Skip to main content
Apr 29, 2012

Authorities target disclosure leaks

Regulators are getting tougher on any type of selective disclosure

The SEC’s enforcement is tough and getting tougher and, beyond the commission, state and federal attorneys are responding to popular pressure to corner companies and managements that step over the line.

But the lines are gray and easily crossed: at a recent New York seminar arranged by Orrick for the Directors Roundtable, David Rosenfeld, joint head of SEC enforcement in New York, shocked even others on the panel by suggesting he could see no reason for the traditional one-on-one meetings after an earnings call. If a CEO or CFO said anything in such a meeting that he/she did not tell all the analysts and investors, Rosenfeld would see that as a prima facie breach of Regulation Fair Disclosure.

While conscientious analysts always say they want to see management sweat under questioning, Rosenfeld implies that even perspiration, a tic, a facial gesture or clear strength of feeling about particular points can get close to insider trading because any of these amount to material non-public information being privately shared. It was a stark reminder of the risks firms might be taking.

The SEC concedes that it is becoming more proactive, and the recent rash of insider trading cases – such as the Galleon affair – highlights the dangers for firms. When courts are involved, ‘the atmosphere is not conducive for juries to make fine distinctions,’ says Bill White of Akin Gump Strauss Hauer & Feld, who was on Raj Rajaratnam’s defense team.

That case ushered in two significant developments. The first is the extension of legal use of wiretaps to include securities cases, with the courts extending the scope for warrants to tap. Throw in stings, confidential informants and the full arsenal of crime fighting, and anyone who cheats should be aware he or she might well be caught and, like Rajaratnam, walk into an 11-year sentence and a $92 mn fine. Wiretaps take cases beyond circumstantial evidence of communication and trading activity into unequivocal evidence.

The second is the need for companies to look very closely at ‘expert network services’, particularly any involvement in them by employees. Massachusetts is already legislating for such networks to be registered as investment advisers and to certify they will not supply confidential information.

Such networks can provide useful information and background but they can also be a minefield, so some companies would like to see a complete ban on staff engaging in them.

Others suggest employees should be able to get clearance to participate, be closely scrutinized and be required to have training on insider trading. As Rosenfeld noted, the sole purpose of these networks is to provide information unavailable to the public. The key issue is establishing where background information segues into insider information.

The default seems to be that if people can get away with something, they will try to do so, which puts an even greater burden on companies. Strong compliance programs send a message – but aggressive business or IR practice can easily slide across the line into insider trading. 

Modern IT means that getting away with it is harder than it was. Emails can be deleted, but their ghosts haunt the system awaiting retrieval. Phone calls can be tapped and even those on discarded phones can be traced and tracked; and transcripts are much clearer and less ambiguous for juries. According to observers, it was the recordings that really galvanized the Galleon jurors.

Traffic control

Indeed, it is not just content that is under scrutiny: records of calls, emails and social network activity can and are being sifted for evidence of patterns. Some companies ban the use of social networks like Facebook at work – because they are harder to monitor than email traffic – but if such traffic is tracked down it is indelible, just waiting for inspection by investigators and juries.

‘You may think it is not there, but it is being kept – and the government will find it,’ warns Ken Herzinger of Orrick.

Vincent Walden of Ernst & Young reports on the software tools being refined that scan the networks, not just for key words, but also for emotional tone, domain analysis and changes in behavior. For example, if two people who have chatted and corresponded regularly suddenly go quiet, it could be a signal they are conducting business by other means.

And recent cases suggest that paid-in-advance cell phones are the preferred method, although – as those same cases revealed – it is a fallible one. 

Of course, the very act of trying to use and dispose of such phones, or of hard drives and computers, can be a strong implication of guilt and awareness of wrongdoing. Compliance officers even suggest limiting joking online: it can send the wrong signals to those who search for such things. 

Clearly it is no joking matter for any company lax enough not to institute a compliance policy covering these issues – and monitoring compliance afterward. Indeed, involvement of employees in insider trading can be damaging at every level, including reputational and financial.

Legal bills mount rapidly into seven figures, say corporate attorneys who have handled such cases, and the reputational damage is also hard to get over with investors when the details hit the media. Activist investors want an edge. Companies need to stop them getting it – or prepare for prime time on Court TV.