Focus on Insider Trading Becomes More Intense

The first week of August usually heralds the dog days of summer, but it also appeared to be “insider trading week,” as the Securities and Exchange Commission and the Justice Department unveiled three high-profile securities fraud cases, with the prospect for more. And another case, involving a former McKinsey & Company managing director, Rajat K. Gupta, took an interesting turn when the S.E.C. dismissed its administrative complaint and is likely to proceed in federal court in the near future.

The S.E.C. filed civil charges in two cases. The first case named William A. Marovitz, the husband of Playboy Enterprises’ former chief executive, Christie Hefner, who is accused of trading in Playboy shares from 2004 to 2009 based on information he obtained from her. The second was against a former major league baseball player, Douglas V. DeCinces, and three people he is accused of tipping. They are charged with trading in advance of a takeover of Advanced Medical Optics by Abbott Laboratories in 2009.

The United States attorney’s office for the Southern District of New York filed criminal charges against H. Clayton Peterson, a former head of the defunct accounting firm Arthur Andersen and a former director of Mariner Energy, along with his son Drew, over trading in Mariner stock before the announcement of its acquisition by the Apache Corporation in April 2010. They each entered guilty pleas and the S.E.C. also filed civil charges against them.

The cases are interesting because they provide some clues about why the government chooses between pursuing only civil charges or prosecuting defendants criminally as well. Any violation of a securities law or rule, such as Rule 10b-5, can be prosecuted by the Justice Department, so it is a matter of prosecutorial discretion whether criminal charges will be filed. The difference is crucial because the S.E.C. can only seek monetary penalties, while a criminal case can result in a substantial prison sentence.

Clue No. 1: Who Was the Source?

The source of the material nonpublic information is often the key determinant of whether the Justice Department will pursue criminal charges. Corporate directors and senior officers who tip or trade are clearly violating a duty of trust owed to the company and its shareholders, and therefore much more likely to be charged when they purposely leak information.

Mr. Peterson was prosecuted, even though he did not trade any Mariner shares, because tipping his son so that he could buy shares for his family and friends was such a blatant breach of his fiduciary obligation. Mr. Marovitz, on the other hand, was accused of taking information from his wife and betraying her directions not to trade, a much less serious breach of duty, or at least one that does not have the same impact on a company and its shareholders.

Mr. DeCinces received the information about Advanced Medical Optics from someone described in the S.E.C. complaint only as the “source” who was “directly involved” with the deal, which sounds like the person was not a corporate employee but worked for an outside adviser. The “source” has not yet been identified, and I expect there is a good chance the Justice Department is considering criminal charges if the person worked for an investment bank or law firm involved in the deal because that type of disclosure is nearly as harmful as one from a corporate officer or director.

Clue No. 2: Who Was the Recipient?

Market professionals, like brokers, hedge fund managers and investment advisers, who trade on confidential information have been singled out for criminal prosecution lately.There is perhaps no better example of the focus on the recipients of inside information than the prosecution of Raj Rajaratnam, the head of the Galleon Group, and various hedge fund managers who received tips from expert network firms.

Drew Peterson is a licensed securities profession and works for an investment adviser, so there is no question he understood the prohibition on insider trading and the confidentiality of the information that his father passed to him.

Mr. DeCinces (and the accused tippees) and Mr. Marovitz, on the other hand, are not involved in the securities industry, so their trading can be viewed as less pernicious, although it certainly violated the securities laws. It even looks as if the S.E.C. accommodated Mr. DeCinces in the timing of its case, filing it the day after he threw out the first pitch at a California Angels game as part of the team’s 50th anniversary celebration.

There is another potential defendant involved with the Petersons who may be charged by the Justice Department in the near future. Drew Peterson passed along the information from his father about Mariner’s acquisition to the chief executive of an unidentified hedge fund in Denver, who bought stock and options resulting in a $5 million gain after the announcement of the Apache deal. That gain far outstripped the $150,000 profits from Drew Peterson’s own trading.

As part of his plea agreement, Drew Peterson is cooperating in the case, which may indicate prosecutors are planning to use him as a witness against the unidentified hedge fund trader. The $5 million gain by the tippee is attributable to Drew Peterson under the federal sentencing guidelines, which could result in a recommended sentence of more than four years in prison.

He has a powerful incentive to help prosecutors make the case against the hedge fund friend in the hope of receiving a reduced sentence. Under the plea agreement with his father, the recommended sentence for Mr. Peterson is 12 to 18 months.

Clue No. 3: How Much Did You Make?

Money talks, and prosecutors can be swayed by the size of the gains from trading on inside information in deciding whether to pursue a case — the more money you make, the more likely a criminal charge will be filed. The $5 million profit on Mariner stock and options is much more likely to draw the Justice Department’s interest than Mr. Marovitz’s $100,000 of gains and losses avoided.

At the same time, an insider who tips without any direct gain from the trading is harder to pursue in a criminal case because there is less evidence of the defendant’s intent to violate the law.

In cases that charge tippers with violations of Rule 10b-5, like those of Mr. Patterson and Mr. Gupta, the government has to show the information was given as part of a quid pro quo. For Mr. Patterson, the relationship with his son helped to show the quid pro quo because it appears to be a gift, something the Supreme Court recognized as sufficient to prove illegal tipping in its decision in Dirks v. S.E.C.

When the person does not receive any financial benefit from the tip or have a close personal relationship with the tippee, then proving the existence of a mutually beneficial arrangement can be more difficult. In Mr. Gupta’s case, the benefit is harder to identify from the alleged sharing of information with Mr. Rajaratnam about Goldman Sachs, where Mr. Gupta served as a director.

In the case involving Mr. DeCinces, the Justice Department may be able to use a different provision to pursue criminal charges that does not require proving a quid pro quo arrangement.

Abbott Laboratories acquired Advanced Medical Optics through a tender offer, and Rule 14e-3 prohibits trading on confidential information related to such a transaction, without requiring proof that the tipper gained anything from disclosing the information.

Even if the Justice Department does not get involved, the S.E.C. is likely to pursue a civil case against the source of Mr. DeCinces’s information because the standard for proving a violation is much lower than that required for a criminal conviction: preponderance of the evidence versus beyond a reasonable doubt.

Clue No. 4: How Good Is Your Evidence?

None of the cases filed last week appear to have involved wiretaps, the powerful tool the government used to great effect in cases against Mr. Rajaratnam and those tied to the expert network firms. Instead, it appears that trading and telephone records were the basis for building circumstantial cases against the defendants.

Neither Mr. Marovitz nor Mr. DeCinces appear to have done much to hide their trading, buying shares in accounts in their own names or those of relatives. Similarly, Drew Peterson bought shares for his sister, his small investment club and in his own name. Once a link from the trader to the source of the inside information can be identified, the case usually falls into place fairly quickly thereafter.

Prosecutors will now have to decide whether Mr. DeCinces and Drew Peterson will be convincing witnesses if it wants to pursue criminal cases against the as-yet-unidentified tipper or tippee in their cases. Without wiretap evidence, the testimony of cooperating witnesses is crucial to establishing a criminal case for insider trading.

The case against Mr. Gupta, however, is more questionable because he did not trade and denies passing along confidential information to Mr. Rajaratnam, who is unlikely to cooperate in a case against his friend.

Prosecutors used wiretaps at Mr. Rajaratnam’s trial that showed him boasting about his source inside Goldman, but unlike his other alleged tippers, Mr. Gupta apparently was not recorded actually passing along any insider information.

The S.E.C.’s agreement to dismiss its administrative case and instead pursue the matter only in a civil proceeding before Judge Jed S. Rakoff of the United States District Court in Manhattan will make the admissibility of that wiretap evidence crucial, if it decides to move forward. The federal rules of evidence do not apply in an administrative proceeding, but they do in cases brought in federal court.

To admit Mr. Rajaratnam’s statements on the wiretaps against Mr. Gupta, the S.E.C. will have to establish that Mr. Gupta and Mr. Rajaratnam were co-conspirators at the time. Under the so-called “co-conspirator exception” to the hearsay rules, the statement of one conspirator (Mr. Rajaratnam) can be used as evidence against another conspirator as long as it was made during the course of and in furtherance of the conspiracy. Whether Judge Rakoff will accept this argument remains to be seen, and without the wiretaps a case against Mr. Gupta becomes much weaker.

The S.E.C.’s agreement to bring any future insider trading case before Judge Rakoff can be seen as a victory for Mr. Gupta, but it may not be as beneficial as one might think. Judge Rakoff has not been shy about criticizing the S.E.C.; for example, in the Bank of America– Merrill Lynch case, he chided the agency for not being aggressive enough in pursuing its case.

And in an opinion issued by the United States Court of Appeals for the Second Circuit issued last week, Judge Rakoff wrote the court’s decision siding with the S.E.C. in overturning the dismissal of fraud charges against a mutual fund adviser related to alleged incomplete disclosures about market timing. The judge is willing to hold the S.E.C.’s feet to the fire, but that does not mean he will ignore the law on insider trading if the evidence is there.

The Justice Department would be hard-pressed to prove a criminal case against Mr. Gupta, but the S.E.C. may be more successful if, as I expect, it files civil charges against him for insider trading, at least if it can use the wiretap evidence to prove its case.