Insider Trading & Whistleblowers Metropolitan Club, NYC February 9, 2011 RISK MANAGEMENT AND LOSS PREVENTION.

Insider Trading & Whistleblowers

Metropolitan Club , NYCFebruary 9, 2011

RISK MANAGEMENT AND LOSS PREVENTION

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INSIDER TRADING, WHISTLE BLOWERS,

RISK MANAGEMENT AND LOSS PREVENTION

Doug Hirsch, Partner, Head of Litigation & Advisers Operations Practice

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Topics for DiscussionInsider Trading & Whistleblowers

▫ Definitions & Theories

▫ Caselaw

▫ Procedures to Prevent

▫ SEC Enforcement

▫ Dodd Frank Act, Whistleblowers Program & the SEC

▫ Solutions

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About the Speaker

Doug Hirsch551 Fifth AvenueNew York, NY 10176

Douglas Hirsch is the head of the Litigation Practice and the

Advisers Operations Practice. This dual role gives him a unique

perspective on litigating financial services issues and counseling

financial services clients. He represents investment advisers in

all phases of their operations, from drafting and counseling

in connection with service provider agreements and employment agreements to representing them in connection with SEC enforcement proceedings and litigating fraud and breach of fiduciary Duty cases.

Mr. Hirsch also counsels clients in connection with potential exposure under a variety of agreements,

includingoperating agreements, ISDA agreements and marketing agreements. Mr. Hirsch’s 20 years of litigation

experience has encompassed a broad range of trials, appeals class

action litigations and arbitrations.

What is Insider Trading?Classic Theory - trading by an “Insider” (1) in violation of Section 16 of the Exchange Act (Short Swing

Profits, Violation of Filing Requirements, Short Sale

Violations, Trades Against The Box); or (2) using non-publicmaterial information in breach of a fiduciary duty

owed to the company or shareholders for direct or indirect

personal benefit with the intent to deceive. An “Insider” is generally defined as an officer, director or 10%

beneficial owner and attorneys, accountants, consultants andothers who temporarily become fiduciaries.

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Tippee Liability – Variation of Classic Theory A tippee assumes a fiduciary duty to the shareholders of a

corporation not to trade on material nonpublic information only when

the insider has breached his fiduciary duty to the shareholders by

disclosing the information to the tippee and the tippee knows or should

know that there has been a breach. Dirks v. SEC, 463 U.S. at 660.

The insider breaches his fiduciary duty when he receives a “direct or

indirect personal benefit from the disclosure”. 463 U.S. at 663

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Misappropriation TheoryUnder the misappropriation theory, a person violates section 10(b)5“when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information”. U.S. v. O’Hagan, 521 U.S. 642, 652 (1997).

In a misappropriation case, the source of the information does not owe

a fiduciary duty to the issuer of the security or its shareholders and therefore, cannot be prosecuted under the classic theory of insider trading.

An example is the employee of Barron’s or the WSJ who trades in advance of the publication of an article. The employee does not owe a duty to the issuer of the security but has breached a duty of trust or confidence owed to his employer.

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Common Misconceptions About Insider TradingSection 10(b)5 does not prohibit trading upon material non-publicInformation. The courts have repeatedly rejected the parity of information theory. No liability is created simply because one party to a trade has material non-public information that the other party does not. U.S. v. Chestman, 947 F.2d at 565.

Fiduciary duties or duties of confidentiality cannot be unilaterally imposed. For example, an officer of a company could not prevent someone from trading the stock of the company by unilaterally divulging material non-public information to the person. U.S. v. Chestman, 947 F. 2d at 567.

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Caselaw

United States v. Chestman, 947 F.2d 551 (2nd Cir. 1991) – no misappropriation

theory liability where wife told husband of pending tender offer for her family

business and told husband it was confidential and husband told broker who then

traded on the information. Court held no fiduciary business relationship existed

between the husband and wife. However, Williams Act violation.

United States v. Kim, 184 F.Supp.2d 1006 (N.D. Cal. 2002) – no misappropriation

theory liability where a CEO advised a member of his club that he could not make

a meeting due to his company’s pending merger negotiations, and the other CEO

traded upon said information. Their relationship was held to be “peers” that

socialize with one another, not a fiduciary relationship.

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SEC v. Cuban, 634 F. Supp. 2d 713 (N. D. Tx 2009) - The District Court held that no misappropriation theory liability existed where Cuban merely agreed to keep information about an upcoming PIPE offering confidential but never agreed not to trade on said information. No fiduciary relationship.

“The agreement, however, must consist of more than an express or implied promise merely to keep information confidential. It must also impose on the party who receives the information the legal duty to refrain from trading on or otherwise using the information for personal gain. With respect to confidential information, nondisclosure FN6 and non-use are logically distinct. A person who receives material, nonpublic information may in fact preserve the confidentiality of that information while simultaneously using it for his own gain. Indeed, the nature of insider trading is such that one who trades on material, nonpublic information refrains from disclosing that information to the other party to the securities transaction. To do so would compromise his advantageous position. See O'Hagan, 521 U.S. at 656, 117 S.Ct. 2199 (“The misappropriation theory targets information of a sort that misappropriators ordinarily capitalize upon to gain no-risk profits through the purchase or sale of securities.”).”

The Fifth Circuit reversed the district court and held that Cuban’s statement to the CEO “Well, now I’m screwed. I can’t sell”, could be interpreted as an agreement not to trade the shares. The court also held that the question of whether a relationship of trust and confidence existed between Cuban and the Company was a fact sensitive inquiry that could not be resolved on a motion to dismiss. SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010).

Caselaw

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Caselaw SEC v. Rorech - The SEC alleges that Mr. Rorech told Mr. Negrin during two

unrecorded cellular telephone calls on July 14 and July 17, 2006, (1) that Deutsche Bank would recommend

to VNU’s financial sponsors that VNU issue the holding company bonds and (2) that at least one

of Mr. Rorech’s customers already had placed an order for $100 million of the holding

company bonds.

Mr. Negrin purchased CDS. After announcement that VNU holding company would issue bonds, the

value of the CDS increased and Mr. Negrin realized a 1.2 million dollar profit.

Court held that the information was neither material nor confidential. For purposes of the securities

laws, information is deemed “material” if there is “a substantial likelihood that the disclosure of the

omitted fact would have been viewed by the reasonable investor as having significantly altered the

‘total mix’ of [available] information.” Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988)

The Court noted that another hedge fund manager who was aware that VNU may issue bonds

actually sold CDS. Court also noted that Deutsche Bank did not treat such information as

confidential.

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Primary Global Research & GalleonPGR December 16th Arrests

• James Fleishman – Sales manager for PGR. It is alleged that Fleishman arranged for

clients to speak with PGR consultants knowing that consultants would provide confidential information.

• Mark Anthony Longoria – employed by AMD as a supply chain manager. It is alleged that

his AMD employment agreement prohibited from disclosing AMD confidential information.

• Walter Shimoon – employed by Flextronics International, Ltd. as a senior director of

business development. Flextronics is a supplier to Apple. The government alleges that

while acting as a consultant to PGR, Shimoon provided clients with confidential sales

forecasts and new product features in violation of the confidentiality provision of his

employment agreement.

• Galleon – Use of wiretaps is legal in connection with a securities fraud case

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Procedures to Prevent and Detect Insider Trading

• Distribute written guidelines and definitions of what constitutes insider trading. Make employees attest that they have read the materials.

• Chinese Walls – limit the flow of non-public information to those on a need to know basis. Physical or informational barriers – restricting access to information, separating functions.

• Review of employee personal trading – restricting employee trading and/or monitoring employee trading are effective ways to prevent insider trading. Force all employees (and perhaps their immediate family members) to use the adviser’s brokerage firm.

• There should be at a minimum, a restricted list. Advisers should also consider watch lists and rumor lists of securities. A watch list is a list of securities in which trading is closely monitored and limited. A rumor list is a list of securities that become the subject of rumors.

• Exception reports

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New Enforcement ToolsFostering Cooperation – The Division of Enforcement is now authorized to use various tools to encourage individuals and companies to report violations and provide assistance to the agency.

These tools include:

Cooperation Agreements – Formal written agreements in which the Enforcement Division agrees to recommend to the Commission that a cooperator receive credit for providing substantial assistance such as full and truthful testimony

Deferred Prosecution Agreements – Formal written agreements in which the Commission agrees to forego an enforcement action against a cooperator if the individual or company agrees to cooperate fully and to comply with express prohibitions during a period of deferred prosecution

Non-prosecution Agreements – Formal written agreements, entered into under limited circumstances in which the Commission agrees not to pursue an enforcement action in exchange for full cooperation and compliance with express undertakings.

Policy Statement – SEC issues written guidelines detailing how it will go about evaluating whether to credit cooperation

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Dodd-Frank Act Expands SEC’s Enforcement Power

• Special Protection for “Whistleblowers”• Substantially Increased Penalties• Ease of Issuing Subpoenas and Investigations• Expanded Causes of Action• SEC Budget Doubles by 2015• Registration Requirements• Swifter Timeline for Enforcement Actions• Power to Limit Arbitration Clauses• SEC’s Current Enforcement Priorities• Solutions

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SEC’s Whistleblower Program Under Dodd-FrankBasic Outline of Program

• SEC must pay “whistleblower” making a “voluntary” submission of “original information” derived from “independent knowledge” leading to enforcement action recovering > $1 million.

• “Voluntary” means that the whistleblower came to the SEC with the information prior to a subpoena, examination or request for information.

• No “independent knowledge” if information is learned through performing legal audit, compliance audit or supervisory responsibilities – unless company fails to disclose to SEC in reasonable time or acts in bad faith.

• Whistleblower gets 10-30% of money collected in any related civil & criminal case.

• Participants in wrongdoing not absolutely barred from collecting reward.

• SEC is required to pass rules fleshing out statute by 4/15/11.

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SEC’s Whistleblower Program Under Dodd-FrankSpecial Protection for “Whistleblowers”• Confidentiality: Can report anonymously with lawyer.

• Identity must be disclosed to the SEC by the time the Whistleblower seeks the award.

• Employer unlikely to learn identity unless & until it is charged by SEC, and only then during discovery in enforcement proceedings.

• Protection Against Retaliation: Private right of action for retaliation, with remedies of reinstatement, payment of 2x back pay and other relief.

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SEC’s proposed rule attempts to balance internal reporting with employee’s financial incentive to report immediately to the SEC.

“We emphasize, however, that our proposal not to require a whistleblower to utilize internal

compliance processes does not mean that our receipt of a whistleblower complaint will lead to

internal processes being bypassed. We expect that in appropriate cases, consistent with the

public interest and our obligation to preserve the confidentiality of a whistleblower, our staff

will, upon receiving a whistleblower complaint, contact a company, describe the nature of

the allegations, and give the company an opportunity to investigate the matter and report back.

The company’s actions in these circumstances will be considered in accordance with the

Commission’s Report of Investigation Pursuant to Section 21(a) of the Securities Exchange

Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency

Enforcement Decisions.”

Pg. 34-35 of SEC Release No. 34-6323?

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SEC’s Whistleblower Program Under Dodd-Frank Example From SEC’s Prior Insider Trading Bounty” Program

• Pequot Capital Insider Trading Case (July 2010): Ex-wife of Pequot executive finds email on family hard-drive showing that at prior job (Microsoft) he grilled co-workers for inside information & gave it to Pequot founder, Arthur Samberg.

• SEC reopened insider trading investigation into Pequot.• SEC orders Pequot to pay $28 million ($10 million penalty & $18 million

disgorgement): investigation causes Pequot to Shut Down. • SEC awards ex-wife $1 million bounty (statutory maximum of 10% of penalty)

– highest ever awarded pursuant to Bounty Program. • Pequot shows SEC will be aggressive and give maximum rewards

under Whistleblowers Program• Whistleblower designed to remedy defects in Bounty Program by requiring

SEC to pay larger reward of all money collected.• Bounty Program gave SEC discretion to pay only up to 10% of civil

penalties.• In more than 20 years, SEC paid only a handful of Bounties.

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Can Shorts Double Dip?• Can a short seller report its analysis of company wrongdoing to

the SEC and recover a whistleblower bounty under Dodd Frank as well as profit in its short position? Possibly.

• U.S., ex re Brickman & Greenlight – using publicly available information, Greenlight concludes that BLX did not comply with underwriting standards and defrauded the government out of tens of millions of dollars by writing loans that would default and collecting origination fees.

• Court holds that Greenlight’s “analysis” did not constitute original information under the False Claims Act and could not recover FCA reward.

• Dodd Frank is different than FCA because it defines “Original Information” to include “analysis”.

• Proposed SEC Rule defines whistleblower as natural person – major hurdle.

SEC’s Whistleblower Program Under Dodd-Frank Suggestions for Updating Internal Compliance Programs

• Re-emphasize that employees have a contractual duty to report wrongdoing internally.

• Highlight that failure to report internally may be participation in or aiding/abetting the wrongdoing.• Grounds for sanctions, including termination from job.

• Note that reporting wrongdoing can lead to promotion, higher salary or other benefits.• Counteracts financial incentive to be “Whistleblower”

instead of reporting internally.

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Solutions• Tailor compliance manuals to particular business needs• Adopt and implement insider trading procedures• Ensure that marketing materials contain appropriate disclosures• Document a review of all cross trades (including rebalancing)• Document pre-approval of personal trades in a manner

consistent with internal policies and review trades for potentially improper trading

• Maintain detailed records of the valuation of assets • Disclose how you will value hard to value assets • Disclose the use of side pocket accounts

• Review proxy voting records to ensure votes have been cast in accordance with procedures and in the best interest of investors

• Retain thorough and organized records of all transactions, brokerage statements, and financial reports

• Purchase and Maintain Professional Liability Insurance

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For More Information Contact:

Douglas Hirsch Sadis & Goldberg LLP

[email protected]

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THANK YOU