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From Boesky and Milken to Rajaratnam and Gupta: What Makes an Insider Trading Case Criminal

Wednesday, January 4, 2012
Raphael Rosenblatt | Bloomberg Law
  • Criminal securities fraud or insider trading requires a "willful" violation of the securities laws.
  • A criminal case typically begins after the SEC, finding sufficient evidence of "willful" conduct, refers the matter to the DOJ.
Insider trading was a topic very much in the news during 2011. The conviction and sentencing of Raj Rajaratnam and a number of defendants formerly employed at or doing business with his Galleon Group LLC, as well as the pending indictment of former McKinsey & Company CEO Rajat Gupta, has shined a spotlight on insider trading not seen since the 1980s prosecutions of Ivan Boesky and Michael Milken. But less frequently discussed when analyzing the Rajaratnam prosecution (and others like it), is what makes insider trading a criminal act, as opposed to a securities law violation that results merely in a civil enforcement action by the Securities and Exchange Commission (SEC). This article will discuss the elements of criminal insider trading, as well as the procedure for bringing an insider trading prosecution.

Criminal Insider Trading

Insider trading is prohibited by Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5 thereunder.1 Section 32 of the Exchange Act criminalizes the willful violation of any provision of the Exchange Act, or the willful and knowing making of a false or misleading material statement in "any application, report, or document required to be filed." But, there is a caveat: "no person shall be subject to imprisonment under this section for the violation of any rule or regulation if he proves that he had no knowledge of such rule or regulation."

— Willful

"'Willfulness' is the element that converts a civil violation of [the securities laws] into a felony crime."2 Thus, a clear definition of what constitutes "willful" conduct will determine when acts constituting securities fraud or insider trading become criminal. The U.S. Court of Appeals for the Second Circuit has defined willfulness as "a realization on the defendant's part that he was doing a wrongful act," provided that the act is "wrongful under the securities laws and that the knowingly wrongful act involve[s] a significant risk of effecting the violation that has occurred."3 The government need not prove, however, that the defendant knew that his or her conduct violates a rule or regulation, unless it seeks imprisonment or is prosecuting an individual for making certain types of false statements. Knowledge generally is not an element of criminal securities fraud or insider trading. If "willfully" also required knowledge, the last clause of Section 32—that a person may not be imprisoned "if he proves he had no knowledge of such rule or violation"—would be redundant because it would mean that a person could not be convicted in the first instance without knowledge.4 By contrast, lack of knowledge of a rule or regulation allows for a securities fraud or insider trading conviction and a fine, but not imprisonment.5 The statutory difference between a willful violation of a statute or regulation and the knowing and willful making of a false statement demonstrates that "[a] person can willfully violate an SEC rule even if he does not know of its existence."6 Willful conduct involves "the intentional doing of the wrongful acts—no knowledge of the rule or regulation is required."7 In an insider trading case, this distinction may take on more relevance than in other types of securities fraud cases: "[u]nlike securities fraud, insider trading does not necessarily involve deception, and it is easy to imagine an insider trader who receives a tip and is unaware that his conduct was illegal and therefore wrongful."8 This is distinct from "one who deliberately misleads investors about a security."9 To summarize, criminal liability may result from the volitional act that violates Section 10(b) or Rule 10b-5, even if the defendant did not have specific intent to knowingly violate the securities laws.

— Exact Standard Undefined

What remains unsettled is the exact standard of scienter to be applied in criminal cases. Reckless Disregard Reckless disregard for the truth may be sufficient to satisfy the willfulness requirement needed to sustain a securities fraud conviction. Because a "willful" violation under Section 32 has been interpreted to mean "voluntarily and knowingly wrongful," rather than "with the intent to violate the law," recklessness has been found to be "adequate to support a conviction for securities fraud."10Knew or Should Have Known Several civil cases have incorporated a "knew or should have known" standard into the scienter definition,11 and the U.S. Supreme Court has used the same language when deciding a criminal case.12 While that issue may remain unsettled for the moment, during the Rajaratnam trial, the district court incorporated Section 32 into its jury instruction, which stated, without objection, that the government had to prove beyond a reasonable doubt "that Mr. Rajaratnam knew that the information had been disclosed by an insider in breach of a duty of trust and confidence."13

Criminal Referral

Now that the essential elements of criminal securities fraud and insider trading have been addressed, the question to be considered is how a criminal case is commenced. A criminal securities or insider trading case begins much like a civil enforcement proceeding. The SEC commences an investigation and if there is sufficient reason to believe the defendant has committed a willful violation of the statute or rule, the SEC will refer the case to the Department of Justice (DOJ) for investigation and prosecution.14 A referral may be formal or informal, and the difference will dictate the SEC's involvement in the investigation. Formal referral requires the SEC to prepare a detailed written report in which it outlines the evidence and recommends future action.15 An informal referral opens the SEC's files to DOJ investigators, but, as the name suggests, does not require a formal written report. In practice, formal referrals are rare, but "[r]equests for access to the [SEC's] files are often made following an informal referral by the [SEC] to the criminal authorities."16 In fact, sharing of files amongst federal law enforcement is encouraged, "even when it has been developed in other than a formal investigation."17 Obviously, the DOJ has the authority to commence its own investigation and prosecution if a criminal violation has been found.18

Parallel Proceedings

A referral to the DOJ does not preclude the SEC from continuing its own investigation.19 The parallel investigation does not implicate Fifth Amendment double jeopardy concerns.20 Provided there is no irreparable prejudice, courts generally will not stay parallel proceedings, even if a grand jury investigation is underway.21 The Supreme Court has explained that irreparable prejudice may occur—and thus a stay would be warranted—if: (1) the government brought the civil action solely to obtain evidence for its criminal prosecution; (2) during the civil proceeding, the government failed to advise the defendant of the potential for criminal prosecution; (3) the defendant is without counsel or stands to be prejudiced by adverse pretrial publicity or other unfair injury; or (4) there are any other special circumstances that suggest the unconstitutionality or impropriety of the criminal prosecution.22 While the Fifth Amendment privilege against self-incrimination may be invoked during a criminal proceeding,23 the SEC may draw an adverse inference from a civil defendant's "silence in the face of accusation."24 However, it is unconstitutional to impose punitive penalties as a result of a defendant invoking his or her Fifth Amendment privilege, or to make the invocation dependent on imposition of sanctions or economic loss.25 The Fifth Amendment privilege must be invoked in response to specific questions (or items requested in a subpoena), and cannot merely be a "blanket" invocation of the privilege.26 Courts have wide latitude to fashion remedies such as protective orders, sealing orders, stays, some combination of them, or limiting testimony in an effort to avoid prejudice to either side if a defendant intends to invoke his privilege against self-incrimination.

Conclusion

With insider trading back in the spotlight, it is important to recall the differences between a civil and criminal violation, how an SEC investigation can turn a civil enforcement action into a criminal prosecution, and the procedures involved in such a process. DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.  

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