What Makes a Securities Case ‘Go Criminal’?

A flagrant violation, compelling facts and a strong public message

You could be Stevie Cohen and get away with a huge fine or end up behind bars like Raj Rajaratnam.

Violate a federal securities law in the US and you will initially be facing the SEC.  Cross your fingers that your next series of meetings aren’t with the Department of Justice.

As the government agency responsible for administering the securities laws, the SEC has the power to penalize you financially and ban you from the securities industry, but it cannot bring criminal charges against you no matter how egregious your behavior.  What the SEC can do, however, is refer your case to the DoJ, which has the authority to indict you and put you in jail.

iStock_000016961490SmallSEC investigations don’t ‘go criminal’ unless the evidence shows that the offender acted with criminal intent.  That means that the perpetrator must have willfully violated the law, whether or not he knew the specifics of the offense.  The most compelling cases are those in which wrongdoers knew the law and ignored or defied it.  Raj Rajaratnam, who is now serving an 11-year sentence for insider trading, was repeatedly heard on tape during his trial boasting about his inside sources at the public companies in whose securities he illicitly trafficked.

If the offender intended to break the law, the SEC next considers the severity of the violation.  How flagrant was the offense?  How large were the stakes? How many people were victimized?  How long did the wrongdoing last?  How much of a risk did it present to the securities markets?  Did the offender cooperate during the investigation or try to obstruct it by making false statements or destroying documents?  Raj Rajaratnam ticked this box too by organizing a vast insider trading ring that netted his hedge fund (Galleon Group) over $60 million in ill-gotten gains and that has already resulted in dozens of felony convictions.

Burden of Proof

Once the DoJ steps in, it will determine whether the facts of the case support a criminal indictment.  Unlike an SEC civil proceeding where the government simply has to have the better of the case, the DoJ must prove its criminal charges beyond a reasonable doubt.

As a practical matter, the higher burden of proof means that the facts of the case have to be simple, straightforward and easily understood by a jury.  Cases involving complex securities (like collateralized debt obligations) or sophisticated trading strategies (like option spreads) will challenge this constraint.  To win a jury over, the incriminating evidence has to show clear illegality on the part of the defendant and there can be no legal ‘grey areas’ which defense counsel can use to create uncertainty around the charges.

One way for the DoJ to eliminate that uncertainty is by having credible, cooperating witnesses who were involved in the offense and have been ‘flipped’ or who have taped the defendant incriminating himself.  Stevie Cohen was never actually caught in a conversation in which insider information was passed to him, but the current criminal case against one of his underlings, Mathew Martoma, is based largely on the testimonies of two college professors who admitted providing him with material, non-public information (even though both received immunity in exchange for their testimonies).  Another way for the government to bolster its case is to impugn the credibility of defense witnesses by ascribing their testimonies to previous financial or other benefits they received from the defendant.

Prosecutorial Discretion

Because of its limited prosecutorial resources, the DoJ is naturally inclined to pursue cases against highly-placed professionals, public company executives and investment fiduciaries whose convictions would send a clear message to the markets that securities violations will not be tolerated.

Because of its limited prosecutorial resources, the DoJ is naturally inclined to pursue cases against highly-placed professionals, public company executives and investment fiduciaries whose convictions would send a clear message to the markets that securities violations will not be tolerated.  Rajat Gupta is a case in point.  The former chairman of McKinsey and director of Goldman Sachs betrayed the latter by divulging its corporate secrets to Raj Rajaratnam who profited greatly from the illegal tips.  Gupta was tried and sentenced to two years in prison (now on appeal), but the evidence against him was entirely circumstantial, so it must have been his prominent professional standing that impelled the DoJ to bring the case against him despite its evidentiary weaknesses.

While the DoJ has thusfar elected not to prosecute Stevie Cohen personally for lack of convincing evidence, it did file a criminal complaint against his hedge fund, SAC Capital, which pled guilty and settled for $1.8 billion.  The probative difference between the Cohen and SAC cases points up the problem the DoJ has prosecuting individual executives in organizations where responsibility is diffuse.  The charge in the SAC case was that the hedge fund as a whole was a “magnet for cheaters” which was based upon the several convictions and pleas the DoJ had already secured from SAC staffers.  Even with all those lower-level convictions, however, the DoJ has still not been able to prove that the hedge fund kingpin himself actually violated the law.

Under US law, prosecutors have discretion over whether to bring charges against an individual or company, and their decisions not to bring such charges are neither reported nor reviewable by the courts.  Though some might say that government transparency in such situations would be informative to the public, how could the subject of any such reported decision clear his good name?