Marked by leadership changes, high-profile trials, and shifting priorities, 2013 was a turning point for the Enforcement Division of the Securities and Exchange Commission (the “SEC” or the “Commission”). While the results of these management and programmatic changes will continue to play out over the next year and beyond, one notable early observation is that we expect an increasingly aggressive enforcement program.
Posts Tagged ‘Insider trading’
Last year, in our annual survey (discussed on the Forum here) of the white collar and regulatory enforcement landscape, we noted that the trend toward ever more aggressive prosecutions reflected a “gloomy picture” for large companies facing such investigations. Our assessment remains the same, as the pattern of imposing massive fines and extracting huge financial settlements from companies continued unabated in 2013. For example, on November 17, 2013, DOJ announced that it had reached a $13 billion settlement with JPMorgan to resolve claims arising out of the marketing and sale of residential mortgage-backed securities—the largest settlement with a single entity in American history. Johnson & Johnson agreed to pay more than $2.2 billion to resolve criminal and civil investigations into off-label drug marketing and the payment of kickbacks to doctors and pharmacists. Deutsche Bank agreed to pay $1.9 billion to settle claims by the Federal Housing Finance Agency that it made misleading disclosures about mortgage-backed securities sold to Fannie Mae and Freddie Mac. SAC Capital entered a guilty plea to insider trading charges and was subjected to a $1.8 billion financial penalty—the largest insider trading penalty in history. And in the fourth largest FCPA case ever, French oil company Total S.A. agreed to pay $398 million in penalties and disgorgement for bribing an Iranian official. Not to be outdone, the SEC announced that it had recovered a record $3.4 billion in monetary sanctions in the 2013 fiscal year.
In my paper, Financial Conglomerates and Chinese Walls, which was recently made available on SSRN, I examine the effectiveness of Chinese walls, or information barriers, in preventing financial conglomerates from misusing non-public information in their trading and other activities. In recent years, empirical evidence has shown that financial conglomerates’ Chinese walls fail in important contexts, allowing firms to trade using non-public information they garner from their clients. Nevertheless, Chinese walls continue to have the legal effect of allowing financial conglomerates to discharge the otherwise incompatible client duties they owe under agency law. These incompatible duties arise due to the inflexible application of agency law and to financial conglomerates’ organizational structure, under which firms act for numerous clients across a broad and diverse range of financial activities, accumulating vast quantities of non-public information in doing so. As agents, firms are duty-bound to disclose material information in their possession to clients, and yet to do so is to breach duties of confidence owed to other clients. Chinese walls help financial conglomerates to reconcile their otherwise incompatible duties.
It is a great honor to have been asked to give the Fifth Annual Judge Thomas A. Flannery Lecture. And it is especially meaningful to be joined tonight by Tom Flannery’s daughter Irene, son Tom, and so many friends, colleagues, and former law clerks who knew and served with him.
I unfortunately did not have the privilege of knowing and working with Judge Flannery. But one of the great benefits of being asked to speak tonight is that it gave me the opportunity to come to know him a little—through learning about his many impressive career accomplishments and through reading his own words and those of others about him. I wish I had known him. He was indeed a remarkable man, lawyer, and judge.
As all here know, Judge Flannery was a highly-respected Assistant United States Attorney, United States Attorney, trial lawyer, and jurist on this court for over 35 years. In fact, he spent most of his life within a few miles of this courtroom.
As part of the Historical Society’s Oral History Project for this Circuit, Judge Flannery gave an interview in 1992. It is a fascinating account of his professional life and the life of this court. Judge Flannery said that his view of the justice system was shaped in great part by watching police court trials here in Washington as a law student.
In our paper, Determinants and Trading Performance of Equity Deferral Choices by Corporate Outside Directors, which was recently made publicly available on SSRN, we investigate the determinants and trading performance of outside directors’ “equity deferrals,” which represent the choice to convert part or all of the current cash compensation into deferred company stock. Director equity deferrals are interesting for two reasons. First, by deferring, the directors give up a sure amount of cash today for firm stock with an uncertain future value, while at the same time substantially increasing the proportion of their compensation that is tied to future firm performance. Second, the equity deferrals can become a form of insider trading, because directors can use these options as a tax-advantaged alternative to open-market purchases of the firm’s stock.
We examine director equity deferrals using a hand-collected sample of U.S. firms that allowed outside board members to defer their cash compensation into equity between 1999 and 2003. We first focus on the factors affecting director equity deferral choices. Consistent with a certainty equivalent story, we find that directors are more likely to defer cash into equity when they receive higher cash compensation levels and when the plans offer premiums for deferrals made into equity. Deferral likelihood also increases with the size of the taxes that are deferred.
Fighting insider trading is clearly at the top of law enforcement’s agenda. In May 2011, Raj Rajaratnam, the former head of the Galleon Group hedge fund, received an eleven-year prison sentence for insider trading, the longest ever imposed. More recently, in July 2013, SAC Capital Advisors, a $15 billion hedge fund, was slapped with a criminal complaint that threatens the fund’s existence, even after having agreed to pay a $616 million civil penalty, the largest-ever settlement of an insider trading action. Yet, despite the high enforcement priority and the high stakes involved, a satisfying theory of insider trading law has yet to emerge. And this is not for want of trying. As Larry Mitchell remarked as early as 1988, “Many forests have been destroyed in the quest to understand and explain the law of insider trading.”
In my forthcoming article, Insider Trading as Private Corruption, to be published next year in the UCLA Law Review, I make the case that insider trading is best understood as a form of private corruption. I begin by arguing that we need a theory of insider trading law that not only makes sense of the law that has developed but also guides the law forward. In my view, such a theory must do two things.
In my paper, Insider Trading in the Derivatives Markets, recently made available on SSRN, I argue that the prohibition against insider trading is becoming increasingly anachronistic in markets where derivatives like credit default swaps (CDS) trade. I demonstrate that the emergence of credit derivatives marks a profound development for the prohibition against insider trading, problematizing conventional theory and doctrine like never before. With the workability of current rules subject to question, this paper advocates for a rethinking of the present regulatory framework for one better suited to modern markets.
Lenders use CDS to trade the risk of the loans they make. And, when they engage in such trading, they are usually privy to vast reserves of confidential information on their borrowers. From a doctrinal perspective, CDS appear to subvert insider trading laws by their very design, insofar as lenders rely on what looks like insider information to transfer the risk of a loan to another institution. Fundamentally, insider trading rules prohibit trading based on information procured at an unfair advantage by those in a privileged relationship to a company. And, increasingly, insider trading laws are taking a fairly broad approach in preventing misuse of confidential information by those who acquire this information through their special access or through deception. For example, Rule 10b-5(2) can ground a claim for insider trading where someone trades on information obtained through a relationship of trust and confidence. In the CDS market, lenders usually buy and sell credit protection based, at least in part, on information they obtain in their relationship with the borrower, one ordinarily protected by restrictive confidentiality clauses. From the doctrinal viewpoint then, old laws and new CDS markets appear to exist in a state of serious tension. Put differently, either this thriving market is operating outside or at the margins of existing law—or the law itself has not adapted to the existence of these markets.
This is truly an opportune time to examine the regulatory landscape for hedge funds and their advisers—many of you are probably returning from vacations during a summer that witnessed the third anniversary of the enactment of the Dodd-Frank Act and just in time for the effective date of some significant rulemakings relating to a private placement exemption often used by hedge funds. As you know, the Dodd-Frank Act imposed greater oversight on advisers to hedge funds, while recent changes were made to the private placement exemptions by the JOBS Act. These changes create both opportunities and challenges for those advisers managing hedge funds.
For this morning, I will begin with a discussion on what you are likely most interested in—the general solicitation and the “bad actor” rules. Afterward, I will focus on our continuing efforts to be better informed regulators. In the post-Dodd-Frank era, we are more cognizant regulators not only because of the enhanced data we receive from you regarding the size and operations of your industry, but also due to our continuous efforts to improve our ability to use that data and our heightened focus on industry awareness. After an overview of what we now know about your industry and how we intend to use it, I’ll highlight some regulatory initiatives of interest to the hedge fund industry. However, before I finish this morning, I want to briefly share some thoughts on the importance of a robust culture of compliance, which is underscored by the recent Commission actions against hedge fund managers for insider trading.
In our paper, Managerial Incentives and Management Forecast Precision, forthcoming in The Accounting Review, we focus on one important characteristic of management forecasts—forecast precision—and examine how managerial incentives affect the choice of forecast precision. We choose to focus on forecast precision (or specificity, as it is sometimes referred to in the literature) for two reasons. First, precision is one of the most important forecast characteristics over which managers have a great deal of discretion. Managers can issue qualitative or quantitative forecasts, and the latter may take the form of point forecasts, range forecasts, or open-ended forecasts. More than 80% of the quantitative forecasts compiled by Thomas Financial are in the range format (i.e., estimates with explicit upper and lower bounds), and there is a large degree of variation in forecast width (i.e., the difference between the upper and lower bounds). One might even argue that managers have greater discretion over the precision of their earnings forecasts than over whether to provide forecasts in the first place (Hirst et al. 2008). Managers cannot always withhold information because it is part of their fiduciary duty to update and correct previous disclosures. Furthermore, withholding information can lead to considerable litigation risks and can cause great damage to a manager’s reputation (Skinner 1994). Second, forecast precision has a significant effect on market reactions to management forecasts. A number of theoretical papers, such as Kim and Verrecchia (1991) and Subramanyam (1996), argue that the magnitude of the market reaction to a disclosure is positively related to its precision, and empirical studies examining the impact of management forecast precision on stock returns and analyst forecast revisions provide support for this argument (e.g., Baginski et al. 1993; Baginski et al. 2007).
I. Overview of the First Half of 2013
The first six months of 2013 represented a time of transition for the SEC’s enforcement program, with a new Chairman and new Co-Directors for the Division of Enforcement at the helm. It is too soon to predict exactly how they may reshape the program—in contrast with this period four years ago, when Chairman Mary Schapiro and Enforcement Director Robert Khuzami assumed their positions in the wake of Madoff and the financial crisis and with a mandate for major reform, the new team is moving more incrementally. However, there can be little doubt that, when it comes to enforcement, the new leadership will be striking an aggressive tone. For the first time in the Commission’s history, the Chairman and the Enforcement Division leadership are all former criminal prosecutors. As Chair Mary Jo White recently emphasized: “The SEC is a law-enforcement agency. You have to be tough. You have to try to send as strong a message as you can, across as broad a swath of the market as you regulate.”