White Collar and Securities: New York Federal Court Okays Wiretap Evidence in Insider Trading Prosecutions

In a series of insider trading prosecutions in federal court in New York judges have ruled that wiretap evidence is admissible. The cases have arisen from a three year investigation of the Galleon hedge fund. The best known of the prosecutions is the case against Raj Rajaratnam, founder of Galleon. he is scheduled to go on trial on February 28, 2011, in the Southern District of New York.

In Rajaratnam's case, as well as the companion cases, the Justice Department has sought to introduce evidence of conversations intercepted pursuant to court authorized wiretaps. These cases appear to be the first time that wiretap evidence will be used by the government in an insider trading prosecution.

Wiretaps are authorized by the Omnibus Crime Control Act of 1968. They are an extraordinary investigative tool and are to be used only when the government demonstrates to the court that such wiretaps are necessary to further its investigation. Wiretaps are authorized when other less intrusive investigative techniques have proved insufficient. Courts refer to this as the "necessity" requirement. Affidavits in support of wiretap warrants must contain sufficient information to satisfy the court that other investigative means will not prove effective and that the wiretap requested is necessary to conduct the investigation. In many ways the law views a wiretap as essentially an investigative technique of last resort.

Historically, government has limited its use of wiretaps to investigations of crimes such as drug distribution and racketeering type offenses. Investigators have not used the technique in pursuit of white collar crime such as securities fraud. The probable explanation for this fact is that white collar type cases often have large numbers of documents that investigators can use to investigate economic relationships and the flow of monies. Moreover, business crime investigation typically affords the opportunity to interview witnesses who are not connected to the criminal scheme. Thus, document review, witness interviews, financial forensic analysis, and a grand jury may all be useful in concluding a successful investigation without the necessity of wiretaps. Additionally, wiretaps are most beneficial in the investigation of ongoing criminal activity. Most fraud investigations are retrospective. Thus, there is less likelihood of obtaining relevant evidence from a wiretap during a fraud investigation.

The fact that the government successfully persuaded courts to authorize the wiretaps and then admit the evidence from the taps in an insider trading prosecution suggests that in the future government investigators will seek to use wiretaps in fraud investigations where they believe that the criminal conduct is ongoing.

If you have any questions about this post, white collar enforcement, or securities litigation, please contact me at (954) 761-2902 or at richard.serafini@ruden.com.

Securities: First SEC Insider Trading of Default Swaps Case Goes to Trial

For the first time the Securities and Exchange Commission is bringing to trial an insider trading case based on credit default swaps. The case is taking place in the United States District Court for the Southern District of New York in Manhattan. It will be a bellwether for the handling of these types of cases by the SEC.

A "credit default swap" is exactly what the name suggests. It is a bet that a credit instrument will go into default. Typically, a credit default swap references a bond or a loan. The buyer of the credit default swap pays a premium and receives proceeds of the contract from the seller if the bond or loan goes into default. The buyer may or may not also hold the underlying obligation. However, in most cases the buyer does not hold the bonds or loan.

The SEC alleges that Jon-Paul Rorech, a bond and credit default swap salesman for Deutsche Bank Securities, provided information about a bond sale to Renato Negrin, a former Millennium Partners portfolio manager. The complaint further alleges that based on the tip, Negrin executed credit default swap transactions, which referenced the bond being offered.

The case revolves around bond offerings by the Dutch media company, VNU Group BV. In July 2006 VNU announced a $1.67 billion bond offer by its subsidiaries. Investors in the offering became concerned that the bonds could not be used to settle credit default swaps referencing them. As a result, on July 24, 2006, Deutsche Bank, the underwriter for the bond offering, announced a restructuring of the bond offer. The restructured offer was to include a 200 million euro tranche from VNU to cover the credit default swaps.

The SEC alleges that Rorech tipped Negrin about the restructuring before the announcement. Negrin bought 20 million euros of VNU subsidiary swaps. Upon the announcement of the restructuring, the price of the swaps rose. Then, Negrin sold his holdings of the swaps to realize a profit. The SEC alleges that the trading realized a gain of $1.2 million of which Negrin's personal gain was $240,000.

The case is significant because derivatives such as credit default swaps are part of the "shadow banking" system which has been essentially unregulated. A threshold issue in the trial is whether the SEC has jurisdiction in the matter. The defendants contend that credit default swaps are private contracts rather than securities and are outside the purview of the SEC. Congress has given the Commission authority to prosecute credit default swap cases where material terms of the contract relate to the price, yield, value, or volatility of a security. The Commission is arguing that the price of the credit default swap involving the VNU bonds brings the matter within its jurisdiction.

How the district court and ultimately the Second Circuit Court of Appeals rules on this issue will dictate how active an approach the SEC will be able to take in its enforcement program concerning credit default swaps. The trial is underway and the initial answer to this question should be forthcoming.

For a further discussion of the pending trial, please see BussinessWeek, "Trial Begins in First SEC Insider Default-Swap Case," April 7, 2010, http://www.businessweek.com/news/2010-04-07/trial-begins-in-sec-s-first-insider-credit-default-swap-case.html.

Securities: SEC Charges Lawyer in Insider Trading Ring Action

Yesterday, the Securities and Exchange Commission brought insider trading charges against Brien P. Santarlas, formerly an attorney at the international law firm Ropes & Gray, LLP. Santarlas was the tenth person charged in the investigation. Last month, the SEC brought charges Arthur J. Cutillo, a former Santerlas colleague at Ropes & Gray, and eight others.

The complaint alleges that Santarlas misappropriated confidential information about mergers from his law firm and provided the information to others who traded in the securities of the companies involved in the mergers. Santarlas received a kickback for providing the inside information. The SEC alleges that the scheme took in more than $20 million in illicit profits.

The essence of the case is that Santarlas and Cutillo breached their duties to Ropes & Gray by misappropriating confidential information about the mergers. Thus, they had duties to either refrain from trading or to disclose the confidential information. When the attorneys passed the information on to other members of the insider trading scheme, the duty to refrain or disclosed passed with the information. This is because those receiving such information allegedly knew that it was misappropriated nonpublic information.

This is a further example of the SEC's tougher stance on allegations of insider trading.

The cases were brought in federal district court in the Southern District of New York. While Ropes & Gray is headquartered in Boston, the two attorneys worked at its New York office.

For an article about the Santarlas case please see The Boston Globe website, http://www.boston.com/business/ticker/2009/12/ex_ropes_gray_a.html.

White Collar Crime and Securities: Wire Taps Lead to Insider Trading Charges

A federal grand jury in the Southern District of New York brought insider trading charges against six individuals, including a billionaire hedge fund operator and executives of major corporations. The indictment alleges that Raj Rajaratnam, a billionaire who operates the $7 billion Galleon Group hedge fund, Rajiv Goel, manging director of strategic investments at Intel Corp., Anil Kumar, a director at McKinsey & Co., Robert Moffat, a senior vice president for IBM, and two former Bear Stearns executives engaged in an insider trading scheme. The indictment charges conspiracy and securities fraud, alleging that the scheme produced more than $20 million in illicit profits. The case appears to be the largest fraud involving a hedge fund ever brought. The Securities and Exchange Commission announced the bring of a civil enforcement action simultaneously.

The government has alleged that Google, Advanced Micro Devices and Hilton Hotels were among the stocks traded upon inside information. Intel has instituted an internal investigation to determine whether its stock was the subject of any insider trading.

Insider trading is the unlawful trading of securities while in possession of material non-public information. For the government to sustain a charge of fraud based on insider trading it must establish that the defendant breached a duty to someone or some entity by acting on the insider information or acted on the information while aware of an other's breach in communicating such information. In many insider trading cases there is difficulty in establishing knowledge of the inside information by those trading. Traditionally, either circumstances or the testimony of a scheme insider provides the proof.

In this instance the government built the indictment, in part, on court ordered wire taps. The recorded statements of the defendants themselves purportedly provide the evidence of the breach of duty and knowledge (referred to as "scienter" by securities litigators). This appears to be the first instance in which the investigation of alleged insider trading employed wire taps.

Court ordered wire taps require investigators to undertake the process of "minimization." This requires agents to monitor the intercepts to determine whether the conversations intercepted involve discussions or evidence of crime. If not, the agents must "minimize" the intercept to avoid capturing innocent conversations. Thus, the use of wire taps is an expensive and laborious undertaking. The fact that the government employed wire taps indicates the importance that federal authorities placed on this investigation.

For more information about the case please see the following articles: Los Angeles Times, "6 Accused of Insider Trading after Wiretapping Investigation," http://www.latimes.com/business/la-fi-hedge-fund17-2009oct17,0,4843899.story, and The New York Times, "Hedge Fund Chief Is Charged with Fraud," http://www.nytimes.com/2009/10/17/business/17insider.html?_r=1&scp=5&sq=rajaratnam&st=cse

White Collar and Securities: JPMorgan Closely Monitoring Cioffi and Tannin Trial

Months before Lehman Brothers collapsed, Bank of America acquired Merrill Lynch, and the securities markets came to the precipice of disintegration, JPMorgan Chase acquired Bear Stearns. The acquisition took place in March 2008 for $10 per share. As is common in acquisitions through stock purchases, JPMorgan also acquired Bear Stearns's potential liabilities including those arising from ongoing Bear litigation.

In 2007 two Bear Stearns hedge funds failed, resulting in a market meltdown that presaged the 2008 market panic. As a result of the failure of the Bear hedge funds, federal prosecutors sought and obtained the indictment of the heads of the two Bear funds, Ralph Cioffi and Matthew Tannin. The indictment charges Cioffi and Tannin with conspiracy, securities fraud, and wire fraud. Cioffi is also charged with insider trading.

The indictment alleges that Cioffi and Tannin were aware of the precarious financial condition of the Bear hedge funds and the grave risk of their collapse, but nevertheless, they failed to inform the funds' investors and the public of the true facts. Instead, the indictment alleges that they made false statements to lull investors into not withdrawing funds. The government alleges that investors lost more than $1 billion upon liquidation of the funds in July 2007 as a result of the fraud.

While JPMorgan is free from exposure in the criminal case, the evidence adduced at trial could have significant impact on civil suits against the firm. There are currently two significant cases that plaintiffs have filed against JPMorgan. In one suit investor Bruce Sherman has filed a claim against Bear (JPMorgan) alleging that Bear fraudulently overstated the value of the hedge funds' assets. This suits seeks unspecified damages, but success could result in plaintiffs recovering billions of dollars. The second suit, filed by Bank of America, seeks damages of $2 billion and alleges that the Bear hedge funds' managers deceived Bank of America about the financial condition of the hedge funds to sell the bank $4 billion of mortgage backed securities and to obtain from BofA a further $1 billion line of credit.

If evidence at the criminal trial of Cioffi and Tannin proves that executives above the hedge fund managers were aware of the true financial status of the funds, the likelihood of success in the civil suits will increase. Moreover, the more such evidence comes to light, the more likely that other plaintiffs will come forward and sue Bear (JPMorgan). In short, JPMorgan has a very keen interest in the evidence adduced in the trial.

For a further discussion of the issues confronting JPMorgan Chase in the Cioffi and Tannin trial, please see the following article in cnnmoney.com, http://money.cnn.com/2009/10/08/news/companies/bear_stearns_trial_jpmorgan.fortune/?postversion=2009100908