Last week, the Wall Street Journal reported that federal investigators have shifted the focus of an ongoing insider trading case from whether Congressional staffers tipped off a research firm about a pending healthcare policy change to what various hedge funds knew about this change prior to trading on the note the research firm provided them.
Background of the Case
On April 1, 2013 at 3:42 p.m., Height Securities, a Washington DC-based research firm, sent an e-mail alert to more than 150 buy-side clients predicting that the Centers for Medicare and Medicaid Services (CMS) would reverse a previous decision reducing the reimbursement rate for private insurance plans. At 4:22 p.m. that day, after the U.S. stock market closed, CMS sent a news release announcing that it would restore the previously announced spending cuts.
According to e-mails and documents made public as part of the investigation, a CMS official with prior knowledge of this decision, spoke with Brian Sutter, a top congressional health-care aide, in the days before the CMS decision was announced.
Mr. Sutter, later spoke on the phone about the CMS decision with Mark Hayes, a lobbyist at Greenberg Traurig, who had previously worked for Height Securities. At 3:12 pm on April 1st, Mr. Hayes sent an e-mail to Mr. Justin Simon, a Height Securities healthcare analyst, saying that credible sources told him CMS would reverse its planned funding cuts for private health insurers.
At first, the Securities and Exchange Commission started its investigation by looking into whether anyone in the government had illegally leaked word of the announcement to Height Securities. This prompted federal investigators to initially focus on what CMS officials told congressional aids like Brian Sutter, what Sutter told lobbyist Mark Hayes, and what Hayes told Height Securities analyst Justin Simon.
Unfortunately for the feds, one of the keys to their investigation, Congressional staffer Brian Sutter, refused to comply with an SEC subpoena to provide detailed records in this matter. In June, the SEC filed a federal lawsuit seeking to force Mr. Sutter to turn over his communications records to investigators. A federal judge is expected to rule on this case shortly.
As a result of this roadblock, the FBI and the SEC has been unable to move their insider trading investigation forward.
Changing Focus of the Probe
According to a WSJ article published last week, the SEC has recently shifted its attention to the more than 20 phone calls, e-mails and instant messages it has discovered which were made between Height Securities and a select group of its hedge fund clients between the time the research firm sent its e-mail alert out and when the stock markets closed.
The hedge funds that are part of this investigation include Citadel, LLC; SAC Capital Advisors (now called Point72 Asset Management LP); Viking Global Investors LP; and Visium Asset Management LLC.
While most of the hedge funds involved declined to comment on the report, a spokesperson for Citadel said the firm’s communication with Height Securities was part of their compliance process, “verifying information contained in what we understood to be a broadly disseminated email.”
It is not unusual, nor is it illegal, for buy-side investors to communicate with research analysts about what is included in their reports – particularly if they intend to trade on the report. This communication has increased in the past few years as buy-side firms have enhanced their compliance practices to make sure they don’t trade on illicit information. However, investors could be held accountable for violating insider-trading rules if they knew the information in a research report was obtained illegally.
What the Government Must Prove
To successfully prove that investors are involved in insider-trading, the SEC must prove that they knowingly traded on material nonpublic information that was obtained from a source in violation of a duty of trust or confidence.
Consequently, the government is trying to determine exactly what Height Securities customers learned from the research firm in their discussions after they received the research note and before they decided to trade on this information.
Justin Shur, a former federal prosecutor now with MoloLamken LLP, explained the legal threshold that the government faces, “To pursue charges against the trader, the government would need to prove that he knew or had reason to know that the original tipper breached a duty by disclosing the information. Thus, figuring out what the trader knew about the source of the information is critical for prosecutors.”
As a result, the government must prove that the hedge funds under investigation traded on the Height Securities research note only after knowing that Sutter had obtained this information from a CMS official and had shared the facts that CMS was planning to reverse its previous reimbursement decision in breach of a duty.