by T. GormanPosted on Posted in SECActions

The SEC and DOJ have long coordinated when appropriate because parallel proceedings can maximize resources.  As former SEC Chairman Harvey Pitt noted:  “The SEC has had, and continues to have, a close relationship with its fellow law enforcement agencies.  Indeed, some of the most significant SEC actions over the last several months have been brought in tandem with criminal complaints and indictments.” Harvey L. Pitt, Remarks at the U.S. Department of Justice Corporate Fraud Conference (Sept. 26, 2002).  Many times parallel civil and criminal investigations are also beneficial for the defense.  Frequently, for example, parallel investigations are more efficient and offer the prospect for a coordinated resolution of a matter. 

On the other hand, parallel proceedings may severely prejudice the defense.  In U.S. v. Stringer, 408 F. Supp. 2d 1083 (D. Ore. 2006), appeal docketed, No. 06-30100 (9th Cir. Feb. 27, 2006), the court dismissed a criminal indictment on grounds of government misconduct where securities fraud investigations by the U.S. Attorney’s office and the SEC were not parallel, but had merged.  Although the USAO decided to indict the defendants early on, it decided not to conduct an investigation and instead use the SEC to gather evidence.  The government attorneys concealed the DOJ’s involvement despite defense counsel inquiries concerning a parallel criminal investigation.  On appeal the SEC argues that its standard Form 1662 warnings are sufficient and that staff does not have to disclose the existence of a parallel criminal investigation even when it knows that one is being conducted and defense counsel makes a specific inquiry about the existence of such an investigation.

Fairness questions were also raised in SEC v. HealthSouth, 261 F. Supp. 2d 1298 (D. Ala. 2003).  There, the court denied an SEC motion to freeze assets of former HealthSouth CEO Scrushy.  The court repeatedly expressed concern about the SEC’s tactics where much of the evidence came from a parallel DOJ investigation, yet the SEC refused to make that evidence available to the defense in response to civil discovery requests claiming that it was in the possession of the U.S. Attorney’s office or the FBI. 

Likewise, in U.S. v. Scrushy, 366 F. Supp. 2d 1134 (D. Ala. 2005), the court granted a defense motion to suppress SEC testimony because the USAO and the SEC investigations had merged to where the USAO dictated questions, limited the SEC’s inquiry topics, and determined testimony location for future criminal venue without telling the defendant of the parallel inquiries.   

Now, in SEC v. Reyes, et. al., No. C 06-04435 CRB (N.D. Cal.) a key issue of fairness has been raised stemming from parallel proceedings.  To much fanfare, both agencies announced in a joint press conference the filing civil and criminal charges tied to option backdating.  Quickly, the USAO moved to stay the civil case, sending a message that the SEC did not intend to litigate immediately.  The court denied the motion noting that it is fundamentally unfair to charge persons with violations of the securities laws and then, when they wish to respond, stay the case.  Subsequently, the defense attempted to depose several witnesses, all of whom have taken the Fifth.  In a subsequent motion, the defense moved “to compel deposition testimony, for an evidentiary hearing, and for other appropriate remedies.”  The Defendants argue that the “Silent Eleven,” as they term them, have no fear of prosecution.  The Silent Eleven made proffers to the USAO that were attended by SEC staff and, according to motion papers, at least one witness has letter immunity.  See Motion of Defendants Reyes, Caova and Jesen to Compel Deposition Testimony, dated January 23, 2007.  Not surprisingly, the SEC argued procedure rather than substance, noting that the motion should be denied because it does not have authority to grant immunity, it is appropriate to conduct parallel proceedings, and if the criminal trial proceeds first many of the witnesses now invoking their constitutional right not to testify may, in fact, become available.

While the court denied the motion as premature, the Judge noted he was “sympathetic to Defendants’ argument that SEC and DOJ attorneys have selectively used their power to grant use immunity[,]” but at this point the factual record was inadequate to support the requested remedies. 

The SEC’s arguments in Reyes – as they were in HealthSouth and Stringer – were not doubt accurate, as far as they went.  But the arguments miss the point.  Government prosecutors from the DOJ and the SEC have an obligation of fundamental fairness and cannot skew the playing filed or truncate the rights of defendants in the name of law enforcement.  Such actions undercut the very system government prosecutors are suppose to serve.  These cases serve as a reminder of this crucial point.  Perhaps more importantly, in a post-Enron world where the pendulum has swung far in favor of the prosecution, perhaps these three decisions signal an appropriate swing back toward the middle.

by T. GormanPosted on Posted in SECActions

The SEC staff confirmed last week at a conference in Washington, D.C. that the Office of Compliance and Inspections is conducting a sweep of selected Wall Street brokers for insider trading. Reportedly, the sweep is focusing on the last two weeks of September 2006. Members of the enforcement staff indicated that they will be looking at the sweep results to determine whether to follow up with investigations or enforcement actions.

The sweep focuses on the activities of hedge funds and other large brokerage customers and potential conflicts of interest involving what is called front running, which here would be based on a complex factual theory and a difficult legal theory. Factually, the focus of the inquiry is to determine whether the brokers leaked information about large trades by institutional investors, such as mutual funds, to hedge funds or other large preferred customers so they could trade at another brokerage firm. Front running is trading in advance of a large customer trade. The practice has long been a concern on Wall Street because it gives the trader an informational advantage by knowing about large transactions of firm customers that could impact the security’s price.

Proof in any cases resulting from the sweep may be difficult. As SEC Enforcement Chief Linda Thomsen noted in her Congressional testimony last fall (see blog entry 9/27/06), proof in any insider trading case is difficult. In the typical front running case, establishing the misuse of the information and linking it to the trade is a difficult task. The difficulty of establishing the factual predicate for the type of case on which the sweep is based would be even more difficult given the complex nature of the suspected transactions.

The legal theory is also complex. The classic insider trading case is premised on a breach of fiduciary duty where the corporate insider breaches a duty owed to the shareholders of the company by using material non-public or “inside” information to trade in the company’s shares. A variation of this theory is the misappropriation theory where the information used to trade is misappropriated or essentially stolen. The legal theory for the sweep situation does not fit squarely under either theory, although traditionally the SEC has not been shy about trying to expand the statutory language of Exchange Act Section 10b, which deals with fraud and manipulation and does not specifically mention insider trading, through case law to accommodate its theories.

In this case, the information belongs to the brokerage house and its customer trader. The new theory argues a breach of duty not to the traditional company shareholders, but to the shareholders of the brokerage house. The breach occurs when the brokerage employee gives the information to another customer to trade in the company stock at another brokerage house. This is the same theory that was used in the Martha Stewart insider trading case that was settled in 2006. This is an aggressive theory premised on the conflict of interest that can arise from large trader clients at brokerage firms and the inherent unfairness of the situation. But, as the Supreme Court has made clear, conflicts and unfairness are not the predicate for insider trading.

All of this suggests that the sweep is an aggressive move by the SEC because there would be inherent difficulties in prevailing on the legal theory and establishing the factual predicate for the cases. On the other hand, it is a well know fact that companies – and particularly regulated entities such as brokers – often make business decisions to quickly resolve virtually any case, and at any cost, to preserve the company as a going concern.