Looking Back

"Unfortunately from what I can see, from my vantage point as the United States Attorney here, illegal insider trading is rampant." So said United States Attorney for the Southern District of New York, Preet Bharara, to a room packed with white collar criminal defense attorneys in October 2010.1 Because "illegal insider trading appears so prevalent,"2 both the Department of Justice and the Securities and Exchange Commission continued to generate headlines with insider trading investigations, prosecutions, and enforcement actions throughout 2010. That trend has only gathered speed in the first six weeks of 2011.

The Galleon insider trading ring may have come to light in 2009, but 2010 saw some of the most interesting issues play out, with court decisions concerning the use of wiretaps in securities fraud prosecutions, and discovery of wiretap evidence in parallel SEC enforcement actions. These decisions will likely guide regulators and defense counsel for years to come. The past year also saw the SEC meet with defeat in its first case alleging insider trading of credit default swaps, but the SEC managed to revive on appeal its high-profile insider trading case against Mark Cuban. 2010 also saw tougher sanctions for insider trading defendants as compared to 2009 and legislative reform that enhances the SEC's ability to enforce insider trading laws. And just as the sprawling Galleon investigation neared its final act – the trial of Raj Rajaratnam – the "expert network" insider trading cases burst onto the stage.

OVERVIEW OF INSIDER TRADING LAW

"Insider trading" is an ambiguous and overinclusive term. Trading by insiders includes both legal and illegal conduct. The legal version occurs when certain corporate insiders – including officers, directors and employees – buy and sell the stock of his or her own company and disclose such transaction to the SEC. Legal trading also includes, for example, someone trading on information he or she overheard between strangers sitting on a train or when the information was obtained through a non-confidential business relationship. The illegal version occurs when a person buys or sells a security while in possession of material nonpublic information that was obtained in breach of a fiduciary duty or relationship of trust.

Two primary theories of insider trading have emerged over time. First, under the "classical" theory, the Securities Exchange Act of 1934's ("Exchange Act") antifraud provisions apply to prevent corporate "insiders" from trading on secret information taken from the company in violation of the insiders' fiduciary duty to the company and its shareholders.3 Second, the "misappropriation" theory applies to prevent trading by a person who misappropriates information from a party to whom he or she owes a fiduciary duty—such as the duty owed by a lawyer or some outside consultant to a client.4

Under either theory, the law imposes liability for insider trading on any person who improperly obtains material nonpublic information and then trades based on such information. Also, under either theory, the law holds liable any "tippee" – that is, someone with whom that person, the "tipper," shares the information – as long as the tippee also knows that the information was obtained in breach of a duty. While the interpretation of the scope and applicability of Section 10(b) and Rule 10b-5 to insider trading is constantly evolving, the anti-fraud provisions provide powerful and flexible tools to address efforts to capitalize on material nonpublic information.

Section 14(e) of the Exchange Act and Rule 14e-3 also prohibit insider trading in the limited context of tender offers. Rule 14e-3 defines "fraudulent, deceptive, or manipulative" as the purchase or sale of a security by any person with material information about a tender offer that he or she knows or has reason to know is nonpublic and has been acquired directly or indirectly from the tender offeror, the target, or any person acting on their behalf, unless the information and its source are publicly disclosed before the trade.5 Under Rule 14e-3, liability attaches regardless of a pre-existing relationship of trust and confidence. Rule 14e-3 creates a "parity of information" rule in the context of a tender offer. Any person – not just insiders – with material information about a tender offer must either refrain from trading or publicly disclose the information.

While most insider trading cases involve the purchase or sale of equity instruments (such as common stock or call or put options) or debt instruments (such as bonds), civil or criminal sanctions apply to insider trading in connection with any "securities." What constitutes a security is not always clear, especially in the context of novel financial products. At least with respect to security-based swap agreements, Congress has made clear that they are covered under anti-fraud statutes applying to securities. In 2000, Congress passed the Commodity Futures Modernization Act ("CFMA"), which amended Section 10(b) of the Exchange Act to extend the rules promulgated by the SEC under Section 10(b) to prohibit fraud, manipulation, and insider trading, and cases decided under Section 10(b), to "security-based swap agreement[s]."6 Section 206B of the CFMA defines a "securitybased swap agreement" as a "swap agreement . . . of which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein."7 In SEC v. Rorech, the SEC's first case alleging insider trading of credit default swaps ("CDSs") (discussed below), the district court shed light on the meaning of "based on" in determining whether instruments such CDSs are "security-based swap agreements."8

The consequences of being found liable for insider trading can be severe. Individuals convicted of criminal insider trading can face up to 20 years imprisonment per violation, criminal forfeiture, and fines of up to $5,000,000 or twice the gain from the offense. A successful civil action by the SEC may lead to disgorgement of profits and a penalty not to exceed the greater of $1,000,000, or three times the amount of the profit gained or loss avoided. In addition, individuals can be barred from serving as an officer or director of a public company, acting as a broker or investment adviser, or in the case of licensed professionals such as attorneys and accountants, from serving in their professional capacity before the SEC.

Section 20A of the Exchange Act gives contemporaneous traders a private right of action to bring a civil lawsuit against anyone trading while in possession of material nonpublic information.9 Although Section 20A gives an express cause of action for insider trading, the limited application and recovery afforded under the statute make Section 20A an unpopular choice for private litigants. Rather, most private securities claims for insider trading are brought under the implied rights of action found in Sections 10(b) and 14(e) and Rules 10b-5 and Rule 14e- 3, respectively.

2010 ENFORCEMENT ACTIVITY

In 2010, the SEC filed 33 insider trading actions, and the DOJ brought criminal charges involving insider trading against 25 individuals. The combined total of civil and criminal cases brought in 2010 declined approximately 12% from 2009. However, the drop in the number of cases is not indicative of a slowdown in insider trading enforcement. In January 2011, the SEC filed seven insider trading actions and the DOJ charged four individuals. In terms of both the number of cases and the scope of the investigations, in 2010 the regulators made clear that "insider trading continues to be a priority."10

As was the case in 2009, insider trading cases in 2010 were notable for their size. As a result of longrunning – and still on-going – investigations, the government continued to bring big cases with multiple defendants. The complicated web of insider trading rings exposed in 2009 continued to grow and spawn new rings in 2010. Law enforcement continued its focus on Wall Street, not Main Street, with financial professionals, particularly at hedge funds, as the primary targets. And, as was the case in 2009, many of the insider trading cases that were brought in 2010 involved allegations of outsized profits.

In its unrelenting crackdown on insider trading in 2010, the government also continued to use law enforcement tactics – such as wiretaps and search warrants – that in the past have usually been reserved for organized crime and narcotics investigations. The government's ability to use recorded conversations was tested in the courts, and so far the government has prevailed. The contemporaneous evidence also proved highly effective, as many of the defendants charged with insider trading in 2009 entered guilty pleas in 2010.

HIGHLIGHTS OF GOVERNMENT ENFORCEMENT EFFORTS

Galleon Update

Insider trading received renewed attention when news of investigations of the Galleon Group and related entities and persons broke in October 2009. In United States v. Rajaratnam11 and the parallel SEC enforcement action, SEC v. Galleon Management, LP,12 the government alleges widespread insider trading at several hedge funds including Galleon Management, LP – a formerly multi-billion dollar hedge fund founded and controlled by Raj Rajaratnam – New Castle Funds LLC, Spherix Capital LLC and S2 Capital Management, LP. The alleged sources of inside information include (now former) high-level executives at prestigious companies such as Intel Corporation, McKinsey & Co. and IBM. The government alleges that, through a complicated web of overlapping relationships and information sharing, the scheme generated more than $49 million in illicit profits or avoided losses.

1. Guilty Pleas

Thus far, the DOJ has charged 26 individuals in connection with the Galleon case and the related Goffer case.13 To date, 19 of those individuals have entered guilty pleas.14 For those defendants turned cooperating witnesses, sentencing is still pending. For those who entered guilty pleas but chose not to cooperate with the government— including Mark Kurland (formerly of New Castle) and Robert Moffat (formerly of IBM)—2010 brought prison sentences.15 However, as discussed in more detail below, there is a growing gap between the stiff sentences sought by the government and the relatively lenient sentences generally rendered by the sentencing judges.

In the United States v. Rajaratnam case, only Mr. Rajaratnam—at the center of the complicated web the government alleges—remains as a defendant. His trial is scheduled to start March 8, 2011.

2. The Legality of Wiretaps and Discovery in Parallel Proceedings

When the story first broke about Galleon and its related cases, one of the most remarkable aspects was that the cases had been built from evidence gathered through the triedand- true law enforcement technique of wiretaps. While wiretaps have long been used by law enforcement agencies in battling organized crime and narcotics traffickers, wiretaps have only rarely been used in insider trading investigations.16 The use of wiretaps permitted the government to build a case based on contemporaneous evidence of the exchange of inside information, rather than relying solely on traditional after-the-fact evidence such as trading patterns and witness statements.

Just how the DOJ and SEC get to use those recorded conversations in their respective cases was the subject of extensive litigation in 2010.

Under Title III of the Omnibus Crime Control and Safe Streets Act of 1968 ("Title III"),17 the defendants in the criminal case received in discovery copies of the wiretap evidence that the FBI and DOJ obtained pursuant to court order during the investigation.

Title III, however, restricts disclosure of the contents of the wiretap to those who need it for law enforcement purposes, and that does not include the SEC. Unlike the defendants in a criminal case, the SEC does not have the right to obtain the wiretaps from the DOJ or FBI to assist it in pursuing its civil case. Unable to get the wiretap recordings from the DOJ or FBI, the SEC in Galleon instead decided to request the recordings from the defendants in the civil case under the broad discovery rules. Defendants refused to produce the recordings, and in January of last year, the SEC moved to compel production of the wiretaps.

The SEC argued that it was entitled to the recordings in the defendants' possession. Although Title III prohibits disclosure of wiretapped communications in certain instances, the SEC argued that the prohibition on disclosure by private parties exists only where the production would obstruct a criminal investigation. In opposition, the defendants argued that because Title III did not explicitly permit disclosure of the wiretap evidence to the SEC, such disclosure was prohibited.

Further complicating the situation, the defendants also argued that— because the legality of the wiretaps had not yet been determined by the court in the criminal case—the decision about whether the SEC was entitled to the wiretap evidence in the civil enforcement action should await the decision on the defendants' motion to suppress in the criminal case.18 Judge Jed Rakoff, presiding over the civil case, found for the SEC and ordered Mr. Rajaratnam and Ms. Chiesi to turn over the wiretap evidence that they had received in the criminal case.

The defendants requested a stay of the discovery order pending appeal, which Judge Rakoff denied. Defendants immediately appealed to the Second Circuit, seeking an emergency stay of the discovery order and requesting a writ of mandamus. The Second Circuit granted defendants' request to stay the discovery order pending appeal.

While the appeal of the civil discovery order was ongoing, Mr. Rajaratnam and Ms. Chiesi were simultaneously fighting the legality of the wiretaps in the criminal case before Judge Richard Holwell. Mr. Rajaratnam and Ms. Chiesi moved to suppress the wiretap evidence on the basis that: "(1) the government was not entitled to use wiretaps to investigate insider trading, a crime not specified in Title III; (2) the government's application and supporting affidavits failed to establish probable cause; (3) the government's application and supporting affidavits failed to establish the inadequacy of conventional investigative procedures and, therefore, the 'necessity' of using wiretaps; and (4) the government failed to minimize various conversations."19 The defendants sought an evidentiary hearing under Franks v. Delaware, at which defense counsel could question government agents regarding the factual allegations that supported the wiretap application.20

During the pendency of the motion to suppress in the criminal case, the Second Circuit issued a strongly worded writ of mandamus, holding that "the district court clearly exceeded its discretion in ordering disclosure of thousands of conversations of hundreds of parties, prior to any ruling on the legality of the wiretaps and without limiting the disclosure to relevant conversations."21 In ordering the extraordinary relief, the Second Circuit concluded that, although the disclosure of the wiretaps was not absolutely prohibited under the wiretap statute, "a district court addressing a discovery demand for such materials must balance the right of access to these materials against the privacy interests at stake."22

In November 2010, Judge Holwell denied defendants' motion for a Franks hearing and found that the wiretap evidence had been lawfully obtained through a valid warrant application. Judge Holwell rejected defendants' four arguments and found that, "[b]ecause Title III authorizes the government to use wiretaps to investigate wire fraud, the government was authorized to use wiretaps to investigate a fraudulent insider trading scheme using interstate wires even though Title III does not specifically authorize wiretaps to investigate insider trading alone."23 For decades, the government has charged insider trading as securities fraud, wire fraud, and mail fraud. In one of the early tests of the misappropriation theory in the Wall Street Journal insider trading case against R. Foster Winans and others, the United States Supreme Court in Carpenter v. United States split 4-4 on the securities fraud counts but affirmed 8-0 on the wire fraud and mail fraud counts.24

Relying on the Carpenter case and the legislative history of the Insider Trading and Securities Fraud Enforcement Act of 1988, Judge Holwell found that defendants' argument "unrealistically assumes a gulf between" insider trading and wire fraud, and that "Congress . . . and the Supreme Court have both endorsed" charging both kinds of fraud for the same core conduct.25

The court also found that the affidavit in support of the warrant—although containing some immaterial misstatements— sufficiently demonstrated the necessary probable cause.26 As Judge Holwell wrote: "Adding it all up, and correcting the affidavit to account for the government's misstatements and omissions, the Court believes that there were enough facts for [the district court] to have found probable cause." The court acknowledged that the government had misled the court by failing to disclose in its warrant application that the SEC had been conducting an on-going investigation into the same activity the wiretap was intended to expose. But even with this "glaring omission," Judge Holwell determined that the government's wiretap application demonstrated the need for the wiretaps.

Based on Judge Holwell's findings, the SEC renewed its motion to compel discovery of the wiretap evidence in the civil case. On February 1, 2011, Judge Rakoff ordered Mr. Rajaratnam and Ms. Chiesi to turn over the tapes to the SEC.27

At least for now, it appears that Mr. Rajaratnam and Ms. Chiesi have lost their quest to exclude the wiretap evidence from both the criminal and civil cases. If he is convicted at trial, Mr. Rajaratnam may still appeal Judge Holwell's denial of the suppression motion. But, if he does, he will be doing so alone, because two weeks prior to Judge Rakoff's ruling, Ms. Chiesi entered a guilty plea in the criminal case.28

In the related Goffer criminal case, presided over by Judge Richard Sullivan, the defendants also moved to suppress wiretap evidence, offering essentially the same arguments as did the defendants in Rajaratnam. In an oral order on January 5, 2011, Judge Sullivan denied the motion and ruled the wiretap evidence admissible, noting: "[T]he defendants move to suppress the wire because Title III does not enumerate insider trading as a predicate offense, which it doesn't, of course. However, wire fraud is a predicate offense under Title III, and the applications of the government were very explicit that that was one of the crimes being investigated. There was no attempt to hide the ball with respect to the insider trading conspiracy. I will note that Judge Holwell explicitly rejected this very same argument in the Rajaratnam case."29 Judge Sullivan also found the government established necessity, probable cause, and showed sufficient minimization. Within days of the order Arthur Cutillo, one of the defendants in the Goffer case, entered a guilty plea.30 The media have reported that more guilty pleas are expected.31

The proximity of guilty pleas in the Galleon and Goffer cases to the rulings on admissibility of the wiretap evidence suggests the significance of these rulings for insider trading cases going forward. In particular, both the fact that the wiretaps were found to be lawfully obtained and that the SEC can have access to the recordings through civil discovery may significantly shape defendants' strategy in the new insider trading cases brought in 2010 (and 2011) arising from some of the same conversations taped in Galleon (discussed in detail below). In addition, because wiretap evidence was ruled admissible in two high-profile cases last year, the government is likely to continue pursuing wiretaps as a means to investigate insider trading in the future.

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Footnotes

1. See The Future of White Collar Enforcement: A Prosecutor's View, available at http://www.nycbar.org/EventsCalendar/show_event_new.php?eventid=1484 ; see also, Jonathan Dienst, Insider Trading "Rampant" on Wall St.: US Attorney (Oct. 21,

2010), available at http://www.nbcnewyork.com/news/local-beat/Insider-Trading-Rampant-On-Wall-St-US-Attorney-105399138.html .

2. Id.

3. See Chiarella v. United States, 445 U.S. 222 (1980).

4. See United States v. Hagan, 521 U.S. 642 (1997).

5. 17 C.F.R. § 240.14e-3.

6. Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, § 1(a)(5), 114 Stat. 2763 (Dec. 21, 2000) (codified at 15 U.S.C. § 78j(b)).

7. Id. at 206B.

8. SEC v. Rorech, 720 F. Supp. 2d 367 (S.D.N.Y. 2010).

9. 15 U.S.C. § 78u-1.

10. Robert Khuzami, Speech by SEC Staff: Speech to the Society of American Business Editors and Writers (SABEW), U.S. Securities and Exchange Commission (Mar. 19, 2010), available at http://www.sec.gov/news/speech/2010/spch031910rsk.htm .

11. United States v. Rajaratnam, No. 09-Cr-1184 (RJH), 2010 U.S. Dist. LEXIS (S.D.N.Y. Nov. 24, 2010).

12. SEC v. Galleon Mgm't, LP, 683 F. Supp. 2d 316 (S.D.N.Y.2010).

13. United States v. Goffer, No. 10-Cr-00056 (RJS), 2010 U.S. Dist. LEXIS 125461 (S.D.N.Y. Nov. 24, 2010).

14. For a summary of the individuals charged and the status of the matters, see Appendix A.

15. See Appendix A.

16. While some reporters stated that the Galleon case marked the first time ever that court-ordered wiretaps had been used in an insider trading case,

in fact the Southern District of New York had used wiretaps in the its so-called "Mob on Wall Street" case more than a decade ago which resulted in the arrest and prosecution of dozens of insider traders. See Organized Crime on Wall Street, Hearing Before the Subcomm. on Finance and Hazardous Materials of the H. Comm. on Commerce, 106th Cong. 118, 262-63 (2000).

17. Pub. L. No. 90-351, § 2510-2522, 82 Stat. 197 (June 19, 1968).

18. SEC v. Galleon Mgm't, LP, 683 F. Supp. 2d 316 (S.D.N.Y. 2010).

19. Memorandum and Opinion at 1, United States v. Rajaratnam, No. 09-Cr-1184 (RJH) (S.D.N.Y. Nov. 29, 2010), ECF No. 148.

20. Franks v. Delaware, 438 U.S. 154, 165 (1978).

21. SEC v. Rajaratnam, 622 F.3d 159, 164 (2d Cir. 2010).

22. Id. at 163.

23. Memorandum and Opinion at 1, U.S. v. Rajaratnam, No. 09-Cr-1184 (RJH) (S.D.N.Y. 2010).

24. Carpenter v. United States, 484 U.S. 19 (1987). (As a footnote to history, Jed Rakoff was counsel for David Carpenter at trial and on appeal.)

25. Memorandum and Opinion, supra note 23, at 9.

26. Id. at 30.

27. SEC v. Galleon Mgm't, LP, Order (Feb. 9, 2011).

28. United States v. Rajaratnam, 09-Cr-1184 (RJH) (S.D.N.Y.).

29. Oral Order of Judge Richard J. Sullivan, United States v. Goffer, No. 10-Cr-00056 (RJS) (S.D.N.Y. Jan 5, 2011).

30. Id.

31. Chad Bray, Judge Allows Wiretaps in Galleon Case, WALL ST. J., Jan. 6, 2011, available at http://online.wsj.com/article/SB10001424052748704405704576063734119118202.html?KEYWORDS=goffe r.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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