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Ms. Linda Thomsen
Director of Enforcement
Before the U.S. Senate Committee on the Judiciary December 5,2006
Thank you for inviting me to testify today about insider trading involving hedge funds. 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. Rigorous enforcement of our current statutory and regulatory prohibitions on insider trading is an important part of the Commission's mission.
I am especially pleased to testify together with Associate Deputy Attorney General Ronald Tenpas of the United States Department of Justice, and Richard Blumenthal, Attorney General of the State of Connecticut. The Commission, as you know, is a civil enforcement agency and we use civil sanctions to address insider trading. However, insider trading may also violate federal criminal law, as well as state securities regulations and other state laws. The respective histories of the SEC and the Department of Justice, as well as those of state attorneys general and securities regulators, demonstrate our collective commitment to prosecuting insider trading, civilly and criminally, under federal and state law. Our respective histories also demonstrate our collective commitment to working with each other.
1) access to material, non-public information;
Before I detail these legal requirements, however, let me step back and discuss some background regarding our insider trading investigations. Insider trading leads come from a host of sources, not only market surveillance but also the media, public tips, and information developed in our own inspections and investigations. Identifying suspicious trading is an essential starting point, but it is only the first step in compiling a viable case. While the SEC's Enforcement Division has brought hundreds of successful insider trading cases, there are also many investigations that are opened and later closed without enforcement action. We may open an investigation based on suspicious trading and all of the circumstances may look troubling, but after a thorough look, we may discover no evidence of insider trading or not enough evidence to prove there has been a violation of law. Because an investigation may not lead to an enforcement action, we are always mindful that public disclosure of the mere fact of an SEC investigation may unfairly impugn the reputations of the entities and individuals whose conduct may be exonerated. For this reason, as a matter of long-standing Commission policy, our investigations are conducted on a confidential basis and, as a general matter, we do not confirm or deny the existence of any ongoing investigations.
As the law of insider trading has developed over time, it has come to impose legal requirements intended to distinguish legitimate conduct fi-om illegitimate conduct. As I mentioned a moment ago, the law requires that the information be confidential and non- public. If so many people already know the information that it crosses the tipping point where it can be deemed public-based on prior media reports, for instance-there is no violation. The staff must also show scienter-a culpable state of mind or intent to violate the law. In other words, the tipping or trading must be undertaken with culpable intent to commit a violation, and not as the result of an inadvertent slip or innocent mistake. Finally, the staff must also show a violation of duty to the source of the information. The duty to the source may be easy to prove against a tipper who passes on information in breach of a confidentiality agreement. But if information is passed along a chain of tippees, it may become harder to prove that a trader who obtained the information third- or fourth-hand had any duty to the source, or knowledge of the original tipper's duty to the source. Though each of these legal requirements must be established in every insider trading case, they are important because they help to distinguish unlawful trading from the much larger universe of lawful trading.
Insider trading can be, and usually is, accomplished within a very small group or even by a single individual. The communications that result in insider trading do not necessarily generate much of a paper trail. The executive working on due diligence for a confidential deal may meet his brother-in-law in a public park on his lunch hour and pass along a tip. Because there are so few people involved, there may not be witnesses or bystanders who will come forward and report the tipping.
Despite these challenges, our staff has become particularly adept at sifting through all available forms of evidence, including phone records, emails, instant messages, and the electronic footprints of internet protocol data. Our staff culls through trading records, interviews and takes the testimony of witnesses, and reviews bank and brokerage statements. With these tools and resources, our staff has built solid, credible enforcement actions against hundreds of wrongdoers.
Investigating potential insider trading by hedge funds presents additional challenges because of their high volume trading and proprietary trading strategies. Because they often have substantial assets under management, hedge funds may place extremely large trades in many different securities on a daily basis. The huge volume of trading by hedge funds across a broad range of securities may generate any number of transactions that appear to be unusual or suspicious, but for some hedge funds these trades may be typical. When the SEC approaches a hedge fund with evidence of a large and suspicious trade in advance of a public announcement by a company, the hedge fund often replies that it placed trades of the same magnitude in the same security on many different occasions- and the trading records generally support that claim.
Tracking a hedge fund's trading in a specific security may also be challenging. It is not uncommon for hedge funds to use the services of multiple prime brokers-registered broker-dealers that facilitate trades and other transactions on behalf of hedge funds. A hedge fund may break up a single large trade into many smaller trades to be facilitated through a number of prime brokers over time because, for example, the hedge fund may want to make its trading less obvious in the market, often to protect its proprietary trading strategy. Thus, to develop an accurate composite view of a hedge fund's trading in a particular security, it may be necessary to review records from all of its prime brokers.
The prime brokers provide the SEC with a window into the trading activities of the hedge funds they serve, but it is admittedly a limited window. While a prime broker has information about the transactions it performs for a hedge fund, it generally has little information about activities the hedge fund may be conducting through other prime brokers. Nonetheless, the Enforcement Division remains optimistic about prime brokers as a source of leads regarding unlawful insider trading.
The SEC's Investigation of Potential Insider Trading by Pequot
Although it is uncomfortable to discuss an individual's job performance in detail in a public setting, the former SEC employee's false allegations against the Enforcement Division have made the facts surrounding his termination a public issue. Therefore, I feel compelled to share with you the Enforcement Division's perspective on his performance problems and his resulting termination. After an unhappy probationary period of employment, the former SEC employee was terminated on September 1,2005 because of "his inability to work effectively with other staff and his unwillingness to operate within the Securities and Exchange Commission (SEC) process." The SEC's termination letter is attached hereto. When the staff attorney was hired, he was required to serve a one-year probationary or trial period during which his employment could be terminated for any reason or no reason, but there were indeed many reasons in this particular case. He had continued personality conflicts with other staff attorneys, resisted standard supervision, and ignored the SEC's chain of command. Despite these problems, the SEC attempted to accommodate him and to ameliorate the problems he caused in his work groups. During his brief tenure, he was, at his request, transferred fi-om his original supervisor to a supervisor he requested, about whom he now bitterly complains. He also requested, and received, official time to pursue an unsuccessful age discrimination claim against the SEC for failing to hire him on 22 prior applications. The EEOC's opinion denying those claims is attached; the former employee is appealing the decision.
During his tenure, the former employee demonstrated his own dissatisfaction with his employment by twice leaving the office abruptly during the workday after disagreeing with other attorneys, and on a third occasion, by actually tendering his written resignation, only to rescind it some time later. After assuming primary responsibility for the Pequot investigation for several months in 2005, the former employee announced he would not draft the customary memorandum summarizing the investigation he now so publicly discusses. With respect to the substance of his work, he issued -without his supervisors' review or approval -subpoenas that violated federal privacy law, which were withdrawn as soon as his supervisors learned of them. But for the corrective actions of his SEC supervisors, the staff attorney's work product could have been extremely damaging to the SEC, and his continued resistance to supervision created a substantial risk of future error. After the SEC expended considerable efforts in attempts to make the employment relationship work, we decided not to extend his employment beyond the one-year probationary period.
Finally, Mr. Chairman, the three supervisors working on the Pequot investigation, who collectively have decades of experience and who have been involved in some of our toughest cases, were not influenced by who any of the particular people involved in the investigation were, but rather by the facts and the evidence. This is consistent with the finest traditions of this agency. We follow the facts, and if those facts take us to John or Jane Doe or some more famous John or Jane, so be it. We have gathered evidence from and about, and in some instances we have sued, captains of industry, Presidential cabinet members, Members of Congress, and celebrities, as well as thousands of other far less well known people. Indeed, a long list of prominent and not so prominent individuals would undoubtedly testify that the Enforcement Division does not pull its punches. I want to assure the Committee that we are passionate about our work and will pursue it with vigor, skill and fairness.