Speech by SEC Staff:
Opening Remarks to the Securities Industry and Financial Markets Association Regulatory Symposium on Insider Trading
Linda Chatman Thomsen1
Director, Division of Enforcement
U.S. Securities and Exchange Commission
New York, New York
May 19, 2008
Good morning. Thank you Ira [Hammerman] for that generous introduction. This is a timely topic and I know that time spent here today is time well spent for all of us. Speaking of well spent time, nothing like a gander through a college catalog to cause those of us with soon to be college bound children to pause over how they will be spending their time and our money. The University of California at Berkley for example offers a two-credit course, entitled "James Bond: The Politics, the Pop Culture, the Hero, " which promises to examine how the Bond franchise has mirrored world events and set trends in pop culture, and why James Bond has retained his popularity, eleven novels and twenty-one films strong, to this day.2
The most recent Bond film, Casino Royale, based on the original 1953 Ian Fleming novel, not too surprisingly was updated with a terrorism plotline and — perhaps less predictably, a potential insider trading subplot. In the film, the villain is a banker to the world's terrorist organizations. As the storyline begins, he is behind a plot to bomb a Boeing prototype airbus at the Miami airport, both as an act of terrorism and financing. He has heavily shorted Boeing stock in anticipation that the bombing will send the company stock plummeting if not bankrupt the company. Needless to say, our protagonist, Bond, thwarts the sinister plan and the villain ultimately loses some hundred and fifty million dollars betting that the foiled bombing would tank the airline stock. The money bet of course was not his own, but belonged to some less than friendly characters.
Now, whether or not that shorting, had the plot succeeded, would have amounted to actionable insider trading might very well have been a case of first impression — but I don't doubt that one way or another, we would have found a way to reach the conduct.
Of course Casino Royale is only one of several films to focus on illegal trading. Others include: Wall Street, Barbarians at the Gate, Boiler Room, The Big Chill and my personal favorite although less well known, That Touch of Mink, a 1962 movie starring Cary Grant and Doris Day. That Touch of Mink is mostly about the relationship that develops between Kathy Timberlake, a wholesome Midwesterner, and the urban sophisticated tycoon Philip Shayne. Its plot is totally predictable, which doesn't make the time with Cary Grant any less enjoyable. But there is also a great subplot involving Mr. Shayne's wisecracking executive aide, the fairly neurotic Roger, who seems to have no last name, and his psychiatrist, Dr. Gruber, who has no first name. Roger visits Dr. Gruber throughout the film to grouse about Mr. Shayne and to sort through the fact that he'd rather be teaching economics at some college. Dr. Gruber — far more attentive to the morsels of material nonpublic information conveyed during Roger's sessions than to ramblings about Mr. Shayne personally — repeatedly sneaks out of Roger's sessions to trade on inside information conveyed in privileged sessions with his patient.
It was nearly thirty years after the release of That Touch of Mink, in a classic case of life imitating art, that a prominent New Jersey psychiatrist pled guilty to two counts of securities fraud for trading on material nonpublic information about a pending merger, which he learned during sessions with one of his patients, the wife of a real life Wall Street tycoon.3
And I suppose it's no accident that Hollywood is fascinated by insider trading. 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. Insider trading 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, there is the unraveling of the scheme; the chase; the investigation.
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.
And although the lure of insider trading crosses all areas of the economic and social spectra, it is often the people with the least need and the most to lose, who are drawn into its web. That is the conundrum of insider trading. While everyone may dream of finding the key to quick riches, 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.
It is these stories that fascinate so many of us. It fascinates us to think: why would they do it? We can never fully know their motives. 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 and their willingness to risk are all qualities we want and need in our corporate and community leaders. Yet somehow, they went awry, they overreached.
This morning I am going to talk about how the law of insider trading developed, some recent trends we've been seeing at the Commission and finally, what the future may hold for this area of enforcement. But before I go any further, I should remind you that my views are my own and do not necessarily represent the views of the Commission or any of its staff.
Insider Trading: Development of the Law
One of the interesting facts about our insider trading law is that it is not specifically proscribed by an "insider trading" statute or rule. Nevertheless, the notion that insider trading is wrong was established long before the passage of the federal securities laws. In 1909, the Supreme Court held that a director of a corporation, who knew that a pending offer to purchase significant land holdings of his company would greatly increase the company's stock value, committed fraud when he bought company stock from an outsider without disclosing what he knew.4
Since the Securities Exchange Act of 1934 was passed, the parameters of illegal insider trading have been shaped, by and large, around court interpretations of the general antifraud provisions of Section 10(b) and 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.5
To recap what we all know, "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. In its pure form, 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 in a classical insider trading case.
Our first insider trading case was the 1961 Cady Roberts case.6 The classical theory and its elements continued to develop over time and were solidified in a pair of early-1980s Supreme Court decisions, the seminal Chiarella7 and Dirks8 cases. 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.9 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.10 The Supreme Court disagreed, 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, i.e., that the trade was "unfair," did not make a trade a fraud under the securities laws.11
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.
Dirks also presents an interesting gloss on the issue of duty. 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.12 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.13
Filling the Gaps: Misappropriation Theory and the Tender Offer Rule
Chiarella and Dirks highlighted that 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 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 misappropriating sensitive information from those with whom they share, for example, an employment or family relationship.
As time went on it became clear that 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.14
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.15 He was convicted at trial, but that conviction was overruled by an intermediate appellate court which rejected the misappropriation theory.16
In its 1997 opinion, the Supreme Court reversed the appellate court and expressly endorsed the misappropriation theory of insider trading.17 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.18
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.
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 when Congress enacted the Williams Act, which addressed abusive practices associated with cash tender offers and gave the Securities and Exchange Commission related rule making authority.19 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. Consequently, in 1980 the Commission passed 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.20
The need for Rule 14e is illustrated by the 1998 case SEC v. Ahlstrom21, which also 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.22
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.
Recent Enforcement Efforts to Combat Insider Trading
At the SEC, since we started classifying our investigations by type, insider trading cases have consistently made up about 7–12% of our caseload, which in recent years has translated to about 50 cases per year. Last year we brought 47 insider trading actions, up one from 46 the year before. But it felt worse. And it was. First, we sued 110 defendants for insider trading, up 16% from the year before.
Second, we are seeing higher penalty and disgorgement numbers than ever before — approximately $150 million in the last year alone.
Third, increasingly the individuals we have seen engaged in the misconduct have been securities professionals, gatekeepers or high-ranking corporate officials. In the past year or so alone, we brought insider trading actions against individuals from UBS, Morgan Stanley, Bear Stearns, Merrill Lynch, Goldman Sachs, Bank of America, Credit Suisse, ING, ABN AMRO and Barclays.
The Commission has also sued a number of lawyers in the past year for insider trading, including: a former associate General Counsel of NBTY (who also was charged with tipping his father and a friend);23 the former managing partner of the Washington D.C. office of a major law firm, who learned about an acquisition from the General Counsel of a firm client and proceeded to trade ahead of public announcement of the deal;24 an attorney and compliance officer of Morgan Stanley, who we alleged tipped a broker-dealer concerning upcoming corporate acquisitions involving Morgan Stanley's investment banking clients;25 and the former General Counsel and chief insider trading compliance officer of a public company, who we alleged made more than 50 illegal trades, trading ahead of significant corporate announcements, most of which were during company blackout periods.26
Fourth, we are seeing fewer insider trading cases involving one-off trades. Rather, recidivist insider trading cases have become more common. In last spring's Guttenberg action, the Commission sued fourteen defendants (many of whom were Wall Street professionals), alleging five years of serial illegal trading on literally hundreds of tips.27
Fifth, increasingly, we are seeing international insider trading, where a resident of one country uses inside information to trade through a financial institution in a second country in the securities of a third country. We also more frequently are combining forces with foreign regulators to pursue these cases.
Just last Friday, we obtained an emergency $2.1 million asset freeze and charged an Italian resident, who the Commission complaint alleges was aware of material nonpublic information regarding an Italian company's pending acquisition of a U.S. company, with illegally trading thousands of call options ahead of public announcement of the deal.28 We allege the defendant made the highly suspicious trades less than two weeks ago, through a U.S. brokerage account he opened only days before purchasing thousands of out of the money call options that would be worthless ten days after his purchase, unless there was a significant jump in the stock price.
In February, we filed settled charges against former Dow Jones Board Member David Li Kwok Po (also the Chairman & CEO of the Bank of East Asia) and three additional Hong Kong residents in a $24 million insider trading case involving illegal tipping and insider trading ahead of news of News Corp's unsolicited buyout offer for Dow Jones last spring.29
Looking Around the Corner: What the Future Holds
Insider traders, particularly the high achievers we've been talking about, are smart and 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 technology changes come new legal issues. 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.30 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.31
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 we look forward to these challenges and intend to meet them.