Financial Regulatory Forum

U.S. insider cases reshape policy for U.S. companies, enforcers

May 9, 2011

David Sokol, Chairman, MidAmerican Energy Holdings, and Chairman, President, and CEO of NetJets, listens to a question during the Fortune Brainstorm Green conference in Dana Point, California in this April 13, 2010 file photograph. Former Berkshire Hathaway executive David Sokol has said he did nothing wrong in buying stock in a company that he then suggested Berkshire acquire.By Erik Krusch

NEW YORK  (Business Law Currents) Inside information seems to be making its way out of the office and boardroom and onto the Street where it is parlayed into lucrative stock trades. From former hedge fund mogul Raj Rajaratnam to erstwhile Berkshire Hathaway executive and reputed Warren Buffett successor David Sokol, individuals alleged to have traded on inside information are sweating in the proverbial hot seat.

Rajaratnam’s alleged violation of insider trading laws and Sokol’s alleged violation of Berkshire policy, and possibly state and federal law, are helping to shape current market norms and the future behavior of investors in U.S. capital markets. These corporate dramas are unfolding before our very eyes and today’s events offer a possible window into what post-Sokol and Rajaratnam corporate policy and insider trading enforcement may look like.

Insider trading policies and enforcement are evolving with changes in the capital markets. Hedge funds and financial M&A play a large role in today’s market, so it should come as no surprise that many of the Securities and Exchange Commission’s (SEC) more novel insider trading enforcement actions involve hedge funds and associated investment structures. Similarly, Sokol’s alleged missteps occurred within the context of a financial deal, as opposed to a strategic merger. Taken together, the Rajaratnam trial and the Sokol insider trading imbroglio have implications for corporate governance and control polices and insider trading enforcement.

As background, on March 30, 2011 David Sokol, former CEO of Berkshire subsidiaries NetJets and MidAmerican Energy, resigned suddenly with controversy swirling around some substantial trades made just ahead of Berkshire Hathaway’s $9 billion Lubrizol acquisition. Sokol pitched the Lubrizol deal to Buffett and purchased shares in the company after learning about the company from Citigroup bankers but before Buffett agreed to purchase the company. Buffett, in a letter-like press release, announced that Sokol had resigned and discussed the fact pattern of the Lubrizol trades, stated that he believed nothing illegal had occurred, and broadly praised the former executive.

Berkshire’s audit committee took a much harder line in its review of Sokol’s Lubrizol trades. With scandal enmeshing former executive David Sokol and threatening to envelop CEO Warren Buffett, the audit committee released a scathing report detailing Sokol’s alleged misdeeds. The report claims that Sokol’s purchase of Lubrizol shares violated Berkshire’s Code of Business Conduct and Ethics and its Insider Trading Policies and Procedures and that he made incomplete disclosure to senior management concerning the purchases, which violated the duty of candor he owed Berkshire.

As far as the legal versus company policy implications of Sokol’s trades, the audit committee’s report succinctly sums up the issue with:

We appreciate that at the time Mr. Sokol traded, he did not know whether Mr. Buffett would support, or reject, the idea of an acquisition of Lubrizol. We also recognize that Mr. Sokol did not know how Lubrizol would respond to an acquisition proposal if Berkshire Hathaway were to make one. We recognize the view that those uncertainties might have kept Mr. Sokol’s information below the level of probability required to support a finding of materiality for purposes of finding a violation of federal insider trading law. But the Trading Policy requires a higher standard of conduct than what is required to avoid being charged with a federal securities violation.

Berkshire’s Code of Business Conduct and Ethics contains further prohibitions on the personal use of confidential information and stipulations on opportunities discovered through the use of corporate property, information or position by covered parties. The report also found Sokol’s disclosure to Warren Buffett and other managers about when, and under what circumstances, he had acquired his stake in Lubrizol possibly violated the duty of loyalty, which includes a candor that representatives owe their company under law of Delaware. Sokol, according to the audit committee, was clearly playing a little too close to the line when it came to company policy and possibly, but not necessarily, even the law.

The insider trading trial of Galleon Management founder Raj Rajaratnam has at least one link that is similar to the Sokol scandal. According to an SEC order, Rajat Gupta, a former director at both P&G and Goldman, allegedly passed on material, non-public information to the hedge fund manager. Goldman Sachs’ CEO Lloyd Blankfein testified at Rajaratnam’s trial that Gupta violated the bank’s Code of Business Conduct and Ethics when he discussed details of confidential board meetings with Rajaratnam. Gupta voluntarily decided to not stand for reelection to Goldman’s board and he has not been criminally charged by the SEC. He has, however, sought declaratory and injunctive relief in an urgent bid to stave off an innovative civil cease-and-desist proceeding brought retroactively by the SEC under the aegis of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The Galleon insider trading scandal seems to be a test case for some of the SEC and the Department of Justice’s (DOJ) more innovative theories on insider trading. In addition to the retroactive application of Dodd-Frank to Gupta’s alleged misdeeds, the criminal prosecution of Rajaratnam is largely based on evidence obtained through wiretaps. The wiretaps have already withstood motions to suppress and the jury began its deliberations on April 25, 2011. With each passing day, however, the DOJ and SEC’s use of wiretap evidence, which was assumed to be a “slam dunk,” seems to be more of what it actually is — an innovation of unknown value in insider trading prosecutions.

Will corporate governance, insider trading and code of conduct policies become even stricter in the wake of the Sokol and Gupta scandals? Berkshire’s board of directors authorized Warren Buffett to release the report because “these events should serve as an opportunity to reinforce to all officers, directors and employees of Berkshire Hathaway and its subsidiaries the importance of adhering to those policies and avoiding conduct that comes close to, or strays over, the line of propriety.” Berkshire is even weighing legal action against Sokol.

Rajaratnam and Gupta’s court proceedings will both have, or will establish, new precedents in insider trading enforcement. Taken together, these trials and scandals are pieces helping to fashion the new mosaic that is tomorrow’s insider trading policy and enforcement practice.

(This article was produced by the Business Law Currents service of Thomson Reuters Accelus (http://accelus.thomsonreuters.com/solutions/business-law/business-law-currents). Business Law Currents delivers lawyer-authored content and Business Law Research source documents together with Reuters news to keep you informed of the latest developments in your areas of interest.)

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