other schemes, including a plan to extract nonpublic information from bankers through the use of exotic dancers. One of the accused architects of this plot is a graduate of the prestigious Harvard University who was employed by the equally, if not more, prestigious Goldman Sachs firm before the age of 25. Once again, we see someone on the fast-track looking for, and taking, a short-cut.22
But flexibility has its limits and no law is infinitely elastic. There are times when conduct can not be reached by existing laws and times when new developments call for additional laws. We saw this in the late 1960s with the then developments, including some abusive developments, associated with cash tender offers. In 1968 Congress enacted new legislation to address a variety of issues relating to hotly contested takeovers and gave the Securities and Exchange Commission related rule making authority.23 As time went on it became clear, especially during the merger mania of the 1970s, that information about takeovers was almost always not simply material, but dramatically material. Whenever news of a tender offer became public the information almost certainly moved the market. So clear was the temptation to insider trade that the Commission refused to rely on subtle interpretations of the duty requirement, enacting in 1980 a separate rule, Exchange Act Rule 14e-3, which prohibits persons in possession of material, nonpublic information relating to a tender offer from buying or selling securities subject to the tender offer, without regard to the existence or absence of any duty owed to the issuer's shareholders or the persons from whom the inside information was obtained.24
One example of this kind of case, where neither the classical nor the misappropriation theory would have reached the conduct, is a case we brought in 1998, right after O'Hagan was decided, SEC v. Ahlstrom25. This case demonstrates the kind of personal drama that I alluded to earlier. A mother of young children, including a newborn, came down with the flu. Under normal circumstances her husband would have stayed home to take care of the children. Only these weren't normal circumstances. He was an executive of a company that was about to be taken over and he was a key participant in the deal. He explained the imminent deal to his wife, as he left for the office. She was still sick and the children still needed attention. So she called her neighbor, Mrs. Ahlstrom, to ask for help and, no doubt in an effort to salvage her husband's reputation, explained why he couldn't stay home that day. The neighbor agreed to help; that evening she explained to her husband what she's been up to all day including the explanation of why the sick woman's husband didn't stay home himself. Mr. Ahlstrom traded in the target's shares, making a small profit when the tender was announced.26 Now Mr. Ahlstrom's conduct was certainly problematic, but it could not be reached under classical or misappropriation insider trading theories. Mr. Ahlstrom had no duty to the source of the information; nor did he owe any duty to the target company or its shareholders. Neither could he be said to have assumed the tipper's duty, since the information was not conveyed for an improper personal gain. But, because the deal was a tender offer, we were able to bring our case and Mr. Ahlstrom eventually settled an action with us.
4. Looking Around the Corner: What the Future Holds
Insider traders, particularly the high achievers we've been talking about, are smart, and they will always be looking for new ways to gain an edge. Wall Street, big corporations, hedge funds, and white shoe law firms, will continue to attract the best and the brightest, who consequently will inevitably come upon morsels, and sometimes huge chunks, of precious valuable information. It would be foolish not to expect some of these individuals, working in high-pressure, high-profit environments, to try their luck at evading the gaze of regulators and prosecutors. And as many have discovered to their dismay, we are not fools.
Two related factors that have recently been changing the nature of insider trading enforcement are technology and globalization. The old assumptions about the logical places to look for connections — neighbors, family, co-workers — may not always bear fruit in a world where you can whisper to someone a half a world away and equally easily trade in a market just as far away.
With these changes come new legal issues. What if an aspiring insider trader doesn't have to bribe nightclub strippers to charm corporate secrets out of executives? What if he can just walk into a room full of confidential information, take what he wants, and let himself out the back door? In the age of the hacker, this is the unfortunate reality. A computer expert can hack into corporate databases and trade on the basis of what he finds there, often without being detected. Put aside for the moment the issue of how technologists will defend against these attacks, and ask how insider trading law will deal with them. The hacker owes no duty to the hacked company's stockholders, nor does he owe a duty to a law firm, consultancy, financial printer or any employer from whom he spirits information. And if traditional notions of duty can't deal with him, what is the common law to do? Create a new kind of duty? Impute to the hacker an existing insider's duty? Or is this simply too far a stretch for our insider trading law's flexibility?
We are starting to confront these kinds of issues. And, in our first case of this sort, we went back to first principles and looked to the statute itself. In late 2005, we brought an action against a 24 year old Estonian trader who used his computer programming skills to infiltrate a U.S. commercial newswire service and steal confidential information about corporate earnings, mergers and the like in the hours before their public release.27 The trader unleashed a "spider" program that surreptitiously entered proprietary files on the newswire's servers. The "spider" electronically crawled throughout the files and transmitted information back to the trader's computer in Estonia where he and others placed trades in their U.S. online brokerage accounts. For over ten months, sitting at a desk thousands of miles away, the trader made trades in advance of 360 announcements by more that 200 companies and reaped illegal profits in excess of $13 million dollars.28 Did the trader have an actionable duty to anyone? We can argue about that one. But duty is not what the statute requires. Duty is a subset of the statutory requirement of deception. So in this case, we alleged that the trader had engaged in deception, by, among other things, using the spider to fool the newswire service into believing he was authorized to access the information on its servers. I expect we'll see more cases like this and that these cases will be the source of more case law. Indeed, we are in the midst of exploring the deception issue in a matter currently pending in the federal courts in New York.
How that particular case will turn out I don't know. Nor do I know the precise details of the matters that will come our way. But come our way they will, that I do know. And When I say our way, I mean our way. Not my way or the U.S. way but all our collective way. To state the obvious, our markets are global and the crooks know it. But so do we. I look forward to our collective efforts, and our collective successes, in policing all of our markets, protecting all of our investors and bringing the full force of all of our laws against anyone who breaks those laws, harms those investors or threatens those markets.
Thank you very much.
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