News Story

Catching Insider Trading


The arrest of an assistant to a Walt Disney Company executive and her companion on insider trading charges reflects what seems to be a common perception about the ethics of these investors – even if most ply their trade legally.

This latest round of charges, which arose from the couple’s efforts to sell confidential earnings data to a number of hedge funds, comes on the heels of the Galleon Group case and highlights how information is the chief currency of Wall Street today.

Add to the  settlement on Thursday of civil securities fraud charges by the hedge fund Pequot Capital Management, now defunct, and its chief executive, Arthur J. Samberg, and it is no wonder that insider trading is considered rampant.

The question now is whether the government will adopt even more aggressive investigative techniques against hedge funds and others perceived as abusing the data flow.

The companion charged in the Disney case, Yonni Sebbag, sent anonymous letters to more than 33 hedge funds, offering advance information about a coming earnings release “for a fee that we can determine later.” According to Robert Khuzami, the Securities and Exchange Commission’s enforcement chief, multiple firms reported the scheme (a sign of the times).

But what about the firms that didn’t report having received the letter? Did any of them try to obtain the information, or at least entertain the possibility of doing so? Even if none did, could hedge funds be ripe for an undercover operation to see if traders would be willing to buy confidential corporate information: a sort of Abscam sting operation on Wall Street?

The Justice Department has emphasized its willingness to use tactics usually seen in drug and street crime cases to assist in white-collar investigations. Insider trading examinations are usually reactive, taking place well after the transactions have taken place as the government tries to sort out the sources of information.

If prosecutors and the S.E.C. want to be more aggressive, then an undercover operation may be one way to flush out traders willing to traffic in insider information.

At about the same time that agents from the Federal Bureau of Investigation arrested Mr. Sebbag and the Disney employee, Bonnie J. Hoxie, the head of the Justice Department’s criminal division, Lanny Breuer, was delivering a speech on the agency’s increasing resources to investigate financial fraud cases. Speaking at the Compliance Week 2010 conference in Washington, Mr. Breuer discussed the use of a sting operation in a Foreign Corrupt Practices Act investigation in which a cooperating witness posed as the representative to an African country and solicited bribes from suppliers.

Through that operation, 22 individuals were charged.

He also pointed to the use of wiretaps in the Galleon case. “I think it is fair to say that we will continue to look for opportunities to innovate in how we identify financial fraud and corruption,” Mr. Breuer said.

One undercover operation that has met success in the drug area is a “reverse sting,” where the undercover agent or operative poses as a seller. The goal is to obtain evidence against higher-level perpetrators, beyond street dealers.

These operations have worked in public corruption cases, in which agents and cooperating witnesses seek assistance from public officials by offering bribes. Among the chief examples of this kind of investigation are Abscam, in which a number of legislators were caught accepting cash, and Chicago’s Operation Greylord, which ended in a number of judges’ being sent to prison.

A reverse sting involving insider information would certainly be possible. An operative with Wall Street connections could offer traders tidbits of information about various companies, which may be willing to cooperate by allowing the government to selectively disclose corporate developments as part of the sting.

For any operation to work, the undercover operative must be credible, and for an insider trading investigation, that would probably require disclosing some truthful information to help bait the trap.

An additional benefit of a successful sting, beyond capturing suspects, is the mistrust it sows among others in the field. The Galleon prosecutions have already caused many in the hedge fund world to tread much more carefully in how they gather information on companies. A reverse sting could have an even greater effect on how information is passed on Wall Street by making traders wonder if any source of information is actually someone working with the Justice Department or the S.E.C.

Of course, there are dangers in trying out such an operation. The disclosure of information would affect the market, potentially hurting innocent investors and impacting the efficiency of the markets. Establishing the undercover operation would be time-consuming and expensive. And whether insider trading is worthy of such a resource-intensive effort is another question.

If a reverse sting succeeds, a common defense is entrapment, a claim that the government enticed an otherwise innocent person to engage in criminal conduct that he or she otherwise would not have. Entrapment is hard to establish, but it can generate some sympathy with a jury if the investigative tactics appear to cross the line into outrageous conduct.

In fairness to the hedge funds that did not report the letter from Mr. Sebbag, it’s possible that his message was the equivalent of e-mail messages seeking assistance in moving funds from a recently deceased overseas finance minister’s secret bank account. The letter was so amateurish that hedge fund managers could have viewed it as spam.

A real and expansive reverse sting would need to be much more sophisticated than Mr. Sebbag’s effort, and even then it’s not clear whether it would ensnare Wall Street traders. But Mr. Breuer’s comments about looking for “opportunities to innovate” should be seen as a warning that the government is looking for new ways to ferret out insider trading.

Peter J. Henning

About White Collar Watch

Peter J. Henning, writing for DealBook’s White Collar Watch, is a commentator on white-collar crime and litigation. A former lawyer at the Securities and Exchange Commission’s enforcement division and then a prosecutor at the Justice Department, he is a professor at the Wayne State University Law School. He is currently working on a book, “The Prosecution and Defense of Public Corruption: The Law & Legal Strategies,” to be published by Oxford University Press.