Every litigator says that trials are messy affairs because no one can predict how they will play out. After a string of recent unfavorable verdicts in fraud cases, the Securities and Exchange Commission may, too, be concerned with that trend.
The S.E.C. is a bit like the New York Yankees, because every defeat is magnified, so we should be careful not to read too much into the anecdotal evidence as garnered by the results of a few recent trials. Most cases filed by the agency are settled, garnering only modest publicity, so the effectiveness of its enforcement program is not tied solely to its wins in the courtroom.
The S.E.C.’s authority extends to civil actions, which require a lower burden of proof than the higher criminal standard of proof beyond a reasonable doubt. Nevertheless, it appears that in some recent actions – including the closely watched Mark Cuban case and ones involving accounting fraud — the S.E.C. may have pushed too far in trying to prove fraud. And now that the agency has said it would be more aggressive in seeking admission of wrongdoing in some cases, the agency will face pressure to figure out how to avoid wasting its resources on losing efforts.
Last month, a jury in Chicago rejected insider trading charges involving a railroad worker and his sons. The worker had deduced, based on a number of tours being given at his facility to people dressed in suits, that a merger involving his employer was likely. He and his family members bought call options, making about $1 million in profits.
The S.E.C.’s tried to prove that an employee who pieces together information about a possible transaction — but is not explicitly told about a deal – should constitute insider trading. When the defendant is a blue-collar worker and there is no evidence of any type of theft of confidential information, proving fraud will be difficult. Juries like to hear about some type of deception — not just that a low-level employee made a good guess and profited from it.
In a trial last November, a federal judge in Georgia rejected insider trading charges of a defendant who had a longtime friendship with a chief executive. In S.E.C. v. Schvacho, the S.E.C. entered into evidence a number of telephone calls and meetings between the two men while an acquisition of the company was being negotiated. But it had nothing to show that confidential information was passed to the defendant.
Although the timing was certainly suspicious, that alone was not enough to prove insider trading.
The chief executive testified he was careful not to intentionally or accidentally leak corporate information to his friend, who had bought shares of the company over a number of years, not just right before the acquisition. In an opinion issued in January, the judge concluded that: “While this timing is interesting, it is not persuasive and does not meet the S.E.C.’s burden of proof in this case.”
Stock purchases or sales immediately before a major event are always open to question. The S.E.C. is right to look at them closely, because you never know when a connection to confidential information might be uncovered.
Circumstantial evidence can be enough to sway the jury. Witness the criminal conviction last week of the former SAC Capital Advisors trader Mathew Martoma, which hinged on a 20-minute telephone call with his boss, Steven A. Cohen, shortly after Mr. Martoma received information about a failed drug trial.
But timing in life isn’t everything, and there is always the danger of falling for the logical fallacy of “post hoc, ergo propter hoc,” which means “after this, therefore because of this.” In the Schvacho case, the S.E.C. had little more than well-timed trading in the face of consistent testimony from the chief executive that he was always careful to avoid disclosing information, which the judge found “to be credible and believable.”
Even when a defendant admits to having confidential information, it alone is not enough to prove insider trading, as shown by the failed case against Mark Cuban, the owner of the Dallas Mavericks. The S.E.C. claimed that Mr. Cuban understood that he could not sell shares of a company after speaking with its chief executive about an impending development that would hurt its stock price.
The S.E.C. could not bring the chief executive to court because he refused to come from Canada to the United States, so all it had was a video recording of his testimony. Mr. Cuban denied having any agreement not to trade, so proving a violation in a case involving a “he said, he said” situation required more than just recorded testimony of a key witness whom the jury never had a chance to observe in person.
The agency has also had its share of difficulties in the courtroom involving accounting fraud cases as well. In December, two other accounting cases went against the S.E.C. A jury in Kansas rejected charges against a company’s chief financial officer, who was accused of failing to properly disclose $1.18 million in perks to the company’s chief executive. And a federal judge in Los Angeles rejected all charges against two former executives of a water treatment company accused of inflating its revenue and misleading the outside auditor.
Proving fraud is always difficult. And thanks to the oft-mentioned revolving door between the S.E.C. and private law firms, defense lawyers know almost all the tricks for fighting the agency.
The recent spate of defeats involves cases that were filed years before Mary Jo White became chairwoman of the S.E.C. Now that she has vowed to push a tougher stance in enforcement actions that calls for defendants to admit violations, the agency is going to have ratchet up the pressure on defendants. Companies are likely to balk at that standard because admitting wrongdoing could expose them in other litigation.
So the agency is likely to go to trial more often, which increases the risk of losing. Defense lawyers may invoke the recent losing streak to push the agency into dropping cases out of fear of unfavorable verdicts.
The interesting question is whether these decisions will make the agency more skittish in bringing defendants to court. The agency was criticized for not doing enough before the financial crisis to adequately police financial firms, epitomized by the long-running Ponzi scheme perpetrated by Bernard L. Madoff. Fair or not, the S.E.C. has a reputation for being afraid to push too hard.
However, if defense lawyers believe the S.E.C. will have trouble winning close cases, then they will be more willing to fight. And if an admission of liability is sought only when there is overwhelming evidence of a violation, then the new approach will be used only in a few cases.
The S.E.C. will have to strike the right balance in pursuing cases that are worth its effort. Finding that balance will be crucial to whether the S.E.C. is perceived as a fair regulator, or one that pushes too hard on losing causes.