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What’s Next?: The Future of Insider Trading and High-Frequency Trading Prosecutions

Clifford C. Histed, a partner at K&L Gates in Chicago and a former supervisory Assistant U.S. Attorney and supervisory enforcement lawyer with the Commodity Futures Trading Commission, explores the fallout from Dodd-Frank and the future of insider trading prosecutions, given the Second Circuit’s recent decisions and cases pending before other federal circuits and the U.S. Supreme Court.

Clifford, Assessing the impact of United States v. Newman and its progeny, including United States v. Riley decided in January, what is the Second Circuit saying about the future of insider trading prosecutions? Is there activity in other circuits or in the Supreme Court that might have further impact?

Newman had a tremendous impact on those insider trading cases involving tipper-tippee liability. In Newman, the Second Circuit suggested that the government had gone too far in aggressively prosecuting insider trading, specifically commenting on the “doctrinal novelty of its recent insider trading prosecutions, which are increasingly targeted at remote tippees (like defendants Newman and Chiasson) many times removed from corporate insiders,” and observing that there was not “a single case in which tippees as remote as Newman and Chiasson have been held criminally liable for insider trading.”

Newman held that to sustain a criminal conviction against a tippee, the government must prove that the tippee knew of the tipper’s breach of fiduciary duty, including that the tipper breached the duty for the tipper’s personal benefit. Its more dramatic holding was that a judge or jury may not infer a “personal benefit” solely from a personal relationship between a tipper and tippee in the absence of “a meaningfully close personal relationship that generates an exchange that is objective, consequential, or represents at least a potential gain of a pecuniary or similarly valuable nature.” This added requirement raised the bar to a height that the government could not reach in Newman. Notably, the court did not merely remand the case to the district court for retrial, but instead dismissed the entire indictment with prejudice.

The Second Circuit has been called the “Mother Court” of securities cases. Its holdings in this area always merit careful scrutiny, and are of critical importance to the SEC, but Newman is not yet the law of the land. Indeed, in the later Ninth Circuit case, United States v. Salman, the defendant (a tippee) argued that Newman required the government to prove in his case that his tipper received a tangible benefit from his breach of fiduciary duty, rather than simply the benefit of gifting the inside information to a person close to him; in this case, his own brother. In affirming Salman’s conviction, the Ninth Circuit said it was not bound to follow Newman, and that to the extent that Newman could be read to stretch as far as Salman argued, the Ninth Circuit would decline to follow Newman.

In Riley, the Second Circuit in January affirmed an insider trading conviction of a tipper who received an immediate financial benefit from the tippee. For this reason, the Court held that Newman had no bearing on the case. Riley reaffirms that when a tipper gets a personal benefit, there is criminal exposure post-Newman, but does not shed light on the murky terrain of what constitutes an “objective consequential gain” between tippers and tippees who are closely connected.

Although the Supreme Court refused the Justice Department’s request to review Newman, it recently agreed to review Salman. Market participants are anxious to see clarification on tipper-tippee insider trading liability, and the issue is now front and center at the highest U.S. court.

How can public companies and the financial industry best adapt to the new civil and criminal enforcement paradigms?

Remember, there is no specific statutory prohibition of insider trading. It is a species of securities fraud that is charged using the same laws that prosecutors and SEC enforcement lawyers use in many other different kinds of fraud, so uncertainty is baked into the offense. And when federal appellate courts construe the same offense differently, and with the Supreme Court about to weigh in, it is harder than ever to know where the lines are drawn in certain cases.

Now more than ever, to prevent insider trading and investigations of alleged insider trading, public companies and market participants must sharpen their focus on compliance. That sounds obvious, and it is, but both history and today’s news stories are full of examples of failed compliance efforts. Compliance officers and risk managers need to work both harder and smarter to prevent and detect insider trading because the government is working harder and smarter to detect it.

The government has many tools and uses them aggressively. Would-be whistleblowers are being encouraged and paid by the SEC. Tips are flowing to the SEC at a healthy rate, and when they arrive at the SEC, they may be greeted by an FBI agent detailed to the SEC. Once the FBI gets a promising tip, they are eager and able to seek the issuance of grand jury subpoenas, search warrants, and even court-ordered wiretaps. Market participants need to understand that it is common for prosecutors and agents to obtain the participants’ emails without their knowledge. While the service of a subpoena or the knock on the door by an agent will signal an investigation, the government can and does obtain their email quietly and routinely. The government often builds its cases quietly and methodically, and a market participant often will not learn of the investigation or its results until they are at a tremendous disadvantage. The level of cooperation and coordination between the Justice Department and the regulators is unprecedented, and market participants must now assume that when they are dealing with one agency, they are also dealing with the other agency, even if the second agency has not yet stepped out of the shadows and revealed itself.

The SEC is making serious use of its data and continues to develop its analytical capabilities. To illustrate all of these points, there was an insider whose trading in the shares and options of his employer led to the generation of a routine automated exception report that made its way to the SEC. When the report arrived at the SEC office in Washington, D.C., it was greeted—not by an SEC staffer—but by an FBI agent. The agent sent the report to the appropriate field office where agents, after consulting with the SEC, acted on the tip right away without waiting for the SEC to investigate using its customary tools and protocols. The trader confessed to the FBI during a “doorstep” interview, and ultimately was indicted, pleaded guilty, and was sent to prison. This is real and increasingly common in today’s enforcement environment.

What are the key takeaways from the first-ever “spoofing” conviction under Dodd-Frank? Beyond a couple of similar pending cases, will we see even more of these cases in the future? What do traders need to do to stay out of regulators’ and prosecutors’ crosshairs moving forward?

The key takeaway from the jury’s guilty verdict in United States v. Coscia is that prosecutors are now more confident than ever that they can present complex trading cases to a jury in a clear and streamlined manner. They will be emboldened to bring more of such cases—assuming that those cases are otherwise meritorious—and now have a blueprint of how the cases can be presented effectively. They are looking harder at, and working smarter, on such cases. The Justice Department, the CFTC, and the SEC all have brought spoofing cases, and there is no reason to think they will ease up on their efforts now.

Before his trial, Coscia asked the judge to dismiss the indictment as unconstitutional, arguing that the spoofing statute was so vague as to be void altogether. The judge denied that motion. Coscia now stands convicted, and it is virtually certain that he will appeal to the Seventh Circuit. As with insider trading, the courts considering spoofing cases are treading new ground, and drawing lines as they go.

In the past 16 months, the government has brought the first, second, and third criminal spoofing cases—two in the futures markets, and one in the securities markets. In order to stay out of crosshairs moving forward, traders, their compliance officers, and risk managers need to stay abreast of exchange, regulatory, and criminal actions. They need to know what law enforcement and regulators investigate and how they investigate. The SEC, CFTC, trading exchanges, and the Justice Department all are using data mining to create “heat maps” to see where the greatest risks are. And they are using whistleblowers to help them do that; two of the CFTC’s spoofing enforcement actions—one of which has a parallel criminal case—were generated with the assistance of whistleblowers.

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