Corporate Governance

SEC Investigates Staff Members for Insider Trading

By Katharine Jensen

Two United States Securities and Exchange Commission ('SEC') employees are currently under investigation for suspected insider trading and other SEC regulatory violations. The investigation, which the SEC Office of the Inspector General ('SEC OIG') turned over to the United States Attorney's Office and the Federal Bureau of Investigation, focuses on two currently unnamed Enforcement Division attorneys.

The SEC opened its investigation after hearing of a 'standing Monday lunch' among three SEC employees. The three agency staffers would discuss stocks, acquisitions, and companies under SEC investigation. The trio met approximately 40 times a year. The SEC chose not to investigate the third employee because she held very little stock and admitted to violating various SEC regulations.

During its investigation, the SEC discovered that the two employees regularly emailed each other during work hours seeking stock advice. Moreover, the male employee admitted sending to his brother and sister-in-law emails containing nonpublic information and advice on which stocks to trade. These email exchanges violate the SEC's regulation concerning the proper use of government computers (SEC Regulation 24-4.3).

The report concludes that the female employee executed two stock trades that violated Rule 5 of the Commission's Conduct Regulation (17 C.F.R. 200.735-5). The rule prevents SEC employees from using non-public information gained in the course of employment for trading purposes and, with limited exceptions, requires employees to hold purchased securities for six months.

The first violation occurred when she sold her shares in a large health care company two months before it underwent SEC investigation. The second occurred when she bought shares of an oil company and then sold them three weeks later, two days before the company underwent SEC investigation. The report suggests that she had knowledge of both investigations.

In investigating these two employees, the inquiry revealed that the SEC lacks a compliance system that can monitor employees' stock portfolios and instead uses a system that relies almost entirely on the honor system. Additionally, the system appears to contradict the procedures contained in the previously mentioned Rule 5.

Currently, an employee who wants to buy or sell stock must apply to gain clearance to conduct the trade from the SEC's Conduct Regulation Securities Transaction System ('CRSTR'). If the CRSTR clears the trade, the employee must then file Form 681 within five business days with the SEC's Office of Administrative and Personnel Management. Rule 5, however, specifically states that Form 681 must be filed with the SEC's Office of Human Resources. Alternatively, if the employee is notified that the stock is restricted then he or she is instructed to contact the SEC's Ethics Office. That office may clear the trade, even though this loophole is not mentioned in the language of Rule 5. Certain higher-paid employees must also file Form 450 once a year, reporting all assets worth more than $1,000 or which have produced more than $200 in income. The two employees under investigation both fall into this category but failed to file these forms for all transactions.

Under this system, the female employee under investigation executed 247 trades between January 2006 and January 2008 and filed Form 681 for four CRSTR restricted transactions. Although she testified her portfolio was worth about $45,000 at the time of the investigation, her June 2008 brokerage account statement valued her portfolio at approximately $167,732. The male employee traded 14 times between January 2006 and January 2008 and holds a stock portfolio valued at more than $200,000.

Both employees testified they do not keep records of their transactions and recall information concerning their stock from memory. Surprisingly, neither employee agreed that their conduct could appear improper or that nonpublic information they acquire based on their position in the agency could influence their trading decisions.

The report notes that neither employee received appropriate training concerning Rule 5 or other SEC confidentiality regulations. When questioned, each employee had a different view on the exact conduct regulated by Rule 5. The only training SEC employees receive on the confidentiality of nonpublic information is in the New Hire Orientation Manual, which was not in existence when the two employees were hired.

The SEC OIG recommended in their investigation that there be an integrated, computerized system to track employee trading and other conduct regulated by Rule 5. Following this recommendation, Chairman Mary Schapiro announced that the SEC is contracting with an outside firm to develop a consolidated computer compliance system that will track, audit, and oversee employee securities transactions. The SEC also drafted a new set of internal rules governing employee transactions that will prohibit employees from trading in the securities of any company under SEC investigation, regardless of whether or not the employee has knowledge of the investigation. The new rules set forth additional limitations for employees engaging in personal trading, including requiring employees to provide the agency with duplicate trade confirmation statements and certifying that they do not possess non-public information about the company being traded. Chairman Schapiro also signed an order consolidating responsibility for overseeing employee transactions within the Ethics Office and is in the process of hiring a new chief compliance officer to help oversee the computer system.

Full post as published by The Race to the Bottom on July 18, 2009 (boomark / email).