Unless you've been under a rock, you've heard the government's recent "wake-up call" to the financial markets.

The announcement of insider trading charges against the operators of the Galleon and New Castle hedge funds in New York, several Silicon Valley executives, and additional Wall Street professionals and attorneys have sent alarm bells ringing throughout corporate America.  Thousands of news articles, dozens of law firm alerts, and a multitude of bloggers have dissected the case, the tapes, the tippers, and the tippees, and debated-to quote the former Director of Enforcement at the Securities and Exchange Commission-the "comparatively thin line that separates initiative and impropriety, moxie and malfeasance."

Market Intelligence Or Inside Information-Rumors From The Warehouse
You probably did not hear, however, about another recent insider trading case -SEC vs. Robert Tedder, et al., 3:08-CV-1013 (N.D. Tex.)-recently heard by a jury.  That matter concerned alleged unlawful trading in the securities of Aviall Inc. before a merger announcement with The Boeing Company. Tedder is not as sexy as the Galleon probe, but its lessons are just as important to anyone that seeks to piece together information to inform trading activity.

According to the SEC's complaint, during the  weeks before the public announcement of the acquisition, a number of internal events occurred that raised hopes among Aviall employees-including the two insider defendants, Robert Tedder and Brian Carr-that a significant event involving the company would occur in the near future. The SEC did not allege that Tedder and Carr were high-ranking Aviall insiders that were privy to up-to-the-minute information regarding the proposed acquisition. In fact, Tedder and Carr worked in a warehouse of a subsidiary of Aviall.

The inside information that the SEC claimed these defendants acted upon was as follows: (1) a trading blackout for Aviall's upper management-which did not include Tedder or Carr (remember, they worked in a warehouse); (2) a tour by Boeing executives of Aviall's headquarters; (3) closed-door meetings involving Aviall's in-house counsel and several management employees; (4) "unusual" requests by upper management for information; (5) an inadvertently sent e-mail concerning a conference call to discuss the status of the due diligence process, with the purchaser referred to only by the code name "Andre"; and (6) internal "rumors" that Boeing would acquire Aviall.

These allegations regarding the information gathered by warehouse employees, and their subsequent trades based on that information, raise a number of seemingly legitimate questions about the gray area that separates market intelligence from insider trading. For instance, were the insider defendants-who were not in upper management-in breach of a fiduciary duty to Aviall by trading on the information they pieced together from bits of information?  Were these warehouse employees entrusted with confidential information?

And how about the three trader tippees who were sued by the SEC-did they know or should they have known that the insiders had violated a relationship of trust by providing the nonpublic material information to them?  Defendant Gregory Gunn, for instance, made a financial bet on the basis of information he learned from his brother.  His brother told Gunn that his friend-"Bob"-who worked in a warehouse at Aviall's subsidiary-speculated that Aviall was in discussions with another company, perhaps Boeing, about a possible merger or acquisition.  

So Gunn traded and, because "Bob" the warehouse guy correctly guessed that Boeing would acquire Aviall, he was sued by the SEC for insider trading.

Much of the SEC's allegations were based on circumstantial evidence which would require a jury to draw inferences.  Indeed, in pre-trial submissions, the SEC stated that the factual record was not in dispute and the primary issue would be how to characterize the significance of these facts. On Friday, November 6, 2009, following a three-day trial, a jury deliberated less than one hour before returning a verdict based on those facts in favor of the SEC and against  Gunn.  See SEC Litigation Release 21286 (Nov. 6, 2009).

The Mere Association With Wrong-Doing And Its Dramatic Consequences
So while the Galleon probe might seem fantastically remote-with its wiretaps, disposable cell phones, and code name "Octopussy"-the Tedder case sends a very sobering message to those who routinely seek out market information to gain an extra edge.  Indeed, two truths are evident to all interested parties.

First, at the expenditure of tremendous effort and expense, and even where the link to inside information is remote, regulators will police our markets, protect investors, and bring the full force of the law against anyone who they believe has broken the law.  So while it simply will not be the case that there will be a wiretap on every phone in a hedge fund's office, it is plain that the Commission and other regulators will not be deterred even though insider trading cases will be largely based on circumstances and limited proof.

Second, those embroiled in insider trading investigations risk having their careers ruined and lives devastated by the mere association with wrongdoing.  As we are reminded so often in these cases, the defining moment is the filing of an enforcement action or an indictment.  Even if one has the fortitude to weather the press and public notoriety associated with the filing of an action, juries do not associate with sophisticated traders who seem to have gained an unfair edge, even when those traders are convinced that they did nothing wrong.  (Case in point, Mr. Gunn).

Helping The Truth Seeking Process
These truths mean that how one responds to inquiries from regulators investigating trading activities can be the difference between no enforcement action and the long, hard slog of defending your good name in courts of law and public perception.

Left to their own devices, investigators early on will attempt to develop a case that the trader acted in a manner which demonstrated scienter-a consciousness of guilt.  Negative inferences will be drawn, especially where a trader has directed trading in the accounts of a third-party or traded in a manner that diverged from past trading practices.  Likewise, enforcement authorities will work to develop evidence to establish that the individual knowingly possessed or misappropriated material non-public information in breach of a duty.  Facebook friends, Linked-In connections, school affiliations, and club memberships will be scoured to tie the trading activity to sources of material nonpublic information.  One regulator last year described a key piece of evidence in an investigation: a wedding web page which included a picture of the trading broker hugging the insider investment banker at the wedding party.

In contrast, those who proactively engage enforcement authorities at the earliest suggestion that an investigation might materialize have avoided enforcement proceedings, notwithstanding the aggressive enforcement climate and institutional pressures on regulators to crack down on insider trading.  There are several reasons.

First, by affirmatively engaging authorities and placing the cards on the table face-up, the dynamic between the investigator and the investigated changes.  Rather than being defensive, private counsel can engage enforcement staff in a dialogue about the materiality of the information that served as a basis for the trade, or the lack of an intent to manipulate, deceive, or defraud.  Through this dialogue, inappropriate and unfavorable inferences may be avoided and the good faith of those being investigated is reinforced.  And even where enforcement action cannot be avoided, this proactive action can be the difference between a civil and criminal resolution.

Second, seizing the opportunity to provide enforcement staff with all relevant, material information about trading conduct may substantially shorten an investigation by saving time for the government to assemble the information it needs to close an investigation. This benefits everyone.  Enforcement staff does not consume government resources, and those subject to investigation do not live with uncertainty as the investigation drags on.

Finally, the SEC's Enforcement Manual allows enforcement staff, with commission approval, to reward those cooperating with an investigation. The Director of Enforcement recently has stated that it is "critical" to incentivize cooperation by individuals. The Commission previously issued guidance on cooperation to organizations, as referenced in the "Seaboard" Order.  The Enforcement Division now, however, is seeking to create a "Seaboard" for individuals, a public policy statement that will set forth standards to evaluate cooperation by individuals in enforcement actions.  The point of this policy will be to reward "extraordinary cooperation," and will not reward persons for simply complying with routine or expected requests for information.  Hence the further benefit of transparency with enforcement staff early in an investigation before the subpoenas are issued.

So as investment advisors and corporate executives try to make sense of these recent events, in addition to the increasing focus and scrutiny on hedge fund trading activity, consider that the truth-seeking process is a complicated one, and the best approach might be to actively engage the regulators before they dial up their next wake-up call.

Stephen Sutro, a partner with Duane Morris in San Francisco, practices in the areas of complex litigation, internal corporate investigations and compliance and corporate matters.