Naseem and Nacchio: The Beginning of One Era and the End of Another

Insider trading continues to be the flavor of the day, as both the SEC and DOJ continue to focus on the issue along with regulators around the globe. Two high profile securities fraud cases currently moving forward may represent the beginning of one period or phase in enforcement and the end of another.

Naseem begins

In Manhattan, jury selection began yesterday in U.S. v. Naseem, Case No. 1:07-mj-UA-1 (S.D.N.Y. May 3, 2007). Mr. Naseem, an investment banker at Credit Suisse, was originally charged with illegally tipping a Pakistani banker about the takeover of TXU led by KKR which was announced on February 26, 2007. Prior to that announcement the government claims that the tippee purchased 6,700 call options which were later sold at a profit of $5 million. Mr. Naseem was initially charged with having tipped eight others. The inside information came from his employment at Credit Suisse, which was a financial advisor to TXU.

Last month a superseding indictment was filed in this case. The new indictment added three counts relating to trading in shares of Caremark and TXU options. According to this indictment, the scheme has yielded total trading proceeds of more than $9 million and profits of over $7.5 million.

The Naseem case is related to the action brought by the SEC captioned SEC v. One or More Unknown Option Purchasers, Civil Action No. 1:07-cv-01208 (N.D. Ill March 2, 2007) which is discussed here. The SEC’s complaint has been amended twice since filing. That case is currently in discovery.

Naseem is the first of the large insider trading cases filed by the SEC and DOJ this year to go to trial. As discussed earlier, these cases were filed quickly in an effort to freeze at least part of the trading profits as the SEC successfully did in this case. At the same time, the speed with which the cases were brought precluded development of the usual factual record the SEC amasses through its extensive investigative powers.

Nacchio approaches the end

As the Naseem case begins, another huge case heads for what may be the final round. Next week, the Tenth Circuit Court of Appeals will hear the appeal of Joe Nacchio, former chairman of Quest Communications. Mr. Nacchio was convicted last April on 19 counts of insider trading and securities fraud. He was sentenced to six years in prison, ordered to forfeit $52 million in ill-gotten gains and pay a $19 million fine. As has been widely reported, there has been extensive briefing on this case. While the Supreme Court could be requested to review the decision by the Circuit Court, in probability this will be the end of Mr. Nacchio’s case, unless he prevails.

Nacchio and Naseem may thus signal the end of the Enron era mega securities fraud case and the beginning of a renewed period of insider trading enforcement.

A Huge Options Backdating Case Raises the Question of Prosecutorial Standards

The $600 million settlement announced on Thursday against William W. McGuire, M.D., former Chief Executive Officer and Chairman of UnitedHealth Group, is not only one of the largest in the options backdating scandal, but also the first settlement with an individual involving the SOX “clawback” Section 304. Under that Section generally, executives who profit from conduct which causes a restatement of the financial statements can be required to give back financial benefits. Viewed in that context, the case also raises questions concerning the standards of prosecution being used by the SEC in these cases.

In Dr. McGuire’s case, the SEC alleged that, over a twelve year period, he repeatedly caused the company to grant undisclosed, in-the-money stock options to himself and other employees. The compensation expense for these grants was not properly recorded in the company’s books and records. In addition, the company’s filings contained false and misleading statements concerning the true grant dates of the options.

Between 1994 and 2005 Dr. McGuire received more that 44 million split-adjusted options, most of which were backdated. Approximately 11 million of those backdated options were exercised for an in-the-money gain of more than $6 million. In addition, according to the SEC’s complaint Dr. McGuire received about $5 million in incentive-based cash compensation in 2005 and 2006 which was tied to earnings per share targets that UnitedHealth would not have achieved had the financial statements been properly prepared.

Under the terms of the settlement, Dr. McGuire consented to the entry of a statutory injunction prohibiting future violations of the antifraud, reporting, record keeping, internal controls, proxy statement, certification and securities ownership reporting provisions. He also consented to the entry of a ten-year officer-director bar.

In the financial terms of the settlement, Dr. McGuire agreed to disgorge over $10 million, pay prejudgment interest and a $7 million civil penalty. Under SOX Section 304, Dr. McGuire agreed to reimburse the company for all incentive- and equity-based compensation received from 2003 through 2006, which totals about $448 million. Dr. McGuire’s obligations under the terms of the settlement can be satisfied by returning to UnitedHealth about $600 million in cash and options. This resolves employment claims and shareholder derivative lawsuits against Dr. McGuire. SEC. v. McGuire, Civil Action No. 07-CV-4779 (D. Minn. Filed December 6, 2007). The Commission’s Litigation Release is available here.

To date, the SEC has brought approximately 21 option backdating cases. In addition, a number of issuers have announced that they have received closing letters. The case against Dr. McGuire returns to the type of intentional conduct on which the SEC has typically based its options backdating cases. This contrasts sharply with negligence based action recently brought against former Maxim International Products CEO John F. Gifford discussed here. There, the Commission more than pushed the edge by basing an action on the theory that Mr. Gifford should have known that the CFO disregarded his written instructions to properly record the option expenses without explaining how he should have known that. Since backdating options to obtain a better exercise price involves scienter-based conduct, hopefully as the Commission works through its huge inventory of these cases, it will exercise its prosecutorial discretion to bring cases in the McGuire rather than the Gifford mold.