The cooperation of a single Wall Street trader has led directly led to the prosecution of 10 individuals. That makes David Slaine one of the most productive informants in the history of US financial crimes.

In a sentencing memorandum (.pdf), the US Attorney’s office states that “Slaine’s cooperation has been nothing short of extraordinary” and “truly exceptional”. It lays out the series of of prominent insider trading cases that came from his information: Rajaratnam, Goffer, Kimelman, Drimal and others.

This all came from Slaine’s actions back in 2002. According to the information filed by the prosecutors, Slaine starting getting tips from a UBS analyst. The analyst was leaking information in whether UBS was going to change its securities recommendations. Slaine was then trading ahead of the upgrades and downgrades.

To reduce his sentence, Slaine agreed to help prosecutors and helped unravel a huge ring of traders using inside information. One of the startling aspects of the cases was the widespread use of wiretaps. This was a technique not often seen in insider trading cases.

1:09-cr-01222-RJS USA v. Slaine in the Southern District of NY

Sources:

• Insider-Trading Mole Praised by Prosecutors by Susan Pullman in the Wall Street Journal

• Slaine Sentencing Memorandum (.pdf)
• Information US v Slaine (.pdf)
• I love Informants hat from Zazzle

Purchase out of the money call options set to expire in two weeks, do not have any activity on that stock before, exclusively use options when you have rarely traded options in the account before, purchase those options just before the announcement of the company’s acquisition, and then quickly try to move the money off-shore.

Those red flags were enough for the Director of Compliance Operations at Interactive Brokers to put a hold on the account of Luis Martin Caro Sanchez. After reviewing the trades, the information was forwarded to the Securities and Exchange Commission for investigation. It reeked of insider trading, so the SEC obtained an immediate freeze on the account and charged Sanchez with insider trading.

Sanchez had bought several hundred of the risky Potash call options on August 12 and 13, 2010. A week later, the acquisition was announced causing a dramatic rise in the price of Potash stock. Sanchez managed to reap nearly $500,000 in profits at a handsome 1046% return. The actions seemed to be so blatant that I labeled it the perfect way to get caught insider trading. Of course one of the key elements of insider trading is having access to inside information.

Suspicious trades alone are not enough. In order for the SEC to win an insider trading case against a company outsider, the SEC must prove that an outsider made his trades based on material nonpublic information given to him by an insider. The SEC failed to find a connection.

Sanchez claimed he made became interested in Potash based on a technical signal “when he observed a crossover signal in the exponential moving average for the price of Potash stock.” He made the buy after

“there was a consolidation of the impulse of the cross of mediums, average, and that consolidation is known as pull-back, and consists of a slight drop in the price after a push for a higher price. And there was a hole that was filled – a gap that was produced during the increase – the previous increase.”

In fairness to Sanchez, he is from Spain and the interview was conducted without a certified, neutral translator. But to me, his explanation is just a bunch of mumbo-jumbo spewing out to make the SEC think he is a trading expert.

As much as the SEC tried, they could not link Sanchez to an insider. They could not even link him to his co-defendant, Juan Jose Fernandez Garcia. Both Garcia and Sanchez lived in Madrid and both made suspicious trades on Potash stock using accounts at Interactive Brokers. That was the only connection.

Garcia also happened to work at Banco Santander, who was an adviser to BHP in connection with its purchase of Potash. Garcia quickly settled with the SEC and forfeited his $576,032.00 in trading profits.

Sanchez was willing to fight for his windfall and challenged the SEC to prove he had inside knowledge. The SEC failed and Sanchez gets to keep his cash.

Sources:

• Memorandum and Order in SEC v. Sanchez (.pdf)
• How to Get Caught Insider Trading – prior post in Compliance Building

Red Flags is Rutger van Waveren

There has always been a theoretical discussion that there could be insider trading on private company shares. I have not seen the theory tested in court. However, a recent enforcement case by the SEC gets close to the theory. The case involves a company re-purchasing shares from employees at a discounted price.

The SEC makes the bold charge that from November 2006 through April 2009, Stiefel Laboratories Inc. defrauded shareholders out of more than $110 million, at the direction of Defendant Charles W. Stiefel, its then chairman and CEO. For example, in late 2008 and early 2009 while purchasing shares for less than $16,500 a share, Steifel did not inform them that the company was in the midst of negotiating the sale at a price of more than $68,000 per share.

The Stiefel family founded Stiefel Labs in 1847 and began to develop some of the world’s first medicated soaps and dermatology products in 1946. The Company has been privately-held, and since 1952 the Stiefel family has been the majority shareholder. Beginning in approximately 1975, Stiefel Labs’ employees began acquiring Stiefel Labs common stock as part of a defined contribution plan. All Stiefel Labs employees located in the United States became participants in the Plan after their first year of employment. Each year, Stiefel Labs made discretionary contributions to the Plan in the form of Stiefel Labs stock or cash. From 1975 to 2008, the Company made contributions of stock, but in 2008, for the first time in its history, the Company contributed only cash. At the time the company was the world’s largest private manufacturer of dermatology products. Charles W. Stiefel also served as the trustee of the plan.

Each year, the company would engage a third-party accountant to determine the price the company would pay shareholders for stock buy backs. According to the SEC complaint, this is where the trouble began. The SEC alleges that accountant used a flawed methodology and was not qualified to perform valuations. The SEC also alleges that Stiefel failed to disclose crucial information about offers and valuations the company received from investment firms. The valuation was only conducted once year.

According to the SEC complaint, the real trouble began in October 2008 when the company was at risk of violating some debt covenants. A part of the austerity measures, the company started buying back stock from current employees, not just from former employees. It’s also around this time that the company started seriously entertaining offers to purchase the company or at least a big chunk of the company.

From December 2008 to April 2009, while seeking bids for its sale the company purchased stock from employees at a price of $16,469 per share. An April 20, 2009 the company announced its sale to Glaxo and closed on July 22, 2009 resulting in a price of $68,131 for shares held in the retirement plan.

Assuming the facts in the SEC complaint are correct, I have some sympathy for the Stiefel. The negotiations with buyers had non-disclosure provisions that likely prevented them from disclosing the purchase price. On the other hand, some of the messages disclosed in the complaint indicate a grab for cash.

This does show that the SEC’s anti-fraud rule in 10b-5 of the Exchange Act can apply to private company transactions. That would prevent a party with material, non-public information from buying or selling those securities. In this case the private company had the information and the employees in the plan did not. Reliance on a third-party valuation is not enough.

Sources:

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• SEC v Stiefel Laboratories and Charles W. Steifel (.pdf)
• SEC Charges GlaxoSmithKline Subsidiary and Former CEO With Defrauding Employees in Stock Plan – SEC Press Release
• a href=”http://www.goodwinprocter.com/Publications/Newsletters/Client-Alert/2011/1219_SEC-Alleges-Securities-Law-Violations-Against-Private-Company-in-Connection-with-Share.aspx?article=1&utm_source=Client-Alert&utm_medium=email&utm_term=article1&utm_content=December-19,-2011&utm_campaign=Newsletter”>SEC Alleges Securities Law Violations Against Private Company in Connection with Share Repurchases from Employees by Goodwin Procter

The insider trading case against Raj Rajaratnam seemed very tight. The prosecutors had him on tape discussing the inside information from wiretaps.
So why did he fight his insider trading charges and get a lesser sentence than the 11 years that was handed down last week?

Ola Leaves.

Suketu Mehta in the Daily Beast discussed the rational and irrational explanations.

A Sri Lankan diplomat close to Rajaratnam told me that she’d met him shortly before he was convicted. “He’d gone to the ola-leaf readers. They told him he’d be acquitted.”

Not tea leaves. Ola leaves.

Three thousand years ago, seven rishis (sages) in India set themselves a mission. They would write down the fate of as many people in the world as they could.

These forecasts are said to have been originally written on goatskins, later transcribed onto copper plaques and then onto ola leaves.

Maybe Rajaratnam’s inevitable appeal will mean the ola leaves were right.

Sources:

• Leaves of life in the Sunday Times
• The Outsider by Suketu Mehta in the Daily Beast

You could watch the movie Wall Street and many things may still ring true. Of course its the 1980s, so the clothes and the women’s hair stick out. But the icon is the big brick cell phone. It was huge and expensive for its time. And all it did was makes phone calls. It was enough of an iconic image that it carried over to the sequel, with the prison guard handing Gecko back his belongings one by one, including the big cell phone.

With Raj Rajaratnam receiving the longest prison sentence ever for insider trading, I wonder which of his personal belongings will be the most iconic in next decade? Rajaratnam 11 year sentence was short of the 19 to 24 years that prosecutors sought. If you look to the movie for inspiration, Gordon Gecko was released from prison after serving eight years.

Of course his phone will be horribly out of date, assuming we still use phones and don’t have chips implanted or whatever the next Steve Jobs-like innovator thinks we should have in our pocket.

Insider trading will still be something that people go to prison for. Not lots of people. Just a few criminals who push too far and whose actions are too nefarious. Plenty more get hefty fines and have to return their ill-gotten gains.

It’s easy to look at these criminals for causing the 2008 financial crisis and the financial mess. Many people are clamoring for more Wall Street heads on pikes. However, insider trading did not cause the 2008 financial crisis.

Sources:

• Rajaratnam and the “No One Has Gone to Prison” Myth by Tim Cavanaugh in Reason
• Galleon Chief Sentenced to 11-Year Term in Insider Case by Peter Lattman in Dealbook

The Massachusetts Secretary of State issued a new regulation that would affect the ability of investment advisors to use expert networks. This was a direct result of Risk Reward Capital Management being based in Massachusetts. Since the management company was registered as an investment adviser in Massachusetts they are subject to examination and enforcement by the Secretary of the Commonwealth.

The regulation highlights the continuing split between the state-lvel and federal-level of regulation of investment advisers. Dodd-Frank only widened that split by kicking thousands of advisers out of registration with the Securities and Exchange Commission and over to the various states.

Risk Reward Capital Management had just under $25 million under management. Dodd-Frank raised that level.

To clarify its new regulation, Massachusetts issued this policy statement:

The Securities Division has received several questions regarding the applicability of the expert or matching services regulation to investment advisers that are under the authority of the Securities and Exchange Commission. This notice is to restate and clarify information included in the Division’s adopting release for the regulations adopted on August 19, 2011.

The expert or matching services regulation will not be deemed applicable to investment advisers subject to Securities and Exchange Commission authority, consistent with the requirements of Section 203A(b) of the Investment Advisers Act of 1940. The Securities Division retains its authority to take enforcement action against an investment adviser or any person associated with an investment adviser with respect to fraud or deceit, consistent with Section 203A(b)(2) of the Investment.

Sources:

• Massachusetts Securities Division Policy Statement on Matching or Expert Network Services Regulation under 950 CMR 12.205(9)(c)(16) and Investment Advisers under SEC Authority (.pdf)
• Adopting Release for the Use of Expert Networks and Performance Based Fees (.pdf)
• Secretary Galvin Adopts New Regulations
  
• Hedge fund paid for inside data, state says by Beth Healy in the Boston Globe
• Administrative Complaint against Risk Reward Capital (.pdf)

The headline was too hard to ignore. I suppose there must be some compliance lessons to be learned. But first, the facts:

William A. Marovitz, who is married to former Playboy Enterprises Inc. Chief Executive Officer Christie Hefner, made $100,952 on the trades, according to an SEC complaint. The SEC alleges that on five occasions between 2004 and 2009, Marovitz traded based on confidential information that he misappropriated from Hefner, in his own brokerage accounts ahead of public news announcements. In November 2009, Marovitz learned about Iconix’s potential acquisition of Playboy and used that confidential information to buy Playboy stock in advance of a public announcement of a potential merger, which caused a 42% increase in Playboy’s stock price. When Iconix ended its efforts to acquire Playboy in December 2009, Marovitz sold Playboy stock before the news became public, resulting in a 10% decrease in Playboy’s stock price.

The case illustrates a tough area for compliance officers: family securities trading. According to the complaint:

Hefner also asked Playboy’s general counsel, Howard Shapiro, to talk to Marovitz about the implications of any trading by him in Playboy stock. Shapiro complied with Hefner’s request by faxing a memorandum to Marovitz’s home and office on September 4, 1998 warning Marovitz of the “serious implications” of Marovitz trading in Playboy stock. Among other things, Shapiro warned Marovitz that “all SEC rules governing Christie’s sale or purchase of stock are equally applicable to you, particularly the rules governing insider trading” and “your purchase is imputed to Christie.” Shapiro requested that Marovitz consult with him before executing any trades in Playboy stock. Marovitz never contacted Shapiro to discuss any of his trades in Playboy.

There are two main reasons for clearing trades. One is to avoid insider trading. The other is to avoid the appearance of insider trading. The trade could be done because he learned of material, non-public information or could be done without having obtained it. (Either way, it looks bad.)

On the adviser side, with the pre-clearance you could be alerted not to trade because of something you are not aware of. If the material, non-public information is in the building your trade is automatically going to be suspicious.

With a public company, like Playboy, there are generally narrow windows of trading to avoid the same set of problems.

The rules are in place to prevent you from accidentally having the appearance of trading on material, non-public information.

The other item in the case that caught my eye was the origination of the case. It came during a SEC examination of a broker-dealer, with assistance of the Internal Revenue Service. It sounds like the different parts of the federal regulators are doing a better job of sharing information.

Sources:

• SEC Complaint against William Marovitz (.pdf 12 pages)
• SEC Charges William Marovitz With Insider Trading in Playboy – SEC Press Release
• Playboy Founder Hugh Hefner’s Son-in-Law Sued by SEC for Insider Trading by Andrew Harris in Bloomberg

Image is by Kaptain Kobold

The SEC announced they had obtained an emergency freeze against three Swiss-based traders under an allegation of insider trading. The SEC claims that Compania International Financiera S.A., Coudree Capital Gestion S.A., and Chartwell Asset Management Services purchased more than a million common shares of Arch Chemicals just prior to the announcement that it was going to be purchased by Lonza Group Ltd.

It does not take much detective work to look at this chart and see that there was some suspicious trading leading up to the July 11 announcement date.

You see the stock price rising and an increase in trading volume. According to the SEC complaint, about 1 million shares in that increased volume came from three defendants. The average trading volume for Arch leading up to the merger announcement was just under 200,000 shares per day.

The hard part will be the SEC proving that the defendants had material, non-public information and used it in breach of some obligation. Clearly, their trading looks suspicious. Proving it was illegal will take more work.

The big question I have, and that compliance professionals that deal with insider trading should have, is how did the trades get flagged?

The SEC has said they are increasing market surveillance and market intelligence to spot suspicious activity. Did the SEC catch this on their own?

Was it compliance? It would seem that the activity coincided very closely with the merger and could easily have been flagged as suspicious by a vigilant broker/dealer compliance department. When a stock usually only trades 200,000 per day, seeing hundreds of thousands of shares being purchased with big public news should be a red flag.

Was it a whistleblower? The SEC has created a new bounty program. Perhaps an insider discover the activity and alerted the SEC in hopes of a financial windfall.

Was it a wiretap? It’s clear from the case against the Galleon Group and Raj Rajaratnam that the government is suing wiretaps to investigate insider trading.

To me the most interesting part of this case will be finding out how the trades got flagged. The rest of the case tied to proving insider trading is not interesting.

Sources:

• SEC Complaint against Compania International Financiera S.A., Coudree Capital Gestion S.A., and Chartwell Asset Management Services (.pdf)
• SEC Obtains Asset Freezes Within Days of Alleged Insider Trading by Three Swiss Entities – SEC press release
• SEC freezes assets on Lonza-Arch Chemicals trades in Marketwatch
• SEC Files Insider Trading Case Over Arch by Bob Van Voris in Bloomberg
• How to Get Caught Insider Trading – prior post on Compliance Building
• The New SEC Whistleblower Rule – prior post on Compliance Building
• Insider Trading: A Dirty Business – prior post on Compliance Building

One of the major tactics of hedge funds is to “arbitrage reality”, operating with a better understanding of a company and its stock price than other participants in the market. In a legitimate operation, that means lots of research. On the wrong side it means getting inside information about a company’s earnings, upcoming deals, and other inside information.

The hedge fund most notably found to be operating on the wrong side was the Galleon Group run by Raj Rajaratnam. On May 11th he was found guilty on all fourteen counts of securities fraud and conspiracy to commit securities fraud. His sentencing is scheduled for July 29th. His appeals will go on for years.

George Packer puts together an insightful look at the Rajaratnam as a lens to explore the difficulties in getting a guilty verdict for insider trading and for prosecutions coming out of the financial crisis in a long article in The New Yorker: A Dirty Business.

I don’t think Rajaratnam’s guilty verdict was a surprise to anyone. Maybe it was a surprise to him and his lawyer. The feds had wiretaps and what appeared to me to be very solid evidence. One of the biggest difficulties is showing the flow of information to show that the trade happened based on material, non-public information. For a company insider or company adviser that is more straightforward than finding that information with a third-party trader. Without the flow of information you can’t show that the use of the information was in breach of a duty.

The death blow in the Rajaratnam trail was Rajat Gupta, a member of the Goldman Sachs’ board of directors. At a board meeting they discussed Warren Buffett’s proposed investment of five billion dollars in Goldman Sachs. The meeting ended at 3:54 P.M. Sixteen seconds later, Gupta called Rajaratnam’s office. At 3:58, just two minutes before the markets closed, Rajaratnam gave an order to buy three hundred and fifty thousand shares of Goldman stock. Fit him for a pinstripe jumpsuit.

Goldman Sachs chairman and chief executive, Lloyd Blankfein was in the witness stand at the Rajaratnam trial. But he was merely there to say that Rajat Gupta had violated the company’s confidentiality rules.

Did insider trading cause the 2008 financial crisis? Did it even play a role?

I’m in the camp with Charles Ferguson, the director of Inside Job, that the financial crisis was caused primarily by shoddy mortgages and trading of those bad loans. But unlike Ferguson, I think the ultimate crisis was caused by greed and stupidity.

The top executives of financial institutions were likely unaware or perhaps willfully ignorant of the low-level players who were originating the toxic mortgages and the packaging of the toxic mortgages into even more toxic mortgage-back securities. Delusion, stupidity and greed are not illegal.

Going back to insider trading, the push for information arbitrage is really a push to the edges of ethical and legal operation. Pushing back from the edge is a person’s morality, their sense of right and wrong. The hammer to that morality is potential prosecution for going past the edge. Packer refers to a 2007 of twenty-five hundred Wall Street professionals.

They were asked if they would use inside information to make ten million dollars if the chances of getting caught were fifty per cent. Seven per cent said yes. But, if there was zero chance of getting caught, fifty-eight per cent said that they would break the law.

That is the real problem with under-funding of the SEC. Without sufficient resources, their hammer of prosecution seems like a negligible risk. If traders see their peers trading on inside information and not getting caught, they are more likely to push past that legal edge. The  Rajaratnam is an important signal that you can get caught.

To be effective the SEC needs more cases, not just bigger cases.

Sources:

• A Dirty Business by George Packer in The New Yorker

If you read about the evidence, you can’t really be surprised that Raj Rajaratnam was found guilty of insider trading. That he was found guilty on all counts was mildly interesting, but not much.

We may get some interesting new legal developments in insider trading law from the appellate decisions. But probably not. The case seems solid. It does not pose the more interesting legal analysis seen in the charges brought in some of the expert network case.

The most interesting aspect of Raj’s case is the government’s use of wiretaps and surveillance. The typical insider trading case relies on some extremely timely trades and a clear opportunity to have acquired knowledge about a significant corporate action. With Raj, his own voice betrayed him. The government was willing to spend considerable considerable effort to gather evidence.

Was it a legal victory? How do you measure success from a legal perspective?:

“We started out with 37 stocks, we’re down to 14,” defense attorney John Dowd said today after his client was found guilty on 9 counts of insider trading and 5 counts of conspiracy. “The score is 23 to 14 for the defense. We’ll see you in the Second Circuit.”

Sources:

• Raj Rajaratnam’s High-Priced Legal Team Pleased With Thrilling 23-14 Victory in Dealbreaker
• Insider Trading 2011: How Technology and Social Networks Have ‘Friended’ Access to Confidential Information
• The Galleon Legacy: White-Collar Wiretaps by Dennis K. Berman in the Wall Street Journal
• Wall Street, Held Accountable in the New York Times opinion page