[Senate Hearing 109-806]
[From the U.S. Government Publishing Office]
S. Hrg. 109-806
ILLEGAL INSIDER TRADING: HOW WIDESPREAD IS THE PROBLEM AND IS THERE
ADEQUATE CRIMINAL ENFORCEMENT?
=======================================================================
HEARING
before the
COMMITTEE ON THE JUDICIARY
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
__________
SEPTEMBER 26, 2006
__________
Serial No. J-109-117
__________
Printed for the use of the Committee on the Judiciary
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COMMITTEE ON THE JUDICIARY
ARLEN SPECTER, Pennsylvania, Chairman
ORRIN G. HATCH, Utah PATRICK J. LEAHY, Vermont
CHARLES E. GRASSLEY, Iowa EDWARD M. KENNEDY, Massachusetts
JON KYL, Arizona JOSEPH R. BIDEN, Jr., Delaware
MIKE DeWINE, Ohio HERBERT KOHL, Wisconsin
JEFF SESSIONS, Alabama DIANNE FEINSTEIN, California
LINDSEY O. GRAHAM, South Carolina RUSSELL D. FEINGOLD, Wisconsin
JOHN CORNYN, Texas CHARLES E. SCHUMER, New York
SAM BROWNBACK, Kansas RICHARD J. DURBIN, Illinois
TOM COBURN, Oklahoma
Michael O'Neill, Chief Counsel and Staff Director
Bruce A. Cohen, Democratic Chief Counsel and Staff Director
C O N T E N T S
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STATEMENTS OF COMMITTEE MEMBERS
Page
Grassley, Hon. Charles E., a U.S. Senator from the State of Iowa,
prepared statement............................................. 88
Specter, Hon. Arlen, a U.S. Senator from the State of
Pennsylvania................................................... 1
WITNESSES
Coffee, John C., Jr., Adolf A. Berle Professor of Law, Columbia
University Law School, New York, New York...................... 15
Cox, James D., Brainerd Currie Professor of Law, Duke University
School of Law, Durham, North Carolina.......................... 17
Macey, Jonathan, Sam Harris Professor of Corporate Law, Yale
University, New Haven, Connecticut............................. 14
Marchman, Robert A., Executive Vice President, Division of Market
Surveillance, NYSE Regulation, Inc., New York, New York........ 10
Tenpas, Ronald J., Associate Deputy Attorney General, Department
of Justice, Washington, D.C.................................... 2
Thomas, Christopher K., President, Measuredmarkets, Inc.,
Toronto, Canada................................................ 12
Thomsen, Linda, Director, Division of Enforcement, Securities and
Exchange Commission, Washington, D.C........................... 4
QUESTIONS AND ANSWERS
Responses of Robert A. Marchman to questions submitted by Senator
Specter........................................................ 26
Responses of Ronald J. Tenpas to questions submitted by Senator
Specter........................................................ 29
Responses of Linda Thomsen to questions submitted by Senator
Specter........................................................ 48
SUBMISSIONS FOR THE RECORD
Beny, of Laura N., Assistant Professor, University of Michigan
Law School, statement.......................................... 53
Coffee, John C., Jr., Adolf A. Berle Professor of Law, Columbia
University Law School, New York, New York, statement........... 61
Cox, James D., Brainerd Currie Professor of Law, Duke University
School of Law, Durham, North Carolina, statement............... 77
Kasowitz, Marc E., Kasowitz, Benson, Torres & Friedman LLP, New
York, New York, statement...................................... 90
Macey, Jonathan, Sam Harris Professor of Corporate Law, Yale
University, New Haven, Connecticut, statement.................. 94
Marchman, Robert A., Executive Vice President, Division of Market
Surveillance, NYSE Regulation, Inc., New York, New York,
statement...................................................... 99
Tenpas, Ronald J., Associate Deputy Attorney General, Department
of Justice, Washington, D.C., statement........................ 113
Thomas, Christopher K., President, Measuredmarkets, Inc.,
Toronto, Canada, statement..................................... 129
Thomsen, Linda, Director, Division of Enforcement, Securities and
Exchange Commission, Washington, D.C., statement............... 137
ILLEGAL INSIDER TRADING: HOW WIDESPREAD IS THE PROBLEM AND IS THERE
ADEQUATE CRIMINAL ENFORCEMENT?
----------
TUESDAY, SEPTEMBER 26, 2006
U.S. Senate,
Committee on the Judiciary,
Washington, D.C.
The Committee met, pursuant to notice, at 9:34 a.m., in
room SD-226, Dirksen Senate Office Building, Hon. Arlen
Specter, Chairman of the Committee, presiding.
Present: Senator Specter.
OPENING STATEMENT OF HON. ARLEN SPECTER, A U.S. SENATOR FROM
THE STATE OF PENNSYLVANIA
Chairman Specter. Good morning, ladies and gentlemen. The
Senate Judiciary Committee will now proceed with our hearing on
oversight of the Department of Justice on the issue of the
insider trading matters.
We have noted a comprehensive study made by
Measuredmarkets, Incorporated, which found that 41 percent of
the companies receiving buyout bids exhibited abnormal and
suspicious trading in the days and weeks before those deals
became public. And Measuredmarkets concluded that these unusual
activities most likely involved illegal insider trading. These
transactions involved very substantial sums of money, into the
billions of dollars.
While the merger activity has increased in recent years, in
the past 6 years the number of insider trading cases pursued by
the SEC has remained steady. We have noted that the Department
of Justice has had some problems in a couple of cases: U.S. v.
Scrushy, where there was a motion to suppress prosecution
testimony taken because the SEC civil investigation had been
undertaken at the behest and with the instructions from the
U.S. Attorney's Office; and in the case of U.S. v. Stringer,
there was a dismissal because of misconduct on a conflict
between witnesses and the attorney involving the Department of
Justice and the Securities and Exchange Commission.
In wake of Sarbanes-Oxley, the Judiciary Committee authored
a new Federal securities fraud statute in 18 U.S. Code, and we
are pursuing this oversight hearing to make an evaluation as to
what is being done to enforce that statute.
The Committee has undertaken some inquiries into the hedge
funds, but in our society it is absolutely indispensable that
the integrity of the markets be maintained. Americans invest
very heavily in the stock market, and that is really the
backbone of our commercial system. And it is very, very
important that the integrity be maintained.
We have a distinguished array of witnesses here today, and
we will begin with the Associate Deputy Attorney General Ronald
Tenpas, whose responsibilities include coordinating the work of
the President's Corporate Fraud Task Force.
Welcome, Mr. Tenpas, and we look forward to your testimony.
Before you begin, let me note for the record that Mr. Tenpas
has an outstanding record, having clerked for Chief Justice
Rehnquist after clerking for U.S. District Judge Louis Pollak.
He had served as U.S. Attorney for the Southern District of
Illinois and an Assistant U.S. Attorney for the Middle District
of Florida and the District of Maryland; a bachelor's degree
from Michigan State, a law degree from the University of
Virginia, and a Rhodes scholar.
That is quite a pedigree, Mr. Tenpas. I expect a lot of
success from a man with your record. Please proceed.
STATEMENT OF RONALD J. TENPAS, ASSOCIATE DEPUTY ATTORNEY
GENERAL, DEPARTMENT OF JUSTICE, WASHINGTON, D.C.
Mr. Tenpas. Thank you, Mr. Chairman. You have set the bar
for me.
Let me first begin by thanking you for inviting the
Department of Justice to testify today concerning our efforts
to prosecute insider trading, and at the outset let me assure
you that the Department and the Corporate Fraud Task Force
share your sentiment about the importance of ensuring that
everyone can invest in our markets, trusting in their integrity
and, in particular, without fear of being taken advantage of by
insiders who improperly use information.
To understand the Department's approach and track record,
it may be best to start with what we as prosecutors are
concerned with proving when presented with allegations of
insider trading. A criminal insider trading case requires us to
prove multiple elements, including that there was, one, a
willful and fraudulent buying or selling of a security; two,
that the selling occurred in breach of a fiduciary duty or
other relationship of trust and confidence; and, three, that
the selling occurred while in possession of and in use of
material nonpublic information about that security.
Given these requirements, proving criminal insider trading
activity requires more than just market surveillance and the
discovery of spikes in trading. Market anomalies may be
indicative of a problem, but they are not enough to prove
criminal activity.
Each of the elements I mentioned can present significant
proof problems. Depending on their role in an inside scheme,
potential defendants can suggest any number of defenses. For
example, as I just mentioned, prosecutors must demonstrate that
the defendant's conduct was a willful violation of the law,
meaning that it must be proven that the defendant was aware at
the time of the insider trade that he or she was doing
something in violation of the law.
A tippee, therefore, may claim that he or she did not know
that it was illegal to trade on the information he received,
especially if the tippee worked outside the corporation.
Similarly, prosecutors must prove that the inside information
at issue in the case was both material, meaning likely to be of
interest to the reasonable investor, and nonpublic. Those who
trade may often deny having known of the material information
or, alternatively, claim that the information was broadly known
and, thus, public.
Similarly, because we must show that the defendant used the
information in making his or her trading decision, a defendant
may claim that the reason for his trade was unrelated to the
inside information and that the trade was prompted by a
personal need for funds, the timing of options, tax
considerations, a desire to lock in previous gains, or any
number of other reasons. Still further, a corporate outsider,
such as the tippee, can challenge the claim that he owed a
fiduciary duty to others. Moreover, given the nature of these
cases and what we have to prove, insider trading cases rarely
have a smoking gun.
So, in sum, these cases almost universally turn on
circumstantial evidence with inside traders frequently
proffering a number of alternative explanations for their
conduct, each of which must be discredited for the case to be
successful.
The challenge of building a circumstantial case that
discredits all plausible alternatives can be daunting, and, of
course, we must do so beyond a reasonable doubt. Nevertheless,
the Department of Justice is committed to bringing such
prosecutions and has compiled a strong record in recent years.
We typically use the anti-fraud provisions of the Securities
and Exchange of 1934, which carries substantial penalties,
including imprisonment of up to 20 years and fines of up to $5
million.
Our typical case can begin in a variety of ways, but often
we will start with a referral from the SEC or from public
reporting that casts attention on a particular transaction or
transactions. We will then work with our prosecutors and
agents, usually from the FBI, and often involving the Postal
Inspection Service, to work cooperatively with the SEC to seek
access to information that the SEC has secured, with each
agency then conducting a parallel investigation--the SEC
focusing on civil violations and remedies, and the Department
prosecutors considering whether to bring criminal charges.
As outlined more fully in my written testimony, in recent
years the Department has brought a wide variety of cases that
have focused on the most egregious offenses that promise the
greatest deterrence. We focus our efforts on those cases where
the evidence is strongest and where the conduct is most
serious, whether because the insider had an important
leadership position or because the criminal ring was well
organized or because it involved a sector of the market that is
especially of concern. In doing so, we try to make our efforts
part of an overall enforcement regime that includes the
parallel and equally important role played by the SEC.
In sum, we are determined to use all tools at our disposal
to attack insider trading, and we appreciate the opportunity to
appear before you this morning to discuss this in more detail.
[The prepared statement of Mr. Tenpas appears as a
submission for the record.]
Chairman Specter. Thank you very much, Mr. Tenpas.
We now turn to the Director of the Securities and Exchange
Commission Division of Enforcement, Linda Thomsen, who has been
with the SEC since 1995, was Assistant Director of the
Department, then Associate Director, then Deputy Director--
really right up the ladder, Ms. Thomsen.
She had been an Assistant U.S. Attorney for the District of
Maryland, bachelor's degree from Smith, and a law degree from
Harvard.
We appreciate your being here, and the floor is yours.
STATEMENT OF LINDA THOMSEN, DIRECTOR, DIVISION OF ENFORCEMENT,
SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, D.C.
Ms. Thomsen. Thank you, Chairman Specter, and I appreciate
being here. Thank you for inviting me to testify today about
insider trading. Our laws against insider trading play an
essential role in protecting our securities markets and in
promoting investor confidence in the integrity of those
markets. I appreciate the opportunity to explain the
Commission's efforts to deal with insider trading and to answer
any questions you may have.
I am especially pleased to testify together with Ron Tenpas
of the United States Department of Justice. The respective
histories of the SEC and the Department of Justice demonstrate
our commitment to working with each other to prosecute insider
trading, civilly and criminally.
Over the years, investigating and prosecuting insider
trading violations has remained a steady component of the SEC's
enforcement mission. Since 2001, the SEC has brought 300
actions against over 600 individuals and entities for insider
trading violations and has frozen millions of dollars in
illicit trading proceeds. Over that same period, insider
trading cases have consistently made up about 7 to 12 percent
of our filed caseload.
At the same time, our enforcement program is, by necessity,
dynamic. Our priorities and resource allocations must change to
meet trends in the market and developing misconduct. Even
within the relatively narrow arena of insider trading, we must
shift our resources to those areas where the greatest threats
lie. Most recently, the focus of our insider trading
investigations has been on globalization, merger activity, and
hedge funds.
We have had some remarkable successes. Over the past year,
we have charged a total of 17 defendants in the Reebok case,
whom we allege participated in an international insider trading
ring that netted at least $6.8 million in illicit gains by,
among other things, stealing information from Merrill Lynch,
from Business Week, and from a sitting New Jersey grand jury.
In recent years, the Commission has also brought several
insider trading cases involving hedge funds or their managers.
Over the past 2 years, the Commission has brought at least
three cases involving insider trading by hedge funds and their
managers in advance of more than two dozen stock offerings
commonly referred to as PIPEs. The Commission has also recently
brought cases against hedge funds or their managers involving
insider trading ahead of mergers and acquisitions.
The Commission is particularly concerned about insider
trading by registered broker-dealers and investment advisers.
Earlier this year, the Commission filed a civil injunctive
action against a former Merrill Lynch broker and ten former
A.B. Watley day traders and their managers for participating in
a scheme that allegedly involved trading ahead of large
institutional orders broadcast over Merrill's in-house squawk
boxes.
A few months ago, we instituted a settled administrative
proceeding against Morgan Stanley for failure to maintain and
enforce adequate policies and procedures to prevent the misuse
of material nonpublic information by the firm or persons
associated with the firm. Morgan Stanley agreed to pay a $10
million civil penalty and to engage an independent consultant
to review its policies and procedures.
Let me step back for just a moment and make some general
observations about our insider trading program.
Our Office of Market Surveillance is in daily contact with
its counterparts in the various self-regulatory organizations,
or SROs. The SROs perform primary surveillance, monitoring the
markets for unusual trading, sudden changes in a security's
price, or other unusual market activity. Our Office of Market
Surveillance maintains an open line of communication with the
SROs.
Insider trading leads also come to us from other sources,
including the news media, our own inspections and
investigations, and tips. When circumstances warrant, we can
and will act swiftly, using asset freezes to preserve any
alleged ill-gotten gains.
Identifying suspicious trading is an essential starting
point, but it is only the first step in compiling a viable
case. The challenge is not to establish facts that show
suspicious trading. The surveillance records alone are often
sufficient to establish that much. The real challenge is to
establish that a particular individual was in possession of
material nonpublic information and traded on it in breach of a
duty and to establish those facts based on admissible evidence.
Piecing together an insider trading case can be a complex
and painstaking process. Because insider trading involves
secret information and communications, it is rare, as Mr.
Tenpas said, to find a smoking gun proving that a trader was
tipped and by whom. Virtually all insider trading cases hinge
on circumstantial evidence, inferences to be drawn from the
trading records, the timing of trades, the movement of funds,
and other facts and circumstances. Building an insider trading
case based on circumstantial evidence can be frustrating,
risky, and time-consuming. But our staff has persevered and
built hundreds of solid credible cases.
The Commission employs a broad range of remedies to address
insider trading. The Commission generally seeks injunctive
relief, disgorgement, and civil financial penalties, which may
be up to 3 times the illegal profits made or the losses
avoided.
In settling cases, we have typically sought and obtained an
injunction, disgorgement, and a one-time penalty that is a
penalty equal to the amount of the illegal profits realized or
losses avoided.
Chairman Specter. Ms. Thomsen, how much more time would you
like?
Ms. Thomsen. I am happy to--I think about a minute.
Chairman Specter. OK.
Ms. Thomsen. We believe that the remedies we have, along
with the threat of incarceration in the event of criminal
prosecution, give us an effective arsenal for enforcement and
deterrence.
Insider trading undermines the integrity and credibility of
our markets. We appreciate the fact that the markets are
dynamic, and we understand the power of technology, and we will
use it all to our advantage. We will continue to work very hard
to protect the world's finest and fairest markets, and we would
be happy to answer any of your questions. Thank you.
[The prepared statement of Ms. Thomsen appears as a
submission for the record.]
Chairman Specter. Thank you very much, Ms. Thomsen.
Mr. Tenpas, as a result of the work of this Committee
following Sarbanes-Oxley, we passed Section 1348 relating to
securities fraud. Has that been helpful to the Department of
Justice? And to what extent has it been used?
Mr. Tenpas. That has been very helpful to the Department.
We have at this point successfully prosecuted somewhere
slightly over 50 defendants.
Chairman Specter. Has anybody gone to jail under the
prohibitions of 1348?
Mr. Tenpas. I believe so. Off the top of my head, I do not
know the exact sentencing--
Chairman Specter. It is pretty important determinant as to
how effective it is, wouldn't you say?
Mr. Tenpas. I believe it is, but as I say, I do not know
the exact spread, but, yes, people have gone to jail.
Chairman Specter. Would you provide the Committee with a
list of the prosecutions and the penalties which were obtained?
Ms. Thomsen, on that same subject, I note a $10 million
fine that the SEC imposed in June of this year on Morgan
Stanley for failing to conduct surveillance on hundreds of
thousands of employees to determine insider trading. Is that
really effective for a company the size of Morgan Stanley? Does
$10 million really make much of an impact on a company like
that?
Ms. Thomsen. Well, I think the proof will be in the
pudding, but I believe it was the largest penalty for that type
of violation to date, which is a violation--
Chairman Specter. Well, that does not mean a whole lot,
largest penalty and proof is in the pudding. The pudding has
been made. Where is the proof?
Ms. Thomsen. Well, I believe that to the extent Morgan
Stanley is improving its procedures, to the extent we have
consistently brought cases against broker-dealers and others
for violations of 15(f), we do see better surveillance and
better procedures. Our remedies are always civil, so our
remedies are always limited to injunctive relief, to procedures
relief, which we obtained in the Morgan Stanley case, as well
as penalties. I think--
Chairman Specter. Your testimony says that the SEC has
experienced recent successes in enforcing insider trading
activities by hedge funds. We are very much concerned about
hedge funds. We have had some investigation already, and some
of it is ongoing. And I note in press reports the city of
Philadelphia lost a lot of money because of a hedge fund
failure. And hedge funds, as we all know, are not regulated,
and that is really the jurisdiction of another Committee.
Ms. Thomsen. Yes, sir.
Chairman Specter. But this Committee has jurisdiction over
criminal law enforcement. Have there been any criminal
sanctions imposed on any of the hedge funds for violations?
Ms. Thomsen. Well, I think I would defer to Mr. Tenpas, but
I did read in the paper this morning that a hedge fund manager
was indicted for insider trading by the Southern District of
New York, and that was announced yesterday.
Chairman Specter. I am interested in indictments. I am even
more interested in convictions and most interested in jail
sentences. How about it? Any jail sentences?
Ms. Thomsen, that is directed to you.
Ms. Thomsen. I am sorry.
Chairman Specter. You were talking about recent successes.
I would like to know how successful you have been?
Ms. Thomsen. Well, I am sorry, sir, but because we have no
criminal jurisdiction, we do not prosecute criminally and we--
Chairman Specter. How many times have you gone for treble
damages? You have statutory authority for that.
Ms. Thomsen. We do have statutory authority for treble
damages. We typically seek treble damages when we are
litigating a matter. When we settle matters, as I mentioned, we
typically seek a one-time--
Chairman Specter. Typically seek them when you have
litigated the matter.
Ms. Thomsen. Yes, sir.
Chairman Specter. How frequently have you obtained treble
damages in the last 2 years?
Ms. Thomsen. Infrequently.
Chairman Specter. Infrequently?
Ms. Thomsen. Infrequently. Courts are--
Chairman Specter. Any?
Ms. Thomsen. There is one case that I know of where we
obtained treble damages, and I cannot remember--
Chairman Specter. Only one case that you know of, and you
are the Director.
Ms. Thomsen. Yes, sir. Courts are reluctant to impose up to
3 times.
Chairman Specter. Would you review those cases for the last
5 years and tell us what the--
Ms. Thomsen. I believe it is one.
Chairman Specter. What the experience has been.
Ms. Thomsen. Absolutely.
Chairman Specter. Mr. Tenpas, the Scrushy case raised the
problem of collaboration between the SEC and the Department of
Justice, and that case states, ``To be parallel, by definition
the separate investigation should be like side-by-side tracks
that never intersect.''
Would you like to see the statute amended to allow you to
intersect those tracks?
Mr. Tenpas. Well, we certainly think it is important that
we have the ability to intersect those tracks by consulting
with one another--
Chairman Specter. Is that a yes, Mr. Tenpas?
Mr. Tenpas. We have not reached a judgment about whether
the statute needs to be amended to allow us to accomplish that.
In the Scrushy case, we were not able to take appeal. In the
similar Stringer case, we have it under appeal. I think our
feeling would be--
Chairman Specter. What are the reasons why you should not
be able to collaborate with the SEC?
Mr. Tenpas. We do not think there are any reasons we should
not be able to collaborate with them.
Chairman Specter. Well, would you review that matter and
talk to others in the Department who have higher rank?
Certainly nobody has a better record in the Department of
Justice than you do.
How was it working for Judge Pollak?
Mr. Tenpas. It was terrific. He is a great man, a great
judge. I owe him a great deal.
Chairman Specter. Would it be a fair question to ask you to
compare working for Judge Pollak with Chief Justice Rehnquist?
Mr. Tenpas. Obviously they have--
Chairman Specter. I withdraw the question, unless you want
to answer.
[Laughter.]
Mr. Tenpas. They were both great people to work for.
Chairman Specter. Very diplomatically stated. Thank you
very much for appearing. I appreciate the work you have done,
and I would like you to take a closer look at the effectiveness
of your work with respect to criminal sanctions or treble
damages. My own sense is that fines do not do a whole lot, but
jail sentences do. And I have had a little experience in the
field.
One of the ideas which this Committee is pursuing is to
impose criminal liability on corporate officials who knowingly
and maliciously put into interstate commerce instrumentalities
which cause death or serious bodily injury. The Ford Firestone
case is a good illustration where Congress did legislate to put
criminal penalties into effect. But if you willfully and
maliciously act in a way which results in someone's death, that
states malice and grounds for prosecution for murder in the
second degree. And typically that carries a jail sentence of 20
years.
And you have the Ford Pinto case, which is another good
illustration. Internal corporate documents showed that they
could save money by putting the gas tank in one spot as opposed
to another spot, with an evaluation as to what they would have
to pay by way of damages. And it seems to me that if it is
knowing and willful--and that is a tough standard for a
prosecutor to maintain. You are both former prosecutors. That
does state malice, and consumers and people ought to be
protected.
You are in a field where market integrity is really
important for this country, and insider trading is insidious.
And when you have this study as disclosed by the New York Times
about 41 percent of the cases raise the probability of
collusion and insider trading, it really ought not to be just
up to the New York Times to conduct the investigations. But if
you have the benefit of their investigation--have you taken a
look at that, Mr. Tenpas, Ms. Thomsen, as to what the Times has
shown as to whether you ought to pursue that line?
Mr. Tenpas. We are aware of the study, Senator. We have
looked at it, and we are addressing it in the way that we
typically would, which is to work closely with the SEC and the
SROs. They have--
Chairman Specter. Do you think that there is a valid basis
for the conclusion of that study conducted by that outfit?
Mr. Tenpas. That is a little beyond my purview because it
involves fairly sophisticated statistical analysis, and that
is--
Chairman Specter. Sophisticated statistical analysis? Is
that tough for a Rhodes scholar?
Mr. Tenpas. It is tough for me. I was not particularly in
the math arena, and one of the--
Chairman Specter. Have you got some sophisticated
statistical analysts in the Department of Justice? If not, we
will get you some.
Mr. Tenpas. Well, we do, but we find that the SROs and the
SEC have active enforcement entities that have those folks--
Chairman Specter. Well, OK. Ms. Thomsen, then you have
looked at the study and you have analyzed it and you are
sophisticated. What have you done?
Ms. Thomsen. We have looked at it. We have not had an
opportunity to study all the underlying data. We have also
looked--
Chairman Specter. You have not had an opportunity to study
all the underlying data? Why not?
Ms. Thomsen. If I may explain, we also have the data that
we are getting from the SROs, and I do not think anyone
disagrees with the notion that there is an increase or there
has been an increase in anomalous or suspicious trading in
advance of merger or acquisition activity--
Chairman Specter. We have to move on, but let me ask each
of you to give a report to the Committee on what you have done
to date with respect to that study. I would hope that when you
see that kind of an analytical study as prominently displayed
as it was in a Sunday New York Times, you would take a look at
it. And then I would like you to tell me what you think about
it. And then the third aspect of the question is: What are you
going to do in the future to pursue it?
Ms. Thomsen. Sure.
Chairman Specter. Thank you both very much.
We will now turn to our second panel, and our first witness
is Mr. Robert Marchman, Executive Vice President of the New
York Stock Exchange Regulation, Inc., oversees the Market
Surveillance Division, which investigates insider trading in
securities listed on the New York Stock Exchange.
Regrettably, I am going to have to excuse myself for a few
minutes at 10 minutes after 10 because we are having a news
conference on the immigration question, and the immigration
bill came out of this Committee, and I am searching to see if
we can find someone who can replace me for a bit while I absent
myself for a very brief period of time. But if we cannot, I am
going to have to ask you to wait. I am sure you will understand
that a big part of this job is juggling a lot of different
issues, and right now we are in very heavy duty as a result of
being the last week we are in session before we break for
October. And I do not like to ask anybody to wait, and
especially as prominent, high-powered, and hourly rates as this
prestigious group. But if I have to, I will have to.
Mr. Marchman, thank you for joining us. The floor is yours.
STATEMENT OF ROBERT A. MARCHMAN, EXECUTIVE VICE PRESIDENT,
DIVISION OF MARKET SURVEILLANCE, NYSE REGULATION, INC., NEW
YORK, NEW YORK
Mr. Marchman. Good morning, Chairman Specter. Thank you for
this opportunity to share my thoughts on insider trading, which
is an area of serious regulatory concern for the New York Stock
Exchange Regulation group.
The mission of NYSE Regulation is to protect the investing
public and the integrity of our markets. We accomplish our
mission by zealously monitoring trades in NYSE Group-listed
securities by regular and ongoing onsite examinations of NYSE
Group member firms and by proactive investigation and
discipline of member firms and associated persons for violation
of NYSE Regulation rules and applicable Federal securities
laws.
The history of the securities markets teaches us that
insider trading is a serious regulatory concern, particularly
today, where the volume, complexity of trades, and products, as
well as cross-border transactions are redefining capital
markets on almost a daily basis.
The Division of Market Surveillance of NYSE Regulation
continues to meet these challenges through the use of extensive
and sophisticated surveillances, systems, and tools that allow
us to timely review and aggressively investigate trading that
may constitute illegal insider trading.
On an ongoing basis, Market Surveillance analysts conduct
reviews of alerts and investigations. Real-time and exception-
based alerts are mostly generated by advanced electronic
surveillance systems within our Stock Watch unit. We have
numerous electronic surveillances that surveill for activity
that may constitute insider trading.
In a typical insider trading investigation, sophisticated
systems complement analysts' requests for trading-related
information from member organizations, listed companies, and
other markets. Where, as is frequently the case, an
investigation indicates possible insider trading by individuals
or entities outside the jurisdiction of NYSE Regulation, for
example, hedge funds, employees of listed companies, or
customers of a member organization, the activity is referred to
the SEC with whom we enjoy a strong and constructive working
relationship.
In addition to our interaction with the SEC on specific
insider trading investigations and referrals, we have ongoing
discussions with the staff regarding practices and trends. In
our view, in addition to our highly advanced technology and
experienced and professional staff, a strong relationship with
the SEC and other market regulators in the U.S. and
internationally is critical to successful surveillance of
activity that may constitute illegal insider trading.
To that effect, we continue to strengthen our proactive
engagement with other market regulators. By way of example,
this August 18th there was a meeting convened amongst various
regulators from the SEC, NYSE Regulation, NASD, and the Chicago
Board of Options Exchange to talk about current developments
and discuss investigative techniques in insider trading.
The last 2 years have seen a significant increase in the
number and complexity of our insider trading referrals to the
SEC. Referrals to the SEC increased from 68 in 2004 to 111 in
2005, a 63-percent increase. For 2006, at the current pace, we
project 140 referrals to the SEC, an increase of 26 percent
from 2005.
We have also seen during this period an increase in the
number of insider trading matters related to hedge fund
activity that had been referred to the SEC. Penalties and
disgorgement from Market Surveillance referrals to the SEC have
also increased. In 2004, penalties were approximately $2.5
million. In 2005, penalties were about $3.9 million. And for
the first half of this year, penalties exceeded $3.2 million,
and we are on our way to surpassing 2005 levels.
In conclusion, at NYSE Regulation we remain vigilant and
cognizant of our responsibility to vigorously pursue the
highest excellence in our regulation of the markets. We also
remain committed to continue to work with the SEC and with our
fellow regulators to improve and strengthen the system of self-
regulation that has made the United States the financial center
of the world.
I thank you again for this opportunity to discuss the
efforts of NYSE Regulation in this important area of insider
trading and invite you and your staff to experience firsthand
our efforts by visiting us in the near future.
Thank you.
[The prepared statement of Mr. Marchman appears as a
submission for the record.]
Chairman Specter. Thank you very much, Mr. Marchman.
I am going to have to take a short recess at this point and
just a word of explanation as to where we stand and why it is
important to do this.
The Senate has reported out an immigration bill, as you may
know. The House has reported out an immigration bill. And we
have been unable to go to conference. And they want border
enforcement and employer verification. We do, too, but we want
to handle guest workers and we want to handle the 11 million
undocumented immigrants. And a good part of our work is
informing the public as to what we are doing so they understand
why the bill is not being finished and to try to induce the
House Members to go to conference, which is going to have to be
after we take the break.
So I gave you that little explanation because it is not
something which is incidental to our work to be at a news
conference, but really very directly tied into getting the job
done. And everybody is just very, very busy right now. We are
struggling the Supreme Court ruling in Hamdan and whether we
are going to have habeas corpus. And we are struggling with the
electronic surveillance issues. We are struggling with the
fence and another matter. So that everybody is moving like
molecules at a high speed in a lot of different directions.
So I hope you will pardon the brief recess, and I will
return just as soon as I can.
[Recess 10:08 a.m. to 10:33 a.m.]
Chairman Specter. We will resume the Judiciary Committee
hearing.
Again, I regret the interruption. This may not assuage you
much, but this may be the shortest recess in the history of the
Judiciary Committee to change buildings and have three Senators
speak and come back.
We turn now to Mr. Christopher Thomas, President and
Founder of Measuredmarkets Inc., an analytical research firm
based in Toronto, Canada. Mr. Thomas had worked as an analyst,
investment adviser, and broker prior to founding
Measuredmarkets; bachelor's degree in economics from McGill
University; studied at Loyola and Marlborough College in
Marlborough, England.
Thank you for joining us here today, Mr. Thomas, and we are
very interested in your study and look forward to your
testimony.
STATEMENT OF CHRISTOPHER K. THOMAS, PRESIDENT, MEASUREDMARKETS
INC., TORONTO, CANADA
Mr. Thomas. Thank you, Senator. I am President of
Measuredmarkets. The firm supplied the underlying data to the
New York Times for its article of August the 27th on abnormal
trading activity.
The analysis we did for the newspaper showed that for more
than 40 percent of the scrutinized mergers with a value of $1
billion or more that were announced in the 12-month period,
deviant trading behavior was evident before the deals became
public. Therefore, we believe that with the data displaying
such aberrant activity, it is more than reasonable to ask: What
prompted this activity? Could it be insider trading?
The Financial Times of London recently reports: ``Insider
trading is endemic in the London stock market. The Financial
Services Authority recently found that almost 30 percent of
takeover announcements...were preceded by suspicious share
price movements....'' If 30 percent is considered endemic, what
would one consider labeling a number greater than 40 percent?
Our company provides a service that statistically examines
the trading behavior of individual stocks. We determine if
today's activity conforms to the particular stock's historical
patterns or deviates from them. When stocks do wander away from
their usual pattern of behavior, our process issues alerts
automatically. If there is no news publicly available that
might explain this aberration, we deem such activity highly
suspicious and irregular, going against historical norms.
Our factual data and experience has shown that very often
such deviations occur several days before substantial changes
in the prices of the identified stocks. We have numerous
examples of such identification of unusual behavior preceding
the release of material news. Some of these are cited in the
New York Times article; others are on our website.
Amongst our clients are a governmental investigatory
agency, news services, money managers, brokers, and individual
investors.
So how does Measuredmarkets use the data? What determined
abnormal trading? And what is considered suspicious trading?
We look at some 3,000 data points for each common stock
each day on the four exchanges, and for some stocks as many as
5,000 data points. We examine a stock's history of trading
using three measures: closing price, total volume, and the
total trades or number of individual transactions. This last
measure is distinct from volume, albeit related to it. A
stock's normal behavior pattern for each measure is then
calculated, covering nine different time periods. We thus have
what can be 3-D pictures, covering each of the nine time
periods, to compare against any day's activity. Each stock's
history mathematically determines what its normal pattern of
behavior is, automatically adjusting should it change from
volatile to stable or vice versa.
Should a day's activity exceed the normal patterns, then it
can be considered as exhibiting mathematically deviant
behavior. It is aberrant, having wandered significantly away
from its well-established normal path.
Each day, for the four markets that Measuredmarkets
currently tracks, hundreds of stocks are flagged as showing
newly deviant behavior. The majority of those so marked are
actually reflecting news that is already in the public domain.
The service our company provides becomes useful, important, and
significant when stocks have deviated from their own norms and
there is no news generally available that could explain the
deviations. Such activity we suggest is suspicious. Referring
to the New York Times articles: ``The companies were not the
subject of widely dispersed merger commentary during the
periods of abnormal trading, nor did they make any
announcements that would seem to explain the moves.''
The Measuredmarkets service deals with real numbers from
the real world--hard data that is in the public domain. From
the immense amount of information that is generated by the
stock markets, we sift the data so that ordinary investors and
interested organizations gain valuable information.
I started this company to level the playing field for
investors. ``What is the use of living if it be not to strive
for noble causes and to make this muddled world a better place
for those who will live in it after we are gone?'' That was
Winston Churchill, and I have to point out that his mother was
an American.
Thank you, Senator.
[The prepared statement of Mr. Thomas appears as a
submission for the record.]
Chairman Specter. Thank you, Mr. Thomas.
Our next witness is Professor Jonathan Macey, Deputy Dean
and Professor of Corporate Law, Corporate Finances and Security
Law, at Yale University; was the Dupont Professor of Law at
Cornell, and also served as an instructor at the University of
Chicago, University of Tokyo, and University of Virginia; law
clerk to Judge Friendly; bachelor's degree cum laude from
Harvard, and law degree from Yale; editor of the Yale Law
Journal.
A very distinguished record, Professor Macey. The floor is
yours.
STATEMENT OF JONATHAN MACEY, SAM HARRIS PROFESSOR OF CORPORATE
LAW, YALE UNIVERSITY, NEW HAVEN, CONNECTICUT
Mr. Macey. Thank you very much, Mr. Chairman. It is a
pleasure to be here, and thanks for inviting me. Insider
trading has been a focus of my teaching and research. Illegal
insider trading is the theft of valuable information about
corporate plans that properly belongs to the corporation and
its investors. Vigorous enforcement is important to protect
intellectual property rights of investors and corporations.
However, not all trading by insiders is illegal, and not
all trading on the basis of informational advantages is
illegal. Rather, insider trading is illegal when securities are
traded in breach of a relationship of trust and confidence,
known as a ``fiduciary duty.'' And it is also, of course,
illegal to tip information in violation of a fiduciary duty or
to misappropriate confidential information.
It is not the case that insider trading is a victimless
crime. Insider trading is a crime that has victims because
insider trading deprives people of what is rightfully theirs--
the ability to profit on material nonpublic information about
their companies or to avoid losses associated with such
information, and in doing so deprives people of returns and
undermines legitimate societal trust and expectations about
market functions.
The problem with insider trading for personal benefits is
that it reduces--another problem is that it reduces the
incentives of legitimate market participants, like analysts, to
allocate scarce resources to research. And the question that I
want to turn to is: How much insider trading do we actually
observe in the U.S., and can we and should we be doing more to
stop it? And I want to make the following points.
No. 1, the available empirical research indicates that the
U.S. has, by far, the most vigorous insider trading enforcement
program in the world, as well as the strictest laws against
insider trading. The U.S. is the country in which insider
traders' profits are the lowest.
In the U.S., unlike many other countries, there is a
private right of action for violation of the laws against
insider trading, and from a causal perspective, the private
plaintiff's bar generally piggybacks on the enforcement efforts
of the Securities and Exchange Commission and also self-
regulatory agencies. The evidence suggests that while coming up
with a benchmark for what is vigorous enforcement is not an
easy task, relative to any other countries the U.S. does a
great deal more, and the SEC in particular. For example, over
the last 5 years, the SEC has brought 260 insider trading
enforcement actions. By contrast, in the U.K. there have only
been 14 insider trading actions, and the largest fine, which
was 25,000 pounds in the U.K., is lower than the average
penalty in the U.S.
The enforcement program of the SEC has targeted not only
corporate officers and directors and their friends, business
associates, tippees, printing firm employees are common
targets, also employees of investment banking firms, law firms,
and accounting firms.
At the same time, I want to point out that trading that is
not done on the basis of a violation of fiduciary duty and
involves making money from investments in legitimate research
about corporate performance and governance is socially valuable
and should be encouraged.
With respect to studies that we have been talking about
today, studies that show increases in trading volume or share
prices in advance of merger and acquisition activities must, if
they are to be useful, do a couple of things that studies that
have been discussed do not do. No. 1, they do not distinguish
between legitimate and illegitimate trading activity. For
example, purchases by a hedge fund or an LBO fund or an
arbitrageur may actually put a company in play, increasing the
chances of an outside acquisition attempt, which in turn can
explain sudden increases in trading volume and share prices of
target companies, thus suggesting that we need to think
carefully about the causation that we observe in studies such
as that reported in Gretchen Morgenson's August 27, 2006, New
York Times article.
I also want to point out that, in terms of thinking about
the allocation of resources in insider trading, there are other
things on the SEC's plate that one can credibly argue should be
the focus of sharp attention, such as options back-dating and
accounting fraud. Thus, one can draw the conclusion, as I have
done, that the SEC in its enforcement program does an excellent
job of balancing the policy goal of detecting and punishing
insider trading with the goal of conducting insider trading
investigations in a careful way so that we maintain the
important deterrent effect that we have associated with the
social stigma that is carried with the act of illegal insider
trading in the U.S. that one does not see as a matter of norms
and social deterrent in other countries.
Thank you very much.
[The prepared statement of Mr. Macey appears as a
submission for the record.]
Chairman Specter. Thank you, Professor Macey.
We turn now to Professor John Coffee, Columbia Law School;
holds the distinguished Adolf Berle Chair; taught at Georgetown
University Law Center, and was in private practice for 6 years
with Cravath, Swaine & Moore; been a member of the NASD's
Market Practices Committee and the Legal Advisory Committee of
the New York Stock Exchange Board of Directors; bachelor's
degree from Amherst, Phi Beta Kappa; law degree from Yale;
master in law from New York University.
We may be overloaded with Yale law grads today-- Professor
Coffee, Professor Macey.
STATEMENT OF JOHN C. COFFEE, JR., ADOLF A. BERLE PROFESSOR OF
LAW, COLUMBIA UNIVERSITY LAW SCHOOL, NEW YORK, NEW YORK
Mr. Coffee. Thank you for inviting me, Senator. As a law
professor, and uniquely for this panel, I teach both criminal
law and securities law, so I look at insider trading from both
sides, and I am going to focus my comments not on whether
insider trading is bad--I assume we all agree on that--but on
the criminal enforcement of it. And I am basically going to
submit that criminal enforcement is the one force that will
truly deter in this field. But there are problems with criminal
enforcement, and there are new problems looming on the horizon.
Now, I am going to ask a series of questions and give
brief, incomplete answers.
Has insider trading increased? There is no universally
recognized proxy, but there is pretty probative evidence that
there has been an increase. The New York Stock Exchange data in
Mr. Marchman's written submission shows that the number of
referrals to their Market Surveillance Unit has made to the SEC
over the last 2 years went up 60 percent in 2005 and 25 percent
in 2006. That is consistent data because their computers are
going to be objective and turn out the same criteria and the
same warning bell each time.
Now, what is driving this increase that I think exists?
Usually, it is related to merger and acquisition activity, but
that is not the story today. I think it is more the intense
competition among hedge funds where there is tough competition
for the investor's dollar. They have to get very high rates of
return to stay in business, and they may do anything to get
material nonpublic information.
Second, there are new classes of transactions-- management
buyouts, PIPE transactions--that are particularly vulnerable
because large numbers of people know in advance about these
transactions, and the risk of insider trading goes up
exponentially. So we have reasons for why it is increasing and
evidence it is increasing. Is the SEC at fault? I cannot say
that. I cannot make a case that the SEC has been inattentive.
They have prosecuted between 7 and 12 percent of their
enforcement cases, insider trading cases, for the last 10 years
or so, and basically I cannot tell the SEC or this Committee
that they should prosecute more insider trading and, thus, less
accounting fraud or less market timing or less stock option
back-dating. All of these things deserve the attention of the
SEC.
Therefore, I would suggest the focus has to be on making
enforcement more efficient, and here I want to give one basic
message. If we look worldwide at what makes enforcement
efficient, it is effective criminal enforcement, and effective
criminal enforcement of insider trading is very difficult. It
is easy enough to find out who traded, but it is very difficult
to identify whether that trading was based on material
nonpublic information that was misappropriated. That requires
evidence that is hard to obtain.
Thus, many insider trading cases are actually prosecuted on
other grounds. You will recall the Martha Stewart case where
she was prosecuted for false statements and conspiracy and her
co-conspirators for perjury, but none of them were prosecuted
for insider trading.
The point I am making is that there needs to be cooperation
between civil and criminal enforcers because often the actual
charges brought will not be securities fraud but something
else. However, it does deter.
Now, when we look worldwide at enforcement, I have to tell
the Committee that in the legal systems closest to the United
States, insider trading has not been successfully enforced
through criminal law. In Great Britain and in Canada, there has
been no success with criminal enforcement. I have just served
on a Canadian commission that has tried to examine why there
has been little success, and basically we find that there are
legal barriers between cooperation between the civil enforcer
and the criminal enforcer, and the cases cannot be made.
Now, cooperation has never in the past been a problem in
the United States, but within the last year, two Federal courts
have dismissed criminal indictments brought by U.S. Attorneys
because of cooperation between the SEC and the U.S. Attorney.
The best known of these cases is the Scrushy case you referred
to, the CEO of HealthSouth. In that case, the U.S. Attorney did
call up the SEC attorney and suggest some questions they would
like asked and some questions they would not like asked because
it would tip off the deponent of the pending criminal
investment. Also, the U.S. Attorney suggested they move the
proceeding to Alabama from Atlanta so that they could indict
the deponent if he committed perjury. Mr. Scrushy was indicted
for perjury, and the case was dismissed by a court that says
the Government had laid a perjury trap.
I think that is a very fallacious logic. I do not accept
the perjury trap argument. The defendant was not induced to
lie. The defendant was merely induced to lie in Alabama rather
than in Georgia, and the defendant has no right to avoid
prosecution because he was not told in advance that the
Government was hiding in the bushes waiting to indict him if he
lied. All defendants should know that they can be indicted if
they lie before the SEC.
I suggest that Congress could fix this. This is not a
constitutional problem. This is a simple problem of supervisory
jurisdiction, and I think there is a quick fix that is
possible. And I will leave it at that point.
[The prepared statement of Mr. Coffee appears as a
submission for the record.]
Chairman Specter. Thank you very much, Professor Coffee.
We turn now to Professor James Cox, Duke Law School;
appointed to the Currie Chair in 2000; previously taught at
Boston University and the University of California at Stanford;
a member of the NASD's Legal Advisory Committee and the ABA
Committee on Criminal Law; bachelor's degree with high
distinction from Arizona State University, law degree from the
University of California, and a master's in law from Harvard.
We appreciate your being here, Mr. Cox.
STATEMENT OF JAMES D. COX, BRAINERD CURRIE PROFESSOR OF LAW,
DUKE UNIVERSITY SCHOOL OF LAW, DURHAM, NORTH CAROLINA
Mr. Cox. Thank you, Senator, for inviting me. My testimony
prepared on a blustery Saturday morning reports a lot of
studies that document everything that you have heard here this
morning: that insider trading in our capital markets is
pervasive and insidious, surrounding almost every event.
By way of illustration and replicating what Mr. Thomas
found, you find that, on average, beginning about 12 days
before takeovers or a merger, roughly 40 to 50 percent of the
premium that is going to be ultimately paid in that unannounced
event is already reflected in the stock's price; that the
deals, earnings reports, listings, delistings, bankruptcy,
offering of new public securities are not well- kept secrets in
our capital markets. So insider trading is a problem.
As Jack pointed out, we do not know whether the right
number of referrals are the 140 cases anticipated this year by
the Stock Watch group. Maybe it should be 300 cases or 400
cases. It is very hard to get a handle on that. What we do know
is that the evidence of insider trading, as I repeated and as
captured in my statement, is pervasive.
The suggestions I make are somewhat consistent with what
both John and Jack have made, and that is that we need to think
about enforcement. But enforcement really has two different
components to it, and I focus in my testimony more on the first
component, and that is, increasing the likelihood of detection.
The other component of that is the sanction. In between there
is the probability of successful prosecution. But let's talk a
little bit about detection.
One of the relevant questions I have suggested in my
written testimony would be an appropriate question for Mr.
Marchman and his organization is whether they really believe
that their data base has sufficient inputs as to who are the
participants in the deal so that when you do find suspicious
trading going on--and how do we know it is suspicious trading?
Generally, a suspicious trade is determined just by the size of
the trade. But maybe we ought to look at suspicious trading by
who the trader is. Do they have in their data base sufficient
knowledge about who the lawyers are, the investment bankers,
the commercial bankers, the accountants that are likely
involved with these transactions so that they are kicked out of
the computers even though they may trade a very small amount?
For close to 20 years now I have studied how the Stock
Watch group operated and how their data base is constructed,
what names were in it, the heuristics that were used for
identifying abnormal volume changes and price changes. And the
question is: Has that data base kept apace with market
developments? How transparent is the trading to the Stock Watch
group of who the traders are vis-a-vis the Stock Watch group,
not necessarily to the market? As we all know, being able to
conceal your identity in the marketplace is an important
attribute of capital markets. We do not want to have it
necessarily totally transparent to other investors who is
trading, but that is quite a separate question from whether we
have a system that allows the self-regulatory organizations,
the first line of defense for the integrity of our capital
markets with respect to insider trading, to know who is trading
and whether those data bases are adequate and sufficient.
I believe that we could have a method that would be
designed to provide sufficient data bases in ways that are
consistent with privacy notions and at the same time enhance
greatly the surveillance of our capital markets, the detection
of insider trading, and most likely the apprehension and
successful prosecution of those who violate their trust by
trading on material nonpublic information.
Thank you, Senator.
[The prepared statement of Mr. Cox appears as a submission
for the record.]
Chairman Specter. Thank you, Professor Cox.
Well, there is certainly a broad divergence of views. That
is an excellent panel from that perspective, and I compliment
my staff on assembling them, more so than easel, if I might
say.
Professor Cox, you are beating around the bush by calling
insider trading only pervasive and insidious. Would you
disagree with that, Professor Macey?
Mr. Macey. Well, the available data suggests one of two
things, Senator. One is we could say that insider trading is
more pervasive in the U.S. than in other countries because the
data that Jim Cox and Mr. Thomas are referring to suggests
greater volume increases and bigger price spikes. But I do not
think with a glancing familiarity with world capital markets
would agree that insider trading is more pervasive.
Obviously, with respect to the question how much illegal
insider trading should be--
Chairman Specter. He did not say it was more pervasive. He
just said it was pervasive.
Mr. Macey. Right. Well, the--
Chairman Specter. And you say it is less pervasive than
other places, but--
Mr. Macey. Fair enough.
Chairman Specter. Is it pervasive--well, I guess if you say
it is less pervasive, it is pervasive. How about insidious?
Mr. Macey. Well, I think by definition it is insidious
because it is sneaky, to the extent that it is illegal. But,
you know, I think again we have to look at causation. We have
to look at the great efficiency of U.S. markets. And Mr.
Thomas' company does suggest in its study that there is more--
that they have more of this aberrant activity in the U.S. than,
say, in London.
Chairman Specter. Well, I think that is a pretty
comprehensive indictment to call it pervasive and insidious. I
do not often ask the same question to other panelists, but is
it pervasive and insidious, Mr. Marchman?
Mr. Marchman. Chairman Specter, our numbers do indicate
that in recent years, at least with regard to our referrals,
activity which could be labeled as insider trading is on the
upswing. Of course, I agree with all the panelists--
Chairman Specter. On the upswing. But is it pervasive?
Mr. Marchman. It is an area of concern for our regulatory
group given--
Chairman Specter. It is a matter of concern for your
regulatory groups, but is it pervasive?
Mr. Marchman. It is a conduct that we are attempting to
ascertain the extent of the pervasiveness of the--
Chairman Specter. Conduct attempting to obtain an
evaluation of the pervasiveness. OK. I am not going to ask it a
fourth time.
Mr. Thomas, is it pervasive and insidious? Mr. Thomas, is
illegal insider trading pervasive and insidious?
Mr. Thomas. Well, certainly insidious if it is illegal.
There is no doubt about that at all, and--
Chairman Specter. Well, it is illegal, so we now know it is
insidious. But is it pervasive?
Mr. Thomas. Certainly it seems to be pervasive based on our
studies and the reports out of London and personal experience
in the past.
Chairman Specter. Well, I do not have so much interest as
to whether it is pervasive and insidious in London. How about
in the United States?
Mr. Thomas. According to our studies, it would certainly
appear to be.
Chairman Specter. Professor Coffee, is it pervasive and
insidious?
Mr. Coffee. It is pervasive and insidious enough to need a
stronger regulatory response.
Chairman Specter. OK. You have touched a core issue,
Professor Coffee, on the parallel tracks matter, and what is
the best rationale to be said in support of the Federal court
decision striking an indictment because of cooperation? It
seems to me a telephone call from--
Mr. Coffee. There are two decisions--
Chairman Specter. Two cases. Well, one was the perjury trap
and the other was the coordination--or were they both
coordination?
Mr. Coffee. Well, they both involved coordination, which
created, in the view of one judge--
Chairman Specter. But was the rationale in both--
Mr. Coffee. I think the underlying rationale--
Chairman Specter. The absence of parallel and disconnected
tracks.
Mr. Coffee. I think the underlying rationale is the
defendant is somehow entitled to warning so that he could
assert his Fifth Amendment rights if he knew that the U.S.
Attorney was using the SEC proceeding as a way of gathering
evidence for purposes of the criminal prosecution. However, in
the past, Congress has written right into the Federal
securities laws that the SEC can turn this information over. We
just have a gap as to whether or not the two bodies can consult
during the process of investigation, and that is where I think
there could be a further fix, because right now there is
considerable confusion in the law. And, frankly, any zealous
defense counsel is almost duty bound to make a motion alleging
that the Government has violated this perjury trap or somehow
improperly cooperated between the civil and criminal sides.
Chairman Specter. I have not been in the prosecution
business for a while. Is there an evolved doctrine of perjury
trap? It is the first time I have heard of it.
Mr. Coffee. Scrushy is the first time I heard it, and I
think it is very surprising to most prosecutors. But as long as
we have two decisions out there and no circuit court decisions,
we are in a state of considerable uncertainty.
Chairman Specter. Entrapment is a well-accepted doctrine
for a defense, but perjury--
Mr. Coffee. Entrapment, as you are well aware, Senator--
Chairman Specter. Well, come back to the question which I
have interrupted. What is the best rational for the conclusion
that the SEC attorneys and the Department of Justice attorneys
ought to be on totally separate tracks?
Mr. Coffee. Well, I think the argument implicitly of the
Scrushy court is that if you knew that the SEC was a stalking
horse, was working hand in glove with the U.S. Attorney, you
would have taken your Fifth Amendment rights, assert it at the
SEC proceeding, and you would have had the case probably
determined adversely against you because you can take
inference--
Chairman Specter. That is the best rationale?
Mr. Coffee. The rationale is that we should broadly
protect--I do not agree with this rationale, but the rationale
would be that we should give the defendant fair notice that the
Government is going to use this evidence and permit him to
assert his Fifth Amendment rights knowing the intended use of
the evidence.
Chairman Specter. Well, a person ought to be on guard at
all times for anything which is said which is incriminating,
because it can be used in an evidentiary way, as we all know,
by anybody who hears it as an admission, even on a hearsay
basis, let alone if you have a governmental agency conducting
an investigation.
Professor Macey, do you think that criminal sanctions ought
not to be employed against illegal insider trading?
Mr. Macey. No. I think criminal sanctions should be
employed against illegal insider trading.
Chairman Specter. Professor Cox, Professor Macey has
emphasized a view that the reputational penalties for insider
trading are very high. Now, he does not think that they should
be exclusive, as he just testified, but how meaningful do you
think reputational penalties are for insider--to discourage
illegal insider trading.
Mr. Cox. My sense is not enough, and the reason for that is
that we still see individuals who are engaged in professions
which trade on reputation--lawyers, accountants, certain high-
level investment bankers that still cross the line, and they
must appreciate the fact ex ante that if they get caught, they
will no longer be a lawyer or an accountant because nobody will
ever retain them in their firm.
So I think individuals discount heavily the loss of
reputation going into it. I think the loss of reputation is an
important part of addressing--causing people to adhere to a
norm. But it breaks down in lots of areas, and I suspect that
the reputation loss for those that are business people, not
professional people, is not nearly as great because the little
bit of casual knowledge I know, individuals that have been
involved in insider trading continue to be executives of firms;
whereas, those who are lawyers or accountants find another
profession other than being a lawyer or accountant. So it
depends upon a little bit about where you came from, but also
it depends a lot on who you are as well.
Chairman Specter. Reputational factors are not as important
to business people as to lawyers or accountants because the
penalties are not as high. They can keep their jobs.
Mr. Cox. That is what my surmise would be, sir.
Chairman Specter. Mr. Thomas, Professor Cox has raised a
question as to whether the data base is sufficient and wants to
know if you cross-check lawyers and accountants and other
professionals who are engaged in demonstrable illegal insider
trading as a factor to be considered in your studies. Does your
data base take into account what Professor Cox has asked about?
Mr. Thomas. Senator, we have no idea who the particular
parties are doing the trading. Something we do do is analyze
the individual number of trades, and it usually happens that
when tippees are involved, the number of individual trades or
transactions increases significantly beyond the norms,
independent of the absolute volume. And this is an important
indicator that something funny may be going on.
Chairman Specter. Do you think it would be a better study
if you tracked lawyers and accountants for the reasons
Professor Cox articulates?
Mr. Thomas. If someone paid us and gave us the mandate to
do so, we would be happy to do it.
Chairman Specter. Well, this Committee is not in a position
to pay you to do so.
Mr. Thomas. I am just pointing out, Senator, with due
respect, that is not the business we are in.
Chairman Specter. But you might propose it to the New York
Times. Or they might have heard about it from what we are
saying here.
It is a very interesting study that you have conducted,
beyond any question.
Mr. Thomas. Thank you.
Chairman Specter. And you have been commissioned to do so,
according to the Times, by the New York Times itself. Correct?
Mr. Thomas. Correct, yes.
Chairman Specter. Do you know the genesis as to why the
Times decided to make these inquiries?
Mr. Thomas. Our company and the New York Times have been
talking for a while about exchanging--our providing some of our
information. And then when the Financial Times of London
reported on the FSA study the 30-percent number out of London,
the New York Times said, Hey, could you do the same sort of
study over here for the United States for, say, mergers and
acquisitions--
Chairman Specter. So it was inspired by the London Times
story as opposed to some preconception that there might be
something rotten in Denmark.
Mr. Thomas. There might have been that preconception. I
have no idea. But the London Times, the Financial Times story
was the trigger that got this investigation going.
Chairman Specter. Mr. Marchman, your statistics are very
interesting about your referrals and the significant increase
in referrals. Do you track what the SEC does with your
referrals in terms of sanctions?
Mr. Marchman. We do. We do, and the--
Chairman Specter. Are they doing a good job?
Mr. Marchman. With the--
Chairman Specter. I withdraw that question. You probably
should not be asked that question. What are they doing? I will
not ask you a leading question. Professor Macey raised his
eyebrows on that.
Mr. Marchman. Well, what they do do, after we referred the
matter, is that--and, Chairman Specter, I would note that
before we do refer a matter to the SEC, there is an extensive
process that is involved by my staff where we do, in fact, have
an extensive data base which contains information with regard
to the identities of attorneys, accountants, individuals who
may have been involved with--
Chairman Specter. So you pick up some of what Professor Cox
suggested.
Mr. Marchman. We pick up almost all of what Professor Cox
has suggested.
Chairman Specter. And what has the SEC done with your
referrals?
Mr. Marchman. With our referrals, they have instituted a
number of disciplinary actions, as noted in my written
testimony, as a result of the referrals. We do keep track with
regard to the numbers. We have discussions with regard to any
additional information that they may need as they are going
forward. And we also are mindful of the evidentiary burdens
that do confront the SEC with regard to the referrals that we
make.
The referrals that we do make, as I noted in my written
testimony, are indications of potential violations of insider
trading, not actual evidence.
Chairman Specter. Mr. Marchman, would you provide to the
Committee your information as to what has happened on the
referrals?
Mr. Marchman. Sure.
Chairman Specter. And give us an evaluation, if you care to
do so--I know this is sensitive--as to whether you think what
the SEC has done is adequate. And we are going to track them on
the other end with the SEC and with the Department of Justice
to see what they are doing.
Mr. Coffee, you have raised the possibility of altering the
mens rea test but think that that would be unwise to do. Would
you expound upon that?
Mr. Coffee. Well, right now, any criminal prosecution for
securities fraud, which is how insider trading is classically
prosecuted, requires you to show that the defendant has a mens
rea of willfully violating the statute, and there are a series
of decisions by eminent judges, like Henry Friendly, that say
willfulness in this context requires proof of a conscious
awareness of wrongdoing on your part.
That is a very high standard, and it is one of the
problems. I do not think it is the principal problem. I think
the principal problem is getting proof that you actually
possessed material nonpublic information.
So it would be a move that would simplify the prosecution.
I do not recommend it because I believe this is an extremely
regulated and complex area, much like the tax law. And there
are many people who trade believing that they are permitted to
trade because they are not breaching a duty. And I think you
should have some awareness that you are breaching a duty before
you get criminally prosecuted for insider trading and face a
penalty of up to 25 years.
Chairman Specter. You mentioned Judge Friendly and his
test. What was it like, Professor Macey, clerking for Judge
Friendly?
Mr. Macey. He was a brilliant lawyer, particularly in the
business law, white-collar crime, corporate and securities
area, and a keen, keen intellect. It was a great honor and
privilege.
Chairman Specter. Chief Justice Roberts clerked for Judge
Friendly, too.
Mr. Macey. That is correct.
Chairman Specter. Why didn't you then go ahead to clerk for
Chief Justice Rehnquist and become Chief Justice?
[Laughter.]
Mr. Macey. I like academic life, and one clerkship year was
plenty for me. I guess Chief Justice Roberts had a bigger
appetite for clerking than I did.
Chairman Specter. When you were on the Yale Law Journal,
did you write a note or comment?
Mr. Macey. Yes.
Chairman Specter. What were the subjects?
Mr. Macey. The Banking Act of 1933, the Glass-Steagall Act.
Chairman Specter. Well, gentlemen, thank you very much for
your participation here today. As a final question, I would
like each of you to give an opinion, if you care to do so, on
whether there is sufficient criminal law enforcement by the
Department of Justice on insider trading or stock exchange
manipulations generally on back-dating options or fraud in a
variety of ways. Adequate or inadequate, Professor Cox? If you
care to say.
Mr. Cox. Well, I think I would like to see more prosecution
just because I think that captures the attention of lots of
people who need to have the message. And my sense is that we do
not have a lot of prosecutions, and I will be very interested
to see, with back-dating of stock options, whether there are
criminal prosecutions there. I would certainly hope so.
Chairman Specter. What is your view, Professor Coffee?
Mr. Coffee. It has only been in the last couple of years
that U.S. Attorneys outside of New York have been willing to
give priority to white-collar criminal prosecutions for
securities fraud. This is still a developing transition. I
think that there are many districts where you do not see the
U.S. Attorney giving any attention to white-collar crime, and
insider trading can occur anyplace.
So I think there is need for more enforcement, and there is
an uneven pattern in the use of criminal sanctions across this
country, as different U.S. Attorneys have different priorities.
Chairman Specter. Well, it is something the Department of
Justice, Main Justice can handle. They certainly should weigh
in. They have some control there.
Professor Macey?
Mr. Macey. Just two quick points. One, I agree with Jack
Coffee that there is strong evidence of regional asymmetries,
biases. Some places are much more active--the Southern District
of New York, for example--in criminal prosecutions.
But, two, before saying that the Department of Justice or
the SEC should do more, I would really like to see a few
factual stories and saying this person did the following,
engaged in the following trading, and shouldn't that person
have been prosecuted. Otherwise, I think it is too easy to say,
gee, I am a good guy, we should be doing a lot more of this.
And, you know, I think that to the extent that we can identify
tangible examples of such misconduct, then I would look at
those on a case-by-case basis.
Chairman Specter. Mr. Thomas, does the Crown bring enough
prosecutions?
Mr. Thomas. Does the Crown bring enough prosecutions?
Chairman Specter. Well, yes.
Mr. Thomas. I doubt it. But Professor Laura Beny of the
University of Michigan Law School has done a study insider
trading law enforcements around the world, and her thesis is
that the stronger the restrictions are and the more they are
enforced, the more liquid and fair the markets become. I think
that is a worthy goal.
Chairman Specter. And does Canada bring enough criminal
prosecutions?
Mr. Thomas. I doubt it.
Chairman Specter. Would you care to venture an opinion on
the United States' criminal prosecutions adequacy?
Mr. Thomas. I would prefer not to, Senator.
Chairman Specter. Well, you are not under subpoena so you
do not have to.
[Laughter.]
Chairman Specter. Mr. Marchman, enough prosecutions under
the criminal statutes in the United States?
Mr. Marchman. Chairman Specter, I can only comment from the
interaction that I have been fortunate to have with the U.S.
Attorney's Office in the Southern District, and they have a
very vigorous and active program. So from that vantage point, I
do believe it is adequate.
Chairman Specter. Without objection, we will admit into the
record a statement from Senator Grassley.
I am going to tell my colleagues what a good hearing they
missed today, and I think next time I am not going to invite
anybody. I like the current make-up of the panel.
[Laughter.]
Chairman Specter. I maintain a record of adhering strictly
to time limits, and each questioner has 5 minutes, and I am now
in excess of 20 minutes, 15 minutes over my time, which is a
first for me. I am prompted to think about one-person grand
juries, and we may adopt that policy for this Committee.
[Whereupon, at 11:15 a.m., the Committee was adjourned.]
Questions and answers and submissions for the record
follow.]
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