Fighting back: responding to insider trading
May 2018 | COVER STORY | FRAUD & CORRUPTION
Financier Worldwide Magazine
May 2018 Issue
Insider trading appears to be a rampant problem on Wall Street. Individuals at some of the US’ largest financial institutions continue to benefit from non-public information, according to a study by the University of Cambridge and Stanford. The report highlights a number of insiders at major US banks who increased their profits thanks to advanced knowledge of government programmes during the financial crisis – and the practice is still rife today.
For legislators and enforcement agencies, insider trading is a grey area. In the US, prosecutors are required to pursue cases despite there being no law defining insider trading. Moreover, courts in the US remain at odds over whether the use of private information should be considered illegal.
For individuals, sanctions including financial penalties, disgorgement and permanent exclusion from the industry have been handed down in recent years. So, too, have custodial sentences from nominal jail terms to 20-year sentences. A string of enforcement actions in recent years has emphasised the focus on insider trading by securities authorities. In February, investment adviser Tibor Klein was sentenced to six months in prison after he pleaded guilty to insider trading in connection with Pfizer Inc’s $3.6bn acquisition of King Pharmaceuticals Inc. He was also sentenced to six months of house arrest, 250 hours of community service, ordered to forfeit $37,225 and pay a $20,000 fine.
For the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) in the US, insider trading remains firmly in their sights. “Prosecutors and regulators have developed an expertise and are good at investigating and bringing insider trading cases,” says Alma Angotti, managing director and co-head of global investigations & compliance at Navigant. In 2017, the DOJ carried out a number of arrests for market manipulation and insider trading. In May, consultant David Blaszczak and three co-defendants, including an executive-level Medicare employee, were charged with insider trading. The SEC also alleged that the four committed securities law violations and pursued action against them in order to recoup $3.9m in ‘ill-gotten gains’.
Last year, the US Court of Appeals for the Second Circuit quashed an appeal from convicted inside trader Mathew Martoma, who was hoping to overturn a nine-year prison sentence handed down in 2014. A federal court jury convicted Mr Martoma of receiving inside information in 2008 about a clinical trial of an Alzheimer’s drug that prosecutors say allowed SAC Capital Advisors to make $275m. Mr Martoma’s legal team argued that, in light of a recent ruling by the Supreme Court that the jury in the trial had not been properly instructed and that the evidence the government presented was not sufficient to support a conviction, Mr Martoma should be freed. However, the court upheld Mr Martoma’s original sentence. The panel found that “the district court’s jury instruction was not obviously erroneous”.
In February 2018, a Florida lawyer, Walter Little, was sentenced to two years imprisonment for insider trading, based on information that he improperly obtained from his law firm’s databases and passed on to a friend. Furthermore, in mid-March, the SEC charged a former Equifax executive – Jun Ying – after he sold nearly $1m of shares in the company before a data breach was announced. “As alleged in our complaint, Ying used confidential information to conclude that his company had suffered a massive data breach, and he dumped his stock before the news went public,” said Richard Best, director of the SEC’s Atlanta regional office. “Corporate insiders who learn inside information, including information about material cyber intrusions, cannot betray shareholders for their own financial benefit.”
For enforcement authorities, tracking the different types of insider trading can be a difficult task. Agencies employ tactics such as market surveillance and acting on tips and complaints. There are a number of differing forms of insider trading, from misappropriation of information, to ‘tippee’ liability and disclosures. “Typical schemes involve variations on the traditional situation where company insiders tip friends, family and others, and misappropriation schemes where non-public information is improperly accessed and then used to trade,” says Ms Angotti. “Both company insiders and hackers are accessing company computer systems and stealing information. Recent insider trading cases involve both unsophisticated individuals and organised groups who use shell companies, code words, disposable cell phones and other encrypted messaging to evade detection.”
Authorities outside of the US have also redoubled their enforcement efforts. In 2017, the UK’s Financial Conduct Authority (FCA) began 84 insider trading investigations, the most ever in a 12-month period, up from a then-record 70 investigations launched in 2016. The FCA has changed its approach to insider trading cases in recent years. Previously, it only focused on winnable cases, whereas today it pursues as many as possible. Since 2009, when insider trading was first prosecuted in the UK, the FCA has secured more than 30 convictions.
In March, New Zealand began its first ever inside trading trial. Hamish Marc Sansom was charged with breaching the Financial Markets Conduct Act when working for transport logistics company Eroad. Mr Sansom is alleged to have sold 15,000 shares in the company as a result of a former colleague giving him confidential US sales information in 2015.
Technology is increasingly influential in the insider trading space, with both perpetrators and enforcement agencies benefitting from its use. Though insider trading remains largely the same as it was 20 years ago, technological advances offer new channels for insiders looking to control the flow of information. Access to material non-public information, the ability to connect individuals who wish to act upon that data, and the number and sophistication of the platforms available for individuals to send and receive data are changing the flow of information. Encrypted messaging apps, such as Signal and WhatsApp, as well as others which cause messages to ‘self-destruct’ after an allotted period of time, are widely used. These apps allow traders to hide illicit communications from internal compliance programmes and regulators.
Cryptocurrencies have also emerged as a potential new tool for insider trading in recent years. Digital currency exchange Coinbase is investigating a number of its staff over the launch of bitcoin cash on the company’s crypto-exchange. Furthermore, South Korea’s Financial Supervisory Service has also indicated that an investigation is underway following claims that one of its staff members was illegally trading a cryptocurrency. Enforcement agencies and compliance departments are paying closer attention to cryptocurrencies as they become more mainstream. Their pseudo-anonymous nature of is an alluring prospect for inside traders. While individual transactions may be hard to trace, due to the fragmented network of exchanges carrying out trades, prices often surge when large financial firms announce their involvement with digital coins. One such surge alerted Coinbase to potential wrongdoing.
“Cryptocurrencies, much like micro-cap securities, are susceptible to offering fraud, market manipulation and insider trading,” explains Ms Angotii. “They are often not widely traded, a small number of people have access to information not available to the general public, and the market for them is dispersed. Regulators are trying to keep up through better technology and increased staffing and focus. The SEC recently formed a cyber unit, and insider trading is one of its areas of focus. In fact, several members of the cyber unit were pulled from the SEC’s Market Abuse unit, so those individuals are skilled in analysing data, identifying seemingly unlawful trading patterns and unwinding trades. At the end of the day, technology and good old fashioned investigative skills will be how cryptocurrency schemes will be overcome.”
Efforts by financial services institutions to stamp out cryptocurrency malfeasance have been stymied by a lack of clear guidance from global financial regulators, however. The US Commodity Futures Trading Commission has defined bitcoins as a commodity; the SEC, on the other hand, says some cryptocurrencies may be securities, but it has shied away from specifying which ones.
Companies are putting their own measures in place, however. The world’s largest cryptocurrency exchange by trading volume, Binance, has introduced trading restrictions for its employees. In the long-term, self-regulation will be insufficient, but while the SEC’s position remains unclear, the emphasis is on businesses to keep their employees in check.
Technology does, however, offer advantages and opportunities for enforcement officials. The SEC has confirmed that it is using Big Data to connect people who have inside information to those who illegally trade on it. Data analysis is also helping to detect illicit trading patterns and suspicious trades. In addition, the Consolidated Audit Trail will significantly enhance the insider trading fight as regulators will be able to more efficiently track securities trading throughout the US markets.
Furthermore, the SEC has issued new cyber security guidance, warning companies to be alert to insider trading. The guidance addresses the oversight role of the board of directors and a company’s disclosure obligations following cyber security incidents and risks. It also stresses the importance of establishing and maintaining comprehensive cyber security policies and procedures, and the application of insider trading prohibitions in the cyber security context.
“The constant evolution and rapid development of digital technology provides those who would use inside information malevolently with new opportunities to do so,” says Claire Cross, of counsel at Corker Binning. “For those involved in the fight against insider trading, the key is to stay abreast of these changes. Enforcement agencies are doing this already by routinely seizing digital devices using maximum surprise. Compulsory notices to produce devices on the spot are being used at airports when suspects travel and at work places when suspects come in to work. Searches of home addresses may then follow. Digital technology can provide companies with a multitude of means of securing and protecting sensitive, non-public information. Companies should ensure that they are up to date and constantly assessing how they can use technology to keep their information safe.”
The efforts of enforcement authorities must be supplemented by companies’ internal efforts. The right compliance procedures must be in place. Firms should foster a culture in which employees are able to discourage and report illegal activity. Companies must also embed robust ethics policies, strong IT infrastructure and regular training and education programmes to help prevent criminal activity. Some firms may also implement blackout periods during which D&Os, as well as other designated people, are barred from purchasing the company’s securities. These periods are usually implemented around earnings announcements and though they are no panacea, they can make a difference.
“Training is a key component of a company’s programme to fight insider trading by employees,” says Ms Angotti. “Other controls, such as advanced approval for stock sales for senior management or others with access to material non-public information, may also help companies protect themselves from employee misuse. Improved data protection and cyber security technology will also help to prevent hackers from accessing information and trading on that information.”
Whistleblowers will also play a role in the insider trading fight. Under the SEC’s whistleblower programme, individuals may be eligible for monetary awards when they voluntarily provide original information about violations of federal securities laws, including insider trading. They can receive between 10 and 30 percent of the monetary sanctions collected if their tip leads to a successful enforcement action resulting in monetary sanctions exceeding $1m. The programme also provides whistleblowers with confidentiality and they may submit a tip anonymously, if they are represented by counsel.
More must also be done to help staff members identify wrongdoing. Employees must be given the tools and training they need to make a difference. “In order to assist your employees, first, take time to understand the information flows in your company, which will help identify the most high risk areas for potential information leaks and allow you to tailor your policies and procedures accordingly,” suggests Ms Cross. “Secondly, provide proper training and education, from the top to the bottom of your organisation. Try to offer face-to-face learning where possible and use real life examples so that individuals can understand, in the context of their individual roles, what ‘inside information’ is, how they may come across it and what they should and should not do. This should be repeated on a yearly basis. People’s memories are short. Thirdly, put in place clear, simple and strict rules governing trading. For example, if any member of your organisation wants to deal in your securities, enforce a rule that they must always ask for pre-clearance to do so. If there is any ambiguity, there is a risk that the rules will be exploited.”
Legalisation and future
Insider trading will not disappear. As technology develops and criminals become more sophisticated, enforcement agencies will need to respond. Legislators, too, will be under pressure to keep laws relevant.
“Despite protestations to the contrary, regulators and law enforcement agencies do not accept that insider dealing is a victimless crime,” says Ms Cross. “These bodies state that insider dealing clearly damages both companies and investors, creating an uneven playing field that allows small groups of people to profit at the expense of others, which, in turn, undermines the public’s confidence in the operation of clean and fair markets.”
Expect more attempts to prosecute insider trading, with regulators growing bolder. The SEC’s Market Abuse Unit will have a key role to play as it uses sophisticated data analysis tools to detect suspicious activity, including encrypted data. Ultimately, however, firms must take the lead and institute policies and procedures to protect themselves.
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