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WHAT TO DO WHEN THE SEC COMES CALLING (AND IT WILL)
 
By Steven M. Cohen, a partner at Kronish Lieb Weiner & Hellman, LLP in New York. He has served as both a federal prosecutor and an SEC staff attorney.

The investigation and prosecution (both civilly and criminally) of insider trading is once again in vogue. The SEC’s get-tough attitude may well mean that a hedge fund’s success – its ability to anticipate the market and respond accordingly, its ability to maximize profits and avoid losses – will make them a magnet for an insider trading investigation. Why should this be so? And, what can a manager do about it?

Nothing Invites an SEC Inquiry More Than Success

You do not have to be a student of the SEC Enforcement Division to understand that, in their effort to ferret out insider trading, SEC staff attorneys often do no more than look to see who beats the market. They do this by relying on computer programs that detect such trading activity as well as by receiving information from clearing houses and brokerage firms, which report suspicious or irregular activities. Shorting a stock before it takes a tumble or being long before a stock’s price jumps may rightly or wrongly put your activities in question. This is especially so when actual misconduct has taken place, regardless of whether you are involved.

In one recent example, it has been alleged by the SEC and a grand jury that Dr. Sam Waksal, founder of ImClone, learned in late December 2001 that the FDA was going to issue a refuse to file letter related to ImClone’s cancer drug Erbitux, and then tipped certain individuals who sold ImClone shares either for their own accounts or on behalf of Dr. Waksal in advance of a public announcement. On October 15th, 2002, Dr. Waksal pleaded guilty to six criminal counts including charges that he caused his daughter to trade on the basis of material non-public information. He maintains an original not-guilty plea concerning allegations that he conspired to commit securities fraud in connection with other ImClone trades, including sales of ImClone shares by his father.

The situation, however, gets more complicated and more ominous for hedge funds when you realize that the ImClone story has repercussions far beyond Dr. Waksal, his family and even Martha Stewart. It is a safe bet that just about any hedge fund manager, stock broker, or private investor who happened to either unwind a long position or short ImClone in the last few days of December 2001 found themselves being questioned – if not subpoenaed -- by the SEC.

It is, of course, likely that anyone lacking a real connection to Dr. Waksal or ImClone or to the inside information that was allegedly leaked in advance of the FDA’s announcement will eventually walk away from such an investigation -- if not exactly unscathed -- then at least without charges being filed. However, regardless of whether such an SEC inquiry is determined to be without merit, no one needs the annoyance, stress, disruption and expense of responding to an SEC inquiry.

Recent Changes To the Law Make Inquiries More Likely

Recent changes to SEC Regulations (coupled with public pressure to get tough) have tended to make such inquiries more not less likely. Last year, in an effort to clarify insider trading standards, the SEC adopted Rule 10b5-1. In addition to other things, the new rule seeks to take the guesswork out of what has often proven to be the most slippery area of the law: determining whether a person traded "on the basis of" material non-public information. Prior to the rule’s adoption, a number of courts had acknowledged that a person might possess inside information but that information might not be the cause of a trading decision. Market professionals, in particular, are often in possession of all sorts of information some of which factors into a trading decision and some of which does not, and some of which might be linked to an insider. Given this reality, it was not uncommon for someone facing an insider trading inquiry to respond by explaining that perhaps they did inadvertently receive what in hindsight appears to be inside information but that was not the basis of a trading decision. While the SEC might not readily accept such claims, the SEC staff understood that certain courts would and did give serious consideration to such a defense. In other words, the SEC had to deal with cases where, even if it could prove that an insider possessed material non-public information, a defense existed if the person could credibly argue that information was not the basis of the trading activity.

To remedy the situation, Rule 10b5-1 draws a bright line and considers any purchase or sale of a security to be "on the basis of" inside information so long as the person making the purchase or sale was in possession (meaning simply aware) of material non-public information. Simply put, if you learn of inside information, regardless of what else you know or what other factors might be motivating your trading activity, you are presumed to be trading on inside information. While Rule 10b5-1 does provide a safe harbor (as discussed below), the new rule makes life a lot easier for the SEC and deprives a person under investigation a fairly practical defense.

What To Do – Or Not Do – When The SEC Calls

If you are an active professional trader, it is likely that you will eventually receive a telephone call from the SEC. Note, I am not talking about receiving a subpoena, I am referring to an actual telephone call that typically comes shortly after the close of the market and sounds something like: "Hello, this is David Miller. I am an SEC staff attorney. We are conducting an informal inquiry into the trading activity of XYZ securities. Would it be alright if I ask you a few questions?" In my experience, just about everyone who receives such a call responds by answering the questions asked. And, that might be a mistake.

Whether you should or should not submit to such an impromptu grilling depends on a variety of factors, including, whether you are facile with the circumstances of your fund’s trading activities, whether you can answer questions clearly, directly and briefly, whether you have a witness who can participate on the telephone call and whether you (or the witness) are capable of taking very detailed notes of the conversation.

It is essential to understand that you have a choice. The staff attorney is inviting you to chat, and you have every right to decline the invitation (although curiously almost no one ever does). When deciding to participate in such discussions, I suggest you realize that you are being called at the end of the day for a reason. Like telemarketers, a skilled lawyer understands that at the end of the day you are likely to be tired and your guard may be down. You are more apt to speak expansively on subjects about which you are better off saying little. Indeed, it is all too common that innocent misstatements made during such a conversation may cause problems at a later time since such errors might be taken as evasions or deceptions.

As a general matter, most people are best off explaining that it is not a convenient time and offering to call back the staff attorney. This tactic gives you an opportunity to familiarize yourself with the trading activity at issue, to think through any questions that might be difficult to answer and to speak with the SEC at a time that is convenient for you. It also will give you a chance to include someone else on the call, who might later serve as a witness should there be a dispute about what you said, and to consult with a lawyer if you feel it is either necessary or helpful. When you do return the call, it is essential that you take thorough notes of both the questions asked and the answers given. If the investigation continues beyond this initial telephone call, your notes will be of vital importance in assessing what the SEC is investigating and assuring that there are no misunderstandings about what you said. Similarly, including a witness will protect you if there is ever a dispute about what you said during the call. It is also helpful to have another perspective on what seems to be of interest to the SEC.

Preparing For The Call

Before you receive that telephone call, there is much that can be done to ensure that you are in a position to answer the SEC’s questions and promptly put an end to its inquiry. First, get in the habit of memorializing your trading strategy. A simple memorandum or outline of your view of a particular security or sector accompanied by a brief synopsis of the position you plan on taking will suffice. If and when it proves necessary to modify or abandon that strategy, a brief follow-up memo should record that fact as well. I would even keep notes of minor changes and disruptions in your strategies. For example, if you unwind a complex position because the only analyst who understands the computer model on which the strategy is based is going on vacation for two weeks and will be unreachable, I would place a note in your files explaining that circumstance. As mentioned above, Rule 10b5-1 provides a safe harbor that includes written plans for trading securities. There is no reason not to avail yourself of this protection.**

Second, track the information you receive and the source of that information. Again, nothing overly formal is required. But, it may prove extremely useful to be able to explain that you shorted Martha Stewart Omni-Media in February 2001, not because you happened to visit Ms. Stewart at her Hamptons estate, but because in February you received a detailed report from a consultant who predicted a sharp downturn in the gracious living industry. Even better, if you happen to have received a written report or taken notes of the meeting with the consultant those should be preserved for easy retrieval.

Third, to the extent you or your staff tends to write pertinent information or thoughts down on scratch paper and blotters, those should be saved. Being able to show that on a particular date you received critical and wholly legitimate information during a telephone call and that information – not an illicit tip -- motivated your action, might one day be extremely important. Being able to produce your daily blotter that shows to whom you spoke, when and about what, might be akin to the silver bullet that can kill an investigation.

Fourth, print out information from on-line sources that are impacting your positions. Whether the information is from a bulletin board or from a trusted and reliable source, if it is having an impact on your strategy or if it effecting your position print it out and stick it in a file. This is the type of information that may turn out to be crucial in your efforts to demonstrate to the SEC that you were acting on perfectly legitimate information.

In all probability, one day you will pick-up the telephone and it will be an SEC staff attorney inviting you to have a conversation about one or your more successful positions. By getting in the habit of saving a few pieces of paper and writing a few reports, you will increase the likelihood that your encounter with the SEC will be – if not pleasant – than at least relatively uneventful. u

 
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