SEC Continues Use of Data Analytics to Aid Enforcement Investigations
The U.S. Securities and Exchange Commission (SEC) charged nine individuals with insider trading in three separate actions on July 25, 2022, alleging the misconduct resulted in ill-gotten gains totaling more than $6.8 million. Although the facts associated with each alleged violation are interesting in and of themselves, it is the common thread between the three that really stands out: the SEC's use of data analytics to detect suspicious trading patterns. In this post, we will provide a brief overview of the actions and some takeaways about the Division of Enforcement's use of data analytics in insider trading investigations.
Overview of Insider Trading Actions
The first complaint involves 1) purported insider trading by the chief information security officer (CISO) of a public company prior to two major acquisitions by his employer during 2021; and 2) the CISO's alleged tips to four of his friends who also traded on the same material, non-public information (MNPI) (the CISO Complaint). The SEC also charged several relief defendants with receiving a portion of the alleged $5.2 million in ill-gotten gains. Among the notable aspects of this complaint, the SEC alleges that the CISO engaged in specific quid pro quo arrangements with certain tippees whereby they either agreed to split trading proceeds with the CISO or where the CISO provided cash for the trading. As has become typical in SEC complaints containing tipping allegations, the CISO Complaint includes allegations of the personal friendships between the CISO and the tippees and the frequency of their communications to support the necessary "personal benefit" element for tipping charges.
In a second complaint, the SEC alleges that an investment banker misappropriated confidential information from his employer to tip his close friend and former graduate school classmate about four impending acquisitions between 2017-2018 (hereinafter Banker Complaint). The SEC specifically includes allegations about the investment bank's warnings about certain information constituting MNPI and the investment banker allegedly bypassing those warnings to tip his friend. According to the SEC, the banker's friend used his brother's brokerage account to purchase call options before each of the four acquisitions. The tippee purportedly made $275,000 from the trades. As part of the agency's allegations that the investment banker obtained a benefit from the tips, the agency alleged that the friend provided the banker with $85,000 – under the guise of a purported loan – three years after the final tip.
The third complaint involves allegations that a former Federal Bureau of Investigation (FBI) trainee and his friend made $82,000 and $1.3 million, respectively, from trades on the basis of MNPI (hereinafter the FBI Trainee Complaint). The SEC alleges that the former FBI trainee secretly learned information from his then-romantic partner – an associate attorney at a law firm – about the planned tender offer of one company to acquire another. The FBI trainee purportedly worked in the same apartment as his partner during the pandemic and thus learned about the potential transaction. According to the SEC's complaint, the FBI trainee "agreed, expressly or by implication" to keep information about his partner's work as confidential. After using the purported MNPI to trade on his own, the former FBI trainee allegedly tipped his close friend, who purchased 35,382 shares of stock in one of the companies two weeks before the transaction. The SEC alleged that the friend purchased a Rolex watch and covered vacation expenses in exchange for the tip.
The U.S. Department of Justice (DOJ) leveled parallel criminal charges for the conduct detailed above.
Analytics Usage Continues
In a previous SECond Opinions blog post, we analyzed the SEC's EPS Initiative, whereby the SEC's Division of Enforcement used data analytics to uncover potential accounting mismanagement. Although in a different space, the three insider trading cases this week are another signal of the SEC's ongoing usage of data analytics to further its enforcement program. Indeed, Director of the SEC's Enforcement Division Gurbir S. Grewal warned, "[The SEC stands] ready to leverage all of our expertise and tools to root out misconduct and to hold bad actors accountable no matter the industry or profession."
Of course, the SEC's use of data analytics is not new in the insider trading space. The Division of Enforcement has long leveraged trading data obtained from various broker dealers and other market makers (called blue sheets) to uncover anomalous and suspicious trading patterns.1 Attorneys and other specialists within the Division of Enforcement can use data as a springboard for utilizing more traditional enforcement tools such as subpoenas and testimony.
In looking at the alleged trades from the three complaints, it is not a stretch to infer that some of these trades would raise obvious flags for the agency in any blue sheet analysis. For example, as alleged in the CISO Complaint, one of the tippees 1) acquired 82,000 shares of company stock and 3,014 call options days before one announcement and then 2) liquidated the position four days after the announcement, generating more than $1 million in alleged ill-gotten gains. Similarly, in the FBI Trainee Complaint, the SEC alleges that the tippee purchased 35,382 shares in the two weeks prior to the merger, generating approximately $1.3 million in alleged ill-gotten gains. Close-in-time purchases prior to a favorable announcement plus sizeable profits are low-hanging fruit for the Division of Enforcement to start an inquiry.
Additionally, other data from the complaints highlights other data tools as the SEC's disposal. For example, in the Banker Complaint, the SEC is only now filing charges for tips and trades that occurred in 2017-2018. Although it's possible that the staff opened an inquiry utilizing trade data or other means, it's also the staff initiated an inquiry based on the $85,000 wire transfer sent by the friend to the investment banker in 2021. Although it's only speculation, it's possible that the wire transfer triggered a Suspicious Activity Report (SAR), a document financial institutions file with the Financial Crimes Enforcement Network (FinCEN). Under the Bank Secrecy Act (BSA), financial institutions are required to assist U.S. government agencies such as the SEC in combating financial fraud, which includes keeping records of certain cash purchases, filing reports of cash transactions exceeding $10,000 and reporting suspicious transactions that might signal criminal activity. The SEC's Division of Enforcement often utilizes SAR information as another data point to not only mine leads for investigations but also to supplement its investigative activity.
Furthermore, although not mentioned in the SEC's complaint, the DOJ's press release concerning the FBI trainee notes that his name had come up in an inquiry by the Financial Industry Regulatory Authority (FINRA) into trading in the target company's stock. FINRA surveils both the equities and options markets for suspicious activity. Because FINRA cannot prosecute insider trading, however, it refers suspicious trading to the SEC. Put another way, the SEC not only has its own analysts scouring the markets for suspicious activity, but also leverages FINRA's surveillance tools as well.
The SECond Opinions Blog will continue to monitor the agency's activity in this space and provide further updates. If you need any additional information on this topic – or anything related to SEC enforcement – please contact the authors or another member of Holland & Knight's Securities Enforcement Defense Team.
1 One can infer how critical the SEC views this data to its overall enforcement program, as the agency has filed numerous enforcement actions over the years that have penalized broker-dealers millions of dollars for making deficient blue sheet submissions.