The Galleon Cases and Trends in Insider Trading Investigation, Prosecution and Enforcement

Presented by:

DLA PIPER LLP (US)

Government Lawyers Are Saying . . .

“[The Galleon case is] a wake-up call for every hedge fund manager and every Wall Street trader and every corporate executive who is even thinking about engaging in insider trading.”

“As the defendants in this case have now learned the hard way, they may have been privy to a lot of confidential corporate information, but there was one secret they did not know: We were listening. Today, tomorrow, next week, the week after, privileged Wall Street insiders who are considering breaking the law will have to ask themselves one important question: Is law enforcement listening?”

“Unlawful insider trading should be offensive to everyone who believes in, and relies on, the market. It cheats the ordinary investor, victimizes the companies whose information is stolen, and is an affront not only to the fairness of the market, but the rule of law. In just over 18 months, this office has charged 47 individuals with insider trading crimes; Rajaratnam is the 35th person to be convicted. We will continue to pursue and prosecute those who believe they are both above the law and too smart to get caught."

-- Preet Bharara

U.S. Attorney for the Southern District of New York

Government Lawyers Are Saying . . .

Insider trading is “systemic” among hedge funds.

Anyone engaged in insider trading “should be worried.”

“The days of insider-trading scrutiny being focused almost solely on the equity markets are now gone.”

The SEC intends to “roll back the curtain . . . and look at patterns across all markets.”

-- Robert Khuzami

Director of Enforcement Securities Exchange

Commission

Galleon cases

Conviction of Raj Rajaratnam:

Unlawful trading involved stocks of 14 companies

Faces significant imprisonment.

21 Guilty Pleas from corporate executives, consultants, lawyers traders and hedge fund managers.

Additional defendants facing trial.

Expert Network Investigations and Cases

DOJ, SEC and State regulators involved.

“In several indictments involving expert networks, authorities claim that hedge fund managers paid outside consultants handsome fees for providing nonpublic information. The government has also charged executives at the expert network firms, the ones who brokered the connections, with knowingly facilitating the exchange of illegal stock tips.”

“Prosecutors say the money managers often sought impending information on large technology companies, like Apple and Dell, whose stocks can turn quickly on tidbits about financial performance and forthcoming products.”

- New York Times

Nuts and Bolts and Lessons of the Raj Rajaratnam Verdict

Nuts and Bolts

§ 240.10b5-1 Trading in the possession of material nonpublic information in insider trading cases.

General. The "manipulative and deceptive devices" prohibited by Section 10(b) of the Act (15 U.S.C. 78j) and § 240.10b-5 thereunder include, among other things, the purchase or sale of a security of any issuer, while in possession of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.

Elements of Insider Trading

Material

Non-public

Duty

Trading in connection with

Scienter

Key Questions in Galleon Trial

Where is the line between material/immaterial and public/non-public in the context of investment professionals?

What role (if any) must the inside information play in the trading decision for liability to arise?

Materiality

Information is material if there is a substantial likelihood that:

A reasonable shareholder would consider the fact important in deciding how to trade

Disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available

Materiality is a fact-specific determination. Assuming information is immaterial without consulting a lawyer can result in civil or criminal prosecution.

Truly objective standard.

Examples of Potentially Material Information

An issuer will show above-expected delinquencies in the pool of mortgages backing its bonds

An issuer is about to release financial projections An issuer is about to make a PIPE offering An issuer is about to receive a tender offer An issuer will soon announce a change in management An issuer will soon announce a rating change An issuer will soon announce a merger or asset sale An issuer will soon announce earnings An issuer will soon disclose a valuable mineral discovery or R&D

development An issuer will soon receive an upcoming buy recommendation from a

financial analyst An issuer will be featured in a financial news column

Non-public

Non-public information is information that has not been disseminated in a manner making it generally available to investors

Information is public when it is widely available in the public domain, such as in press releases, media articles, and SEC filings

After material information is disclosed into the public domain, you need to wait until public investors have had time to react to the information if you previously possessed inside information

Galleon jury charge: Even where there is some “public” information on a given issue, there might well be “more specific and more private” information that remains non-public.

Relevance of Information to Trading Decision

Mere possession of material non-public information is not a securities violation.

Proposed Defense charge: Whether the defendant traded “based on” the information? Causal relationship between information and trade.

Proposed Government Charge: Whether the defendant “used” the information, i.e., whether the information was a “factor, however small” in the trading decision. Presumption of causation based on possession.

Mosaic Theory

mo·sa·ic noun : a surface decoration made by inlaying small pieces of variously colored material to form pictures or patterns. www.merriam-webster.com/dictionary.

The Mosaic Theory Defense

Professional investors make trading decisions based on the amalgamation of myriad pieces of information and data obtained from various sources and resources.

No single piece of information and data is material to the professional.

It is the review and analysis of the whole – the finished mosaic – that determines how the investor will proceed.

Query: What if one piece of information included in the mosaic is independently material?

Why the Mosaic Theory defense failed Raj

Court rejected a different standard for investment professionals.

Information Rajaratnam received appeared material and non-public to the lay person: Subject matter – Big ticket items: M&A, earnings.

Sources – high-profile individuals.

Once the information is deemed material non-public, to prevail the mosaic theory defense requires application of the more restricted standard on “use” of information requested by the defense.

Otherwise, almost by definition, material non-public information – whether obtained lawfully or unlawfully – will be a factor, and thus “used,” in any trading decision made by its possessor.

In such a case, where any piece of the mosaic is improperly obtained material non-public information, the defenses collapses.

Whether the trading in question was consistent with the mix of information available in the marketplace is not truly significant where material non-public information need only have been “a factor, however small” in his trading decision.

Situation on the Ground

New Investigative Techniques, and Aggressive Enforcement

Criminal

Wiretaps Cooperators

SEC

Piggy-backing on DOJ resources Administrative Proceedings:

No discovery No jury

Role of Wiretaps

Bolster Direct Evidence, Allow for Proactive Investigations and Broaden the Web

Wall St. titan Raj Rajaratnam convicted with help from wiretaps, which may get more use in white-collar cases – Washington Post

Wiretaps key in conviction of ex-hedge fund giant - Wall Street Journal

Galleon Conviction Likely to Embolden Prosecutors – New York Times

Insider-trading Cooperators at Heart of Prosecutions – Business Week

Focus On Hedge Funds Encompasses All Corporate America

Galleon: Dozens of stocks. Corporate officers, directors, lawyers, consultants implicated.

Goldman Sachs Intel International Business Machines Corporation McKinsey & Company Moody’s Investor Services, Inc. Market Street Partners Akamai Technologies Polycom, Inc.

Expert Networks:

Numerous public companies and their employees under scrutiny.

Criminal v. Civil

Not bright-line: Individuals engaged in the same conduct regularly end up on opposite sides of the divide.

Indicia of Criminal cases:

Provision of tangible benefit by tippee in exchange for information.

Suggestions of document altering or creation of false trails/cover-up.

Tabloid fodder.

Strong deterrent effect.

Lessons and Responses

Stop, Think and Ask

Whether contemplated trading activity is unlawful raises complex legal questions.

Essential role of internal and outside counsel and compliance departments in scrutinizing and vetting.

Example: David Sokol and Berkshire Hathaway’s Lubrizol acquisition.

Training, Training, more Training and Monitoring

Increasing importance of robust policies, training, and oversight.

Continuous monitoring of communications with third-parties and employee trading.

Responsiveness by legal and compliance to questions and concerns.

Obligations Do Not Stop at the Door

Monitoring executives’ outside board service:

Example: Rajat Gupta

• Monitoring consultants retained in the ordinary course of business. Example: Anil Kumar

Establish rules and procedures for dealing with expert networks/third-party resources.

Options for Targets/Defendants

Plea/Settlement Degree of certainty Resource conservation Limit downside Facilitate moving-on

Litigate Increased skepticism of federal judges to SEC theories and

relief sought (e.g., SEC v. Zachariah, ). Courts may push back against over-reaching. Government’s burden may increase due to expectation of

inflammatory, incriminating evidence via wiretaps – old circumstantial cases now harder to win.

Questions and Answers