Although insider traders often work for business entities, their employers are rarely held criminally liable for their acts. Two recent cases of indictments of businesses, not just their employees, for insider trading raise the question of when the Department of Justice (DOJ) will criminally pursue corporations for insider trading. This article examines the DOJ's policies and practices in this respect.
When will the Department of Justice indict a company on the basis of criminal acts of its employees? This question raises an age-old debate concerning whether a company itself should ever be indicted. As history demonstrates, the collateral consequences of such an indictment can be catastrophic for businesses in the financial services industry. Two notable examples were Drexel Burnham and Arthur Andersen, two major financial services firms that did not survive criminal convictions.
The government’s crackdown on insider trading has generally not targeted business entities. Two recent exceptions are the indictment and guilty plea of SAC Capital Advisors L.P. (SAC) and the plea agreement with Tiger Asia Management LLC. The SAC matter in particular has caused substantial debate because the firm was indicted despite the fact that the government apparently lacked sufficient evidence to indict the firm’s founder and owner, Steven A. Cohen.
This article provides an overview of the guidelines for holding a company criminally responsible for the misconduct of its employees and how such guidelines appear to have been applied in cases of insider trading.
Criminal Liability of Business Entities
According to Blackstone, “[a] corporation cannot commit treason, or felony, or other crime, in its corporate capacity though its members may, in their distinct individual capacities.” This was the early consensus view—that a corporation could not be held criminally liable for the acts of its agents. This view was based on the notion that corporations do not commit crimes, people commit crimes. Blackstone’s view, however, was rejected by the United States Supreme Court in New York Central & H.R.R. Co. v. United States. A railroad company was convicted because two of its managers illegally gave rebates to various sugar companies for shipping on their line. The Supreme Court affirmed the conviction, saying that “there are some crimes which, in their nature, cannot be committed by corporations. But there is a large class of offenses … wherein the crime consists in purposely doing the things prohibited by statute. In that class of crimes we see no good reason why corporations may not be held responsible for and charged with the knowledge and purposes of their agents, acting within the authority conferred upon them.”
Since New York Central, federal courts have generally adopted a broad, respondeat superior approach to business entity criminal liability. “[T]he corporation may be criminally bound by the acts of subordinate, even menial, employees.” See, e.g., United States v. Basic Construction Co. (affirming conviction for bid-rigging, rejecting the corporation’s argument that the offense was carried out by “minor officials” without the knowledge of management and against established company policy); United States v. Harry L. Young & Sons, Inc. (company was held criminally liable when two drivers left a truck full of explosives unattended, in violation of company policy and dispatcher instructions). “[T]he only thing that keeps deceived corporations from being indicted for the acts of their employee-deceivers is not some fixed rule of law or logic but simply the sound exercise of prosecutorial discretion.”
In 1991, Congress provided guidance in the area of corporate criminal liability with the adoption of the Organizational Sentencing Guidelines of the United States. The Sentencing Guidelines rest on two principles: The business entity should “remedy any harm caused by the offense,” and its punishment “should be based on the seriousness of the offense and the culpability of the organization.” Culpability, in turn, was determined by six factors: (1) the business entity’s “involvement in or tolerance of criminal activity”; (2) its “prior history”; (3) any “violation of an order”; (4) “obstruction of justice”; (5) “the existence of an effective compliance and ethics program”; and (6) “self-reporting, cooperation, or acceptance of responsibility.” The Sentencing Guidelines concern post-conviction sentencing, but the standards set forth therein are obviously relevant to charging decisions and the exercise of prosecutorial discretion.
The Department of Justice issued its first formal statement of principles in charging business entities in June 1999. Known as the Holder Memorandum after its drafter, then Deputy Attorney General Eric H. Holder, Jr., it adopted the basic rules of respondeat superior as governing criminal prosecutions: “Under the doctrine of respondeat superior, a corporation may be held criminally liable for the illegal acts of its directors, officers, employees, and agents. To be held liable for these actions, the government must establish that the corporate agent's actions (i) were within the scope of his duties and (ii) were intended, at least in part, to benefit the corporation. In all cases involving wrongdoing by corporate agents, prosecutors should consider the corporation, as well as the responsible individuals, as potential criminal targets.”
The Holder Memorandum went on to set forth a set of guidelines to be followed by the Department of Justice in deciding whether it would exercise its discretion to indict (or refrain from indicting) a business entity. The Holder Memorandum identified eight factors that prosecutors should consider in determining whether to charge a business entity: “the nature and seriousness of the offense,” “the pervasiveness of wrongdoing within the corporation,” “the corporation's history of similar conduct,” “timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation of its agents, including, if necessary, the waiver of the corporate attorney-client and work product privileges,” “the corporation's compliance program,” “remedial actions,” “collateral consequences,” and “the adequacy of non-criminal remedies.” The Holder Memorandum was revised several times, but all revisions retained the basic respondeat superior premise for corporate prosecutions.
In 2003 the new Deputy Attorney General issued the Thompson Memorandum, which added another factor to be considered in determining whether it seeks an indictment against a business entity—“adequacy of prosecution of individuals.” The Thompson Memorandum also elaborated on the effect of a failure to cooperate with the government. This latter factor, especially insofar as it encouraged business entities to waive privileges or to refuse to pay for the criminal defense of its employees, caused much controversy. The DOJ also began to resort more frequently to deferred prosecution agreements, a less harsh form of criminal sanction than a guilty plea.
The business entity guidelines were revised again in 2008 in the Filip Memorandum, and today are reflected into the U.S. Attorneys’ Manual §§ 9-28.000-28.1300. The Manual incorporates the factors set out in the Holder and Thompson Memoranda:
The nature and seriousness of the offense (see USAM 9-28.400)
The pervasiveness of wrongdoing within the corporation (see USAM 9-28.500)
The corporation's history of similar misconduct (see USAM 9-28.600)
The corporation's timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation of its agents (see USAM 9-28.700)
The existence and effectiveness of the corporation's pre-existing compliance program (see USAM 9-28.800)
The corporation's remedial actions (see USAM 9-28.900)
Collateral consequences (see USAM 9-28.1000)
The adequacy of the prosecution
The adequacy of remedies such as civil or regulatory enforcement actions (see USAM 9-28.1100)
In the current U.S. Attorneys’ Manual, deferred prosecution agreements (filed with the court) and non-prosecution agreements (between the DOJ and the target) are discussed in the section on “Collateral Consequences.” Recognizing that the prosecution of business entities may affect other employees, investors, and customers who had no knowledge of the offense and would have been unable to prevent it, the DOJ will, under what it considers to be appropriate circumstances, enter into deferred prosecution agreements or non-prosecution agreements with business entities. Between 2004 and 2009, the Justice Department’s Criminal Division entered into more such agreements than it brought cases. David M. Uhlmann, Deferred Prosecution and Non-Prosecution Agreements and the Erosion of Corporate Criminal Liability, 72 Md. L. Rev. 1295, 1317 (2013).
Prosecution of Business Entities for Insider Trading
In contrast to the numerous individuals indicted in recent years for insider trading, only a handful of business entities have been charged for the insider trading of their employees. It appears that the government is more likely to be satisfied with a business entity’s disgorgement of improper profits and may even treat the entity as a victim, particularly where the entity has strong controls and cooperates with the government’s investigation.
For example, in United States v. Gupta, Rajat K. Gupta, a former director of Goldman Sachs, was convicted of insider trading and received a criminal penalty that included a requirement that he reimburse Goldman Sachs for its fees and costs incurred in connection with the investigation under the Mandatory Victims Restitution Act. Goldman Sachs was not sued by either the DOJ or the SEC. To be sure, it is doubtful that Goldman Sachs would have been liable even on a respondeat superior theory. However, it is noteworthy that Goldman Sachs was considered a victim of the crime.
In United States v. Skowron, a managing director at Morgan Stanley engaged in insider trading, and pled guilty to conspiracy to commit securities fraud. Morgan Stanley was not criminally prosecuted, although the SEC sued the hedge funds that Skowron managed as “relief defendants” and received a $33 million disgorgement payment. In connection with Skowron’s criminal case, the court held that Morgan Stanley was entitled to compensation from Skowron under the Mandatory Victims Restitution Act for its fees and expenses in connection with the government investigation, and for a portion of the employee’s compensation. Then, in a follow-up civil action, Morgan Stanley was awarded the entirety of Skowron’s compensation for his period of insider trading under a “faithless servant” theory. Neither the criminal nor civil courts were willing to award Morgan Stanley restitution of its payment to the SEC, on the grounds that the money was the fruit of illegal conduct and Morgan Stanley had not been entitled to it in the first place. Morgan Stanley’s claim for fraud against Skowron, though, was allowed to stand, although Morgan Stanley ultimately dismissed its remaining causes of action.
Similarly, in the case of United States v. Newman,No. 12-cr-00121, docket # 242, Government’s Sentencing Memorandum (S.D.N.Y. April 26, 2013), the government sought to have the court reimburse Newman’s employer, Diamondback Capital Management, for its legal fees and expenses and a portion of Newman’s compensation. The government asked the court to follow the model of the Skowron case. The government had previously entered into a non-prosecution agreement with Diamond Capital, which also paid $9 million in disgorgement and penalties to the SEC.
The prosecution of SAC stands in contrast to the treatment of Morgan Stanley and Diamond Capital. According to the indictment, SAC hired portfolio managers and research analysts with inside contacts, and then pressed them to develop trading ideas for which they had a “high conviction” of profit. Many of these “high conviction” proposals were allegedly based on inside information. Eight SAC employees were convicted of insider trading.
Before the indictment, SAC had settled with the SEC and had agreed to pay an astounding $616 million in disgorgement and penalties. Nonetheless, the company was indicted on five counts of wire and securities fraud. In addition, the government also brought a civil forfeiture action for the proceeds of the insider trades based on a money-laundering theory. SAC pled guilty to the criminal counts and agreed to pay an additional $284 million in forfeiture. SAC’s plea bargain itself departed from the usual, in that it was reached under Fed. R. Crim. Proc. 11(c)(1)(C), which obliged the district court to either reject the plea agreement or accept it in toto, which it did.
In the Tiger Asia case, Tiger Asia was charged with short-selling on the basis of confidential information it had obtained on a promise of non-trading. The SEC further charged it with attempting to manipulate the Hong Kong Stock Exchange. The SEC sued and settled with both the company and two of its officials, including its founder and principal Sung Kook "Bill" Hwang. Only the company was criminally prosecuted. It pled guilty to one count of wire fraud, agreed to a $16 million forfeiture, and paid an additional $28 million to the SEC.
Despite criticisms of the SAC indictment, it appears from the publicly available record that the government’s decision to prosecute SAC was well within its own guidelines. For example, with respect to the “nature and seriousness of the offense” and the “pervasiveness of wrongdoing,” the government charged and convicted eight employees, and another two settled with the SEC. Moreover, this insider trading scheme made SAC hundreds of millions of dollars in illicit profits. Similarly, with respect to SAC’s compliance program, according to the indictment the program had identified only one example of suspected insider trading in its history. Additionally, it appears that SAC may have decided not to cooperate during the investigation. SAC sent a memorandum to its clients reporting that, “[w]hile we have in the past told you of our cooperation with the government's investigation, our cooperation is no longer unconditional, and we do not intend to give updates in this area going forward.”
Similarly, in the Tiger Asia matter, it appears that the firm was engaged in a scheme to manipulate the Hong Kong stock market and that the firm blatantly violated numerous agreements by using confidential information it had received pursuant to a “no trade” restriction to make trading decisions. The company thus blatantly violated a contractual obligation, and the head of the company consented to an SEC judgment. While there is not much publicly available information regarding this matter, it appears that the violations were serious and pervasive.
The fact that the principals of SAC and Tiger Asia were not indicted does not necessarily raise a question about the government’s indictment of their respective companies. As stated by the then-head of the DOJ Criminal Division, Lanny A. Breuer: “There are of course times when, despite a company’s admission of significant misconduct, we lack the evidence to prove that any particular individual committed a crime.” In both of these cases, one factor may have very well been lack of sufficient evidence to indict the principals where there was overwhelming evidence of misconduct by the firm and other employees.
Beginning with the investigation of Raj Rajaratnam and the Galleon group, the government, and particularly the United States Attorney for the Southern District of New York, have embarked on a broad effort to eradicate insider trading. In practice, the government has demonstrated restraint in targeting companies whose employees engaged in insider trading. However, as the government made clear in the SAC and Tiger Asia indictments, it will pursue a company when the facts warrant it.
Not everyone agrees that the Drexel Burnham and Arthur Andersen experiences prove that criminal prosecution is necessarily fatal. According to one study, “[n]o public company convicted in the years 2001–2010 went out of business because of a federal criminal conviction.” Gabriel Markoff, Arthur Andersen and the Myth of the Corporate Death Penalty: Corporate Criminal Convictions in the Twenty-First Century, 15 U. Pa. J. Bus. L. 797, 827 (2013). The government is, however, sensitive to the collateral consequences of an indictment. For example, in its non-prosecution agreement with Diamondback Capital Management, it explained that one of the reasons it entered into the agreement was because of “the negative effect that the continuing uncertainty regarding the Government’s investigation would have on Diamondback’s financial condition and its remaining employees and investors.”
Given the potentially dire consequences of an indictment on financial services firms, and particularly hedge funds, it is critical that firms exercise diligence in policing its traders, and maintain robust compliance programs. Firms should be able to prove to a prosecutor that it is truly the victim of a rogue employee’s insider trading.