On May 4, 2017, after the House Financial Services Committee approved the Financial CHOICE Act of 2017 (FCA) in a 34-26 vote, Congress moved a step closer to replacing the Dodd-Frank Wall Street Reform and Consumer Protection Act. The bill will now be passed to the full House, proclaiming on the way its objective ‘to create hope and opportunity for investors, consumers and entrepreneurs by… holding Wall Street accountable’. However, many of its proposed changes appear to do the opposite. They hobble the SEC’s enforcement efforts: curtailing prosecutorial approaches and raising the bar for conviction by requiring stricter proof of wrongdoing. Even though other provisions increase the penalties for violations of securities laws, the FCA is likely to expose investors to increased market risk from fraudulent activity, including insider trading.
The scale of insider trading and the profits it promises are enormous. In 2014, for example, Mathew Martoma, a former portfolio manager at SAC Capital Advisors, was convicted for using confidential information to execute trades that yielded him $275 million, dubbed by former U.S. Attorney Preet Bharara, ‘as the “most lucrative” example of insider trading in history’ (http://dtn.fm/gZ5VK). Yet despite such staggering statistics, the FCA undermines the SEC’s ability to go after market manipulators like Martoma by including two provisions.
The first of these, which applies to the ‘standard of proof in administrative proceeding’, raises the bar by requiring the Commission to show ‘clear and convincing evidence’ that securities laws have been broken. This is a much more exacting standard than the ‘preponderance of the evidence’ standard required in federal courts and employed in SEC in-house hearings under existing rubric. Consequently, it is likely the SEC will decrease the number of cases pursued through administrative proceedings as it takes the path of least resistance.
Empowered by Frank-Dodd, in-house or administrative proceedings have proved to be a very effective enforcement tool for the SEC, so much so, that ‘according to a report (on May 9) by Cornerstone Research, the SEC filed 80 percent of its enforcement actions in the first half of fiscal year 2017 as administrative proceedings, not civil suits’, according to Reuters (http://dtn.fm/B1JQu).
The New York Times’ Deal Book explains (http://dtn.fm/RUn0O) this ‘attack on administrative proceedings’ as a ‘reaction to a provision of the Dodd-Frank Act that authorized the S.E.C. to pursue a wider range of penalties in cases filed with its own judges, which is usually a more expeditious procedure.’ The Deal Book story also questions ‘another provision (that) could allow defendants sued by the S.E.C. a means to challenge charges by claiming they had not been informed in advance of the theory of liability being pursued.’ The controversial provision referred to would ‘prohibit the S.E.C. from using “unproven legal theories” to establish a violation’, a clear sign that the FCA intends to keep insider training inside and not extend its penalties to outsiders.
Classic cases of insider trading occur when those who have obtained confidential information by reason of being a fiduciary of a corporation use that information to trade in the corporation’s securities. Such fiduciaries include directors and employees but also those who might temporarily become fiduciaries, such as attorneys, accountants, and consultants. However, in 1997, the Supreme Court, in United States v. O’Hagan, redefined insider trading. By ratifying the ‘misappropriation theory’, it cast a wider net of culpability when non-public information is used to trade securities.
O’Hagan was a partner in a law firm retained by a British company that planned to make a bid for the Pillsbury Company. Although, he was not assigned to work on that deal, O’Hagan learned about it over lunch. He, subsequently, began purchasing shares and options that netted him over $4 million in profits after the acquisition closed. Convicted at first instance of securities violations, the decision was reversed by an appellate court. On appeal by prosecutors, the Supreme Court held that an individual may be found liable for violating rule 10(b)-5, which forbids any fraud or deceit in connection with the purchase or sale of a security, by ‘misappropriating’ confidential information.
Now, any action to close the misappropriations route or make it more difficult for the SEC to take, might amount to declaring open season for insider trading.
At present, the law appears to allow an outsider to trade on confidential information, if the insider divulged the confidential information to the outsider because of friendship rather than for pecuniary gain, particularly if the outsider gave no undertaking that the information would not be used to trade. Indeed, in defending himself from ongoing SEC action, hedge fund billionaire Leon Cooperman is arguing ‘that even if he did get inside information, he did not agree to refuse to trade on it until after he’d already received it—and that therefore, the agreement was moot, from a legal standpoint’, according to Fortune magazine (http://dtn.fm/q2rA5). Cooperman, CEO of Omega Advisors, has been accused of making dozens of trades in Atlas Pipeline Partners securities in 2010, netting profits of $4 million, after learning from a company insider that the troubled oil and gas company was on the verge of a merger deal.
None of this bodes well for the financial markets. If Congress pursues its agenda of hamstringing the SEC, who will protect small investors?
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