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Elevated Enforcement

The SEC charged 14 defendants in an insider trading scheme that netted more than $15 million in illegal profits on thousands of trades in March 2007. The defendants, who used information stolen from UBS Securities and Morgan Stanley, included a UBS research executive, a Morgan Stanley attorney, three hedge funds, two broker dealers and a day-trading firm.

The SEC called the charges "the most significant insider trading case in 20 years"--and indeed it was. But perhaps more important, the charges were not an isolated occurrence.

"Insider trading cases against Wall Street professionals and corporate executives are back in a big way," says Christopher Steskal, a partner with Fenwick & West. In the 1990s the SEC brought only 10 insider trading cases. By contrast, it sued more than 20 professionals for insider trading in the first half of 2007 alone. To be sure, many of the charges arise in the context of M&As, the traditional hotbed of insider trading.
But driving the new surge are hedge funds and Rule 10b5-1 plans, which the SEC has publicly marked for special scrutiny.

"The SEC has seen that some people who should know better and should be the ones policing insider trading are sometimes the ones most deeply involved in it," says David Priebe, a partner with DLA Piper.

Hedge Fund Abuse
The hedge-fund phenomenon has been around for about 20 years. But the funds' lack of transparency has only become a news item relatively recently.

"The criticism of hedge-fund secrecy combined with their eye-popping returns has led the SEC to wonder publicly whether and how the hedge-fund community has been getting ahead of the market," says Joris Hogan, partner at Torys' New York office.

Bolstered by a $700 million budget increase, the SEC has set up a hedge-fund fraud unit, and the number of hedge-fund trades referred by the SEC to private market regulators increased from 20 in 2002 to 88 in 2006. In addition, the SEC, the NYSE, the Financial Industry Regulatory Authority and the Options Regulatory Surveillance Authority have created combined "scheme teams" to target insider trading operations.

Electronic trading also has facilitated enforcement efforts. "The added manpower that the budget increase allows, combined with the requirement that all trading activity must be filed electronically, means the SEC can now fully engage sophisticated detection software that makes it much easier to put two and two together than when everything was done on paper," says Andrew Katz, a partner at Mitchell Silberberg & Knupp.

After identifying suspicious trades, the SEC uses its subpoena powers to try to identify the connections between the traders and the insider informants. But that can have unfortunate consequences.

"Many companies are hit with broad SEC subpoenas that are nothing more than fishing expeditions for potential leaks of inside information," Steskal says. "So a company that is not the formal target of the investigation may have to bear the cost of complying with the subpoena."

Given the current enforcement environment, Steskal suggests the time is ripe for companies to review and upgrade their insider trading compliance policies. When doing so, they might want to keep an eye on their executives' 10b5-1 plans.


10b5-1 Investigations
The trading plans known as 10b5-1 plans allow corporate executives to trade in their company's stock without becoming subject to the presumption that they are basing their trades on nonpublic insider information. Executives entering into such plans sign agreements allowing brokers to make nondiscretionary trades on their behalf.

"Because the executive has no say in the trade, which is made by a third party, there is no presumption that there's been misuse of insider information," Hogan explains.
But the SEC has recently become suspicious of these plans. "It has started to worry that corporate executives are misusing their plans by canceling them when they learn their company is about to merge," Hogan says.

There is considerable temptation to abuse 10b5-1 plans. "It's just a natural proclivity for folks who have securities over which they want some control, and on occasion they try to exercise that control by tweaking the plan just a bit too much," Katz says. "Some people may want to see how close to the edge they can come."

Still, Steskal believes companies should encourage trading plans for their executives. However, he recommends a conservative approach that includes initiating the plan during an "open window" period when the insider doesn't possess material nonpublic information.

At a minimum, the plans also should prohibit the insider from trading at all for at least 30 days after initiations; require the insider to relinquish trade execution; prohibit trade modifications of any kind after initiation; and bar trading in company securities not included in the plan. Steskal advises that plans terminate one year after initiation "except in special circumstances" and that companies and executives fully disclose the plans and all trades made under the plans.


Bad Timing
"Insider trading goes to the core of our securities law," Priebe says. "So regardless of the level of enforcement at any particular time, insider trading is something that is always a concern of the SEC."

Hogan believes that insider trading enforcement fluctuates because the activity is directly related to the economic cycle. "Historically, we have a hot M&A cycle once a decade and that seems to be the time when insider trading comes to the fore," he says.

In this scenario, the relatively depressed 1990s were short on opportunities for insider trading. "So there was an enforcement lull, and by the turn of the century, many--including hedge fund managers--may have forgotten the lesson of the '80s," Steskal says.

The SEC, it seems, is determined to remind them.

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Julius Melnitzer

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