Mark J. SteinSimpson Thacher & Bartlett LLP

Developments in Insider Trading Law and Enforcement

November 10, 2009

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Insider Trading Overview

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Overview of Insider Trading

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Section 10(b) and Rule 10( b)(5) make it unlawful for an individual to engage in a securities transaction while in the possession of material

non-public information.

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What is material non-public information?

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Basic Rule: A fact is deemed material if there is a substantial

likelihood that a reasonable investor would consider it important

in determining whether or not to make a trade at a particular price.

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Material Information

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3 basic kinds of material information:■

Information about the issuer’s earnings and profits.

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Prospective information –

such as plans for a forthcoming tender

offer or other strategic transaction.

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Bad news (e.g., product development, departure of a key executive).

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Factors demonstrating materiality:

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The timing

of a trade can be determinative in establishing

materiality (if an insider trades close in time to learning certain non-

public information, it supports a theory that it is material

information).

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The reaction of the market

after the information is disclosed.

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Materiality of a Future Possible Event

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The Supreme Court has held that materiality must be based upon a

balancing of both the indicated probability

that the event will occur and the magnitude

of the event for the company.

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For probability, look at where the process stood within the company.

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For materiality, look what an event could potentially do for the

company and its stock price.

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Concrete information from an insider has value over mere speculation in the press.

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In SEC v. Maio

(1995) the court found knowledge of a single meeting between a potential target and bidder to be material information

because of the importance of the individuals in attendance and the substantial nature of the potential transaction to the parties.

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Scienter

(Intent/Recklessness)

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Elements of Scienter:

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Actual knowledge of the non-public information;

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Knowledge that the information was undisclosed; and

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Knowledge that the information was material.

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Evidence of Scienter:

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An attempt to conceal the transaction (like be spreading them

among different accounts).

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Timing –

trading just before information is disclosed.

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Parallel trading by relative of someone in possession of insider

information.

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Open Issue –

Must the information be the reason for the trade?

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Must it be established that the individual traded on the basis

of the non-public information he/she

received?

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Can a defendant argue that he/she would have traded anyway?

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The SEC recently pronounced that a defendant only needs to be in possession of such information.

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2 Primary Bases for Insider Trading

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The Special Relationship Theory: An insider trades with a victim with knowledge of material non-public information.

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The Misappropriation Theory: U.S. v. O’Hagen (1997): A person misappropriates material non- public information in breach of a duty to the

information source.

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Lawyer at Dorsey & Whitney traded on the basis of a proposed tender offer for Pillsbury Corp. Held that he misappropriated information from his firm and the client in connection with his trades.

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The Special Relationship Theory

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Based on a fiduciary duty

owed by a corporate insider to one buying or selling stock in the corporation.

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Applies equally to trading by insider or tipping by insider.

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How does one become subject to the special relationship with the shareholder?

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Employment by the issuer (does not have to be a high level employee).

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Former employees who still have access to information.

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Independent Contractors: Attorneys, investment bankers, etc.

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The Special Relationship Theory (Cont’d.)

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Applies to tipping behavior

if the tipper will obtain a personal benefit

from the tip:

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Pecuniary gain;

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An enhancement of reputation that will translate into future earnings;

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An expectation of reciprocal tips of items of value;

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A good feeling from giving confidential information to friend or relative.

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Tippee

Liability

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A tippee

assumes a fiduciary duty to shareholders of the corporation not to trade when the insider has breached his fiduciary duty to shareholders and the tippee

knew of the breach.

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If a tipper mistakenly provides information to a tippee, he has not violated 10b-5 and therefore the tippee

has not either.

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If a tippee

accidentally overhears inside information –

there is no bad act on the part of the tipper and

therefore, no liability.

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Galleon Insider Trading Investigation

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Criminal and civil cases have been filed against 20 individuals in what the

U.S. Attorney’s Office for the Southern District of New York calls “the

largest hedge fund insider trading case in history.”

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The SEC and DOJ allege that a network of hedge fund managers, corporate

insiders and lawyers exchanged and traded on nonpublic information

regarding several companies, including Google, Hilton Hotels, and Intel.

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The U.S. Attorney filed criminal charges against 6 individuals on October

16th and 14 individuals on November 5th for operating related insider

trading networks.

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The SEC filed an overlapping civil suit against 15 individuals as well as

several hedge funds and investment firms, including Galleon, Spherix

Capital and S2 Capital.

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Galleon Insider Trading Investigation (Cont’d.)

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The individuals charged include:

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Raj Rajaratnam, founder of Galleon.

•

Rajiv Goel, managing director with Intel’s treasury group

and Intel

Capital.

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Anil Kumar, senior partner at McKinsey & Co.

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Robert Moffat, senior vice president at IBM.

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Deep Shah, former Moody’s

analyst.

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Steven Fortuna, former managing director of S2 Capital.

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Arthur Cutillo, attorney at Ropes & Gray

(second wave of arrests).

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The government employed new investigation tactics normally used for organized crime, such as tapping phones and wiring cooperating witnesses.

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The Misappropriation Doctrine

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The liability is based on someone misappropriating information from a company. In that case the victim is the company who has had the information stolen from it.

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Elements:

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Misappropriates non-public information.

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By a breach of a duty arising out of a relationship of trust and confidence.

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Uses that information in a securities transaction.

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The Misappropriation Doctrine (Cont’d.)

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Positions of trust and confidence:•

Employee of a law firm/investment bank/financial printer

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Independent contractor (electrical contractor convicted)

•

Potential independent contractor (interviewer for consulting job on a deal not convicted when found out information over lunch)

•

Journalist –

Wall Street Journal case “Heard on the Street column”

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Doctor-patient and attorney-client

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SEC v. Mark Cuban

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The SEC charged Cuban with insider trading for trading on confidential information he obtained from Mamma.com

in 2004.

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Mamma.com’s

CEO contacted Cuban, the then-largest known shareholder, to invite him to participate in a “PIPE”

offering days before it was publicly announced.

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The CEO prefaced the conversation on Cuban’s agreement to keep their discussion and the information confidential.

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Cuban then sold all of his shares in Mamma.com

without informing the company and before the information became public, avoiding $750,000 in losses.

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SEC v. Mark Cuban (Cont’d.)

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The SEC proceeded against Cuban under the misappropriation theory of liability.

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The court held that the SEC failed to establish that Cuban undertook a duty of non-use of the information, and he was not liable because he never agreed to refrain from trading on the confidential information.

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The court essentially rejected the SEC’s view that third parties who accept material nonpublic information from a company on a confidential basis are precluded from trading on the information.

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The implications of this decision are far-reaching because it has not only muddled the stance of the SEC in adopting Regulation FD, but has also left both providers and recipients of such information with a lack of guidance as to what constitutes illegal insider trading.

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Recent Developments

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SEC and DOJ Emphasis on Insider Trading

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Both the SEC and the DOJ have recently signaled an increased emphasis on investigating and bringing insider trading cases.

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This increased emphasis is evidenced by both an increase in the sheer number of insider trading actions as well as in recent press statements.

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Increase in SEC Insider Trading Enforcement Actions

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SEC insider trading enforcement actions have

increased in the last year:

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2004: 42

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2005: 50

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2006: 46

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2007: 47

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2008: 61

(http://www.sec.gov/spotlight/insidertrading.shtml)

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Recent SEC Pronouncements Showing Emphasis on Insider Trading

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The SEC plans to “continue our concerted effort to root out insider trading on Wall Street and in the hedge fund industry.”

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Robert Khuzami, Director of SEC Division of Enforcement, at press conference announcing new IT charges in Galleon and another alleged IT ring, Nov. 6, 2009.

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“It is unconscionable when these highly paid individuals abuse their access to sensitive information and enrich themselves at the expense of others,”

. . . “As today’s actions demonstrate, we are aggressively working to combat insider trading wherever it occurs and whoever is involved.”

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Scott Friestad, Deputy Director of SEC Division of Enforcement, announcing insider trading charges, Feb. 5, 2009.

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Recent DOJ Pronouncements Showing Emphasis on Insider Trading

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“People will probably ask just how pervasive is insider trading these days? Is this just the tip of the iceberg? . . . We don’t have an answer to that yet but we aim to find out.”

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Preet

Bharara, US Attorney for the Southern District of New York, referring to the Galleon investigation, Nov. 5, 2009.

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“We have become more aggressive. I also think we have become and we will continue to become more collaborative.”

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Lanny

Breuer, Assistant AG in charge of DOJ Criminal Division, referring to the Galleon prosecution, Nov. 6, 2009.