Financial Regulatory Forum

Gupta insider case puts focus on monitoring board members, financial-crisis challenges

By Guest Contributor
June 18, 2012

Rajat GuptaBy Julie DiMauro and Stuart Gittleman

NEW YORK, June 18 (Thomson Reuters Accelus) - The insider-trading conviction of Rajat Gupta, a former McKinsey group chairman and a-list board member, had federal prosecutors and securities regulators glowing. But companies face stiff challenges protecting their boards from breaches confidentiality by directors and the reputational and other damages that ensue, consultants and lawyers said.

The conviction also draws a contrast with the relative lack of high-level prosecutions stemming from the 2008 financial crisis, which analysts said was rooted in practices harder to establish a case on. A Manhattan federal court jury on Friday found Gupta, a former director of Goldman Sachs and Procter & Gamble, guilty of leaking material nonpublic information on Goldman to Raj Rajaratnam, head of the Galleon hedge fund group. Gupta was convicted of conspiracy to commit securities fraud and three counts of tipping Rajaratnam about Goldman, but was acquitted of leaking information on P&G, and of one Goldman-related count.

Gupta faces up to five years in prison on the conspiracy charge and up to 20 years on each of the fraud charges when federal judge Jed Rakoff sentences him, which is scheduled for October 18.

Rajaratnam is serving an 11-year prison sentence.

“Almost two years ago, we said that insider trading is rampant, and today’s conviction puts that claim into stark relief,” said Manhattan U.S. Attorney Preet Bharara.

The evidence showed that Gupta called Rajaratnam within about 60 seconds of a Goldman board meeting approving a $5 billion investment by Berkshire Hathaway and within 23 seconds of learning that Goldman was facing its first quarterly loss as a public company, Bharara’s office said. The first call resulted in significant gains by Rajaratnam’s funds and the second call avoided millions of dollars in losses.

“Those who engage in insider trading, irrespective of their station in life, can expect to be prosecuted to the fullest extent of the law,” added Robert Khuzami, enforcement director of the Securities and Exchange Commission, which separately sued Rajaratnam, Gupta and others for violating the federal securities laws.

What – if anything – can boards do to protect themselves?

The verdict indeed warns corporate officers and directors to not commit securities fraud, but neither Bharara nor Khuzami addressed guidance to boards on how to protect themselves against insiders sharing boardroom or executive suite secrets. Companies have fewer tools than enforcement authorities.

“The insider trading-related violation that Mr. Gupta is alleged to have engaged in, tipping outsiders with information he gleaned in his role as director, is particularly difficult for an issuer to prevent,” Philip Thomas, director of Asian operations for CompliGlobe, a regulatory adviser, told Thomson Reuters Accelus. “The tools the government used in this instance – bugged conversations and informants – helped make the case against Mr. Gupta. These are not tools ordinarily at an issuer’s disposal,” he said.

If the insider does not personally trade on information, there may be little that boards can do to prevent a director from tipping off an associate.

“It is very difficult to monitor a director’s phone calls and communications. The directors are not usually employees, and if they decide they want to share inside information, there is little the company can do to stop them. Using insider information, however, is a different story. Companies should monitor trading by their directors and insiders and be on the lookout for any unusual trading in advance of any corporate announcements,” added a financial industry legal source who asked to not be identified because of professional ties to companies named in the charges against Gupta.

Thomas said companies need to review their policies in light of the Gupta case.

“Boards should redouble their efforts in the area of insider-sharing prevention and detection, and be held to account where red flags have been ignored. … Internal counsel should be, at this moment, preparing a briefing for their boards on the implications of the Gupta situation. And a review of the policies designed to prevent insider-trading abuses by directors should also be underway by the chief compliance officer, with lessons learned from recent cases baked in,” Thomas told Thomson Reuters Accelus.

One immediate impact of the verdict may be to focus on directors’ business and other relationships, which are often among the reasons they were nominated in the first place, said Francis H. Byrd, senior vice president and corporate governance risk practice leader at Laurel Hill Advisory Group, LLC in New York City.

“Boards will need to spend more time on determining potential conflicts and examining the potentially problematic relationship of their board members. But it should be noted strongly that no review system or conflict check will fully deter people motivated to commit disclosing material information. Independent directors should be asking their boards to review existing director and officers policies and understand that coverage in the event a director is found to have breached his or her fiduciary duties to the company,” said Francis H. Byrd, senior vice president and corporate governance risk practice leader at Laurel Hill Advisory Group, LLC in New York City.

Another immediate impact may be to sow distrust in the boardroom.

“Board members may never look at each other across the table the same way again after the Gupta verdict. At the present time, compliance procedures relating to board members on a personal level are not widely used; however, we believe this area may be further developed in the future as a result of the Gupta case,” added Judy Gross, a principal of JG Advisory Services LLC in New York City.

What about the financial crisis?

“Gupta was one of the most respectable people netted in the insider trading probes, but Rajaratnam dealt mostly with lower level people, who are generally the best source of inside information,” Wayne State University law professor Peter Henning told Accelus.

Critics have chided federal prosecutors and the SEC for focusing on insider trading at the expense of cases related to the financial crisis, but Henning, a former federal prosecutor and SEC enforcement lawyer, said the cases require different investigative resources.

Once an investigation yields enough evidence to obtain judicial approval for wiretaps or eavesdropping, the targets have been clearly identified. Investigators are reasonably assured that the resources are being put to good use, Henning said.

Investigating a potential accounting fraud “requires a different kind of knowledge and is much more time-consuming,” Henning added. Agents could review 20 million documents without knowing what they’re looking for or whether they found it. “It’s hard to identify the nugget of misinformation you can build a case on,” he said.

Moreover, much of the evidence against Rajaratnam involved continuing frauds, but accounting fraud investigations are “retrospective rather than in real time,” Henning said.

“Insider trading is the low-hanging fruit of securities fraud. Like meth dealers, tippers and traders know they are committing crimes, but accounting frauds often involve judgments where participants can find experts to say what they are doing is permissible,” Henning said.

Henning compared the current allegations over mortgage originations and securitizations with cases stemming from the savings-and-loan scandals, where the evidence showed that that top bankers knew appraisals had been inflated and assets had been double-counted.

For the most part, the more recent cast of top bankers seem to have had “layers of protection” between them and the brokers selling the loans so as to prevent a “clear pattern of fraud” from becoming evident beyond a reasonable doubt, Henning said.

Being able to rely on accountants and lawyers, as Lehman did in its “Repo 105 transactions,” can make the actions of top executives seem “not right but not clearly wrong,” Henning said.

Not all former prosecutors are as sanguine about the lack of crisis-related cases.

“Insider-trading prosecutions give the Department of Justice cheap headlines that are easy wins but are a distraction of resources and divert the attention of the populace,” Solomon Wisenberg, a partner at the law firm Barnes & Thornburg, told Accelus.

For the most part decisions to bring – or not bring – crisis-related cases are made at the Justice Department, Wisenberg noted, saying, “In fairness to Preet Bharara, [Manhattan] does not have a significant history of prosecuting institutional bank fraud.”

Wisenberg related anecdotal evidence of red flags not being pursued by the Justice Department, but acknowledged that there may be weaknesses that warrant dropping an investigation and that were not present in the savings-and-loan frauds he successfully prosecuted at the Justice Department.

However, insider trading cases may yet affect institutional banking conduct, Wisenberg said.

“There has been a culture of lawlessness on Wall Street in the last ten to 15 years. A good effect [of the Gupta verdict] may be to stop some of it, to show fraudsters we’re not going to let them do this with impunity. There was a real danger of reaching a tipping point,” said Wisenberg.

Whatever the challenges in prosecuting criminal activity in originating and securitizing risky mortgages and securities, the Justice Department should pursue them, Wisenberg said.

“The dereliction of duty was comparable to the S&L frauds. The conduct was absolutely appalling,” Wisenberg said.

 

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=”http://accelus.thomsonreuters.com/solut ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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