[Senate Hearing 109-806]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-806
 
  ILLEGAL INSIDER TRADING: HOW WIDESPREAD IS THE PROBLEM AND IS THERE 
                     ADEQUATE CRIMINAL ENFORCEMENT?

=======================================================================

                                HEARING

                               before the

                       COMMITTEE ON THE JUDICIARY
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                               __________

                           SEPTEMBER 26, 2006

                               __________

                          Serial No. J-109-117

                               __________

         Printed for the use of the Committee on the Judiciary


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                       COMMITTEE ON THE JUDICIARY

                 ARLEN SPECTER, Pennsylvania, Chairman
ORRIN G. HATCH, Utah                 PATRICK J. LEAHY, Vermont
CHARLES E. GRASSLEY, Iowa            EDWARD M. KENNEDY, Massachusetts
JON KYL, Arizona                     JOSEPH R. BIDEN, Jr., Delaware
MIKE DeWINE, Ohio                    HERBERT KOHL, Wisconsin
JEFF SESSIONS, Alabama               DIANNE FEINSTEIN, California
LINDSEY O. GRAHAM, South Carolina    RUSSELL D. FEINGOLD, Wisconsin
JOHN CORNYN, Texas                   CHARLES E. SCHUMER, New York
SAM BROWNBACK, Kansas                RICHARD J. DURBIN, Illinois
TOM COBURN, Oklahoma
           Michael O'Neill, Chief Counsel and Staff Director
      Bruce A. Cohen, Democratic Chief Counsel and Staff Director


                            C O N T E N T S

                              ----------                              

                    STATEMENTS OF COMMITTEE MEMBERS

                                                                   Page

Grassley, Hon. Charles E., a U.S. Senator from the State of Iowa, 
  prepared statement.............................................    88
Specter, Hon. Arlen, a U.S. Senator from the State of 
  Pennsylvania...................................................     1

                               WITNESSES

Coffee, John C., Jr., Adolf A. Berle Professor of Law, Columbia 
  University Law School, New York, New York......................    15
Cox, James D., Brainerd Currie Professor of Law, Duke University 
  School of Law, Durham, North Carolina..........................    17
Macey, Jonathan, Sam Harris Professor of Corporate Law, Yale 
  University, New Haven, Connecticut.............................    14
Marchman, Robert A., Executive Vice President, Division of Market 
  Surveillance, NYSE Regulation, Inc., New York, New York........    10
Tenpas, Ronald J., Associate Deputy Attorney General, Department 
  of Justice, Washington, D.C....................................     2
Thomas, Christopher K., President, Measuredmarkets, Inc., 
  Toronto, Canada................................................    12
Thomsen, Linda, Director, Division of Enforcement, Securities and 
  Exchange Commission, Washington, D.C...........................     4

                         QUESTIONS AND ANSWERS

Responses of Robert A. Marchman to questions submitted by Senator 
  Specter........................................................    26
Responses of Ronald J. Tenpas to questions submitted by Senator 
  Specter........................................................    29
Responses of Linda Thomsen to questions submitted by Senator 
  Specter........................................................    48

                       SUBMISSIONS FOR THE RECORD

Beny, of Laura N., Assistant Professor, University of Michigan 
  Law School, statement..........................................    53
Coffee, John C., Jr., Adolf A. Berle Professor of Law, Columbia 
  University Law School, New York, New York, statement...........    61
Cox, James D., Brainerd Currie Professor of Law, Duke University 
  School of Law, Durham, North Carolina, statement...............    77
Kasowitz, Marc E., Kasowitz, Benson, Torres & Friedman LLP, New 
  York, New York, statement......................................    90
Macey, Jonathan, Sam Harris Professor of Corporate Law, Yale 
  University, New Haven, Connecticut, statement..................    94
Marchman, Robert A., Executive Vice President, Division of Market 
  Surveillance, NYSE Regulation, Inc., New York, New York, 
  statement......................................................    99
Tenpas, Ronald J., Associate Deputy Attorney General, Department 
  of Justice, Washington, D.C., statement........................   113
Thomas, Christopher K., President, Measuredmarkets, Inc., 
  Toronto, Canada, statement.....................................   129
Thomsen, Linda, Director, Division of Enforcement, Securities and 
  Exchange Commission, Washington, D.C., statement...............   137


  ILLEGAL INSIDER TRADING: HOW WIDESPREAD IS THE PROBLEM AND IS THERE 
                     ADEQUATE CRIMINAL ENFORCEMENT?

                              ----------                              


                      TUESDAY, SEPTEMBER 26, 2006

                                       U.S. Senate,
                                Committee on the Judiciary,
                                                   Washington, D.C.
    The Committee met, pursuant to notice, at 9:34 a.m., in 
room SD-226, Dirksen Senate Office Building, Hon. Arlen 
Specter, Chairman of the Committee, presiding.
    Present: Senator Specter.

 OPENING STATEMENT OF HON. ARLEN SPECTER, A U.S. SENATOR FROM 
                   THE STATE OF PENNSYLVANIA

    Chairman Specter. Good morning, ladies and gentlemen. The 
Senate Judiciary Committee will now proceed with our hearing on 
oversight of the Department of Justice on the issue of the 
insider trading matters.
    We have noted a comprehensive study made by 
Measuredmarkets, Incorporated, which found that 41 percent of 
the companies receiving buyout bids exhibited abnormal and 
suspicious trading in the days and weeks before those deals 
became public. And Measuredmarkets concluded that these unusual 
activities most likely involved illegal insider trading. These 
transactions involved very substantial sums of money, into the 
billions of dollars.
    While the merger activity has increased in recent years, in 
the past 6 years the number of insider trading cases pursued by 
the SEC has remained steady. We have noted that the Department 
of Justice has had some problems in a couple of cases: U.S. v. 
Scrushy, where there was a motion to suppress prosecution 
testimony taken because the SEC civil investigation had been 
undertaken at the behest and with the instructions from the 
U.S. Attorney's Office; and in the case of U.S. v. Stringer, 
there was a dismissal because of misconduct on a conflict 
between witnesses and the attorney involving the Department of 
Justice and the Securities and Exchange Commission.
    In wake of Sarbanes-Oxley, the Judiciary Committee authored 
a new Federal securities fraud statute in 18 U.S. Code, and we 
are pursuing this oversight hearing to make an evaluation as to 
what is being done to enforce that statute.
    The Committee has undertaken some inquiries into the hedge 
funds, but in our society it is absolutely indispensable that 
the integrity of the markets be maintained. Americans invest 
very heavily in the stock market, and that is really the 
backbone of our commercial system. And it is very, very 
important that the integrity be maintained.
    We have a distinguished array of witnesses here today, and 
we will begin with the Associate Deputy Attorney General Ronald 
Tenpas, whose responsibilities include coordinating the work of 
the President's Corporate Fraud Task Force.
    Welcome, Mr. Tenpas, and we look forward to your testimony. 
Before you begin, let me note for the record that Mr. Tenpas 
has an outstanding record, having clerked for Chief Justice 
Rehnquist after clerking for U.S. District Judge Louis Pollak. 
He had served as U.S. Attorney for the Southern District of 
Illinois and an Assistant U.S. Attorney for the Middle District 
of Florida and the District of Maryland; a bachelor's degree 
from Michigan State, a law degree from the University of 
Virginia, and a Rhodes scholar.
    That is quite a pedigree, Mr. Tenpas. I expect a lot of 
success from a man with your record. Please proceed.

   STATEMENT OF RONALD J. TENPAS, ASSOCIATE DEPUTY ATTORNEY 
        GENERAL, DEPARTMENT OF JUSTICE, WASHINGTON, D.C.

    Mr. Tenpas. Thank you, Mr. Chairman. You have set the bar 
for me.
    Let me first begin by thanking you for inviting the 
Department of Justice to testify today concerning our efforts 
to prosecute insider trading, and at the outset let me assure 
you that the Department and the Corporate Fraud Task Force 
share your sentiment about the importance of ensuring that 
everyone can invest in our markets, trusting in their integrity 
and, in particular, without fear of being taken advantage of by 
insiders who improperly use information.
    To understand the Department's approach and track record, 
it may be best to start with what we as prosecutors are 
concerned with proving when presented with allegations of 
insider trading. A criminal insider trading case requires us to 
prove multiple elements, including that there was, one, a 
willful and fraudulent buying or selling of a security; two, 
that the selling occurred in breach of a fiduciary duty or 
other relationship of trust and confidence; and, three, that 
the selling occurred while in possession of and in use of 
material nonpublic information about that security.
    Given these requirements, proving criminal insider trading 
activity requires more than just market surveillance and the 
discovery of spikes in trading. Market anomalies may be 
indicative of a problem, but they are not enough to prove 
criminal activity.
    Each of the elements I mentioned can present significant 
proof problems. Depending on their role in an inside scheme, 
potential defendants can suggest any number of defenses. For 
example, as I just mentioned, prosecutors must demonstrate that 
the defendant's conduct was a willful violation of the law, 
meaning that it must be proven that the defendant was aware at 
the time of the insider trade that he or she was doing 
something in violation of the law.
    A tippee, therefore, may claim that he or she did not know 
that it was illegal to trade on the information he received, 
especially if the tippee worked outside the corporation. 
Similarly, prosecutors must prove that the inside information 
at issue in the case was both material, meaning likely to be of 
interest to the reasonable investor, and nonpublic. Those who 
trade may often deny having known of the material information 
or, alternatively, claim that the information was broadly known 
and, thus, public.
    Similarly, because we must show that the defendant used the 
information in making his or her trading decision, a defendant 
may claim that the reason for his trade was unrelated to the 
inside information and that the trade was prompted by a 
personal need for funds, the timing of options, tax 
considerations, a desire to lock in previous gains, or any 
number of other reasons. Still further, a corporate outsider, 
such as the tippee, can challenge the claim that he owed a 
fiduciary duty to others. Moreover, given the nature of these 
cases and what we have to prove, insider trading cases rarely 
have a smoking gun.
    So, in sum, these cases almost universally turn on 
circumstantial evidence with inside traders frequently 
proffering a number of alternative explanations for their 
conduct, each of which must be discredited for the case to be 
successful.
    The challenge of building a circumstantial case that 
discredits all plausible alternatives can be daunting, and, of 
course, we must do so beyond a reasonable doubt. Nevertheless, 
the Department of Justice is committed to bringing such 
prosecutions and has compiled a strong record in recent years. 
We typically use the anti-fraud provisions of the Securities 
and Exchange of 1934, which carries substantial penalties, 
including imprisonment of up to 20 years and fines of up to $5 
million.
    Our typical case can begin in a variety of ways, but often 
we will start with a referral from the SEC or from public 
reporting that casts attention on a particular transaction or 
transactions. We will then work with our prosecutors and 
agents, usually from the FBI, and often involving the Postal 
Inspection Service, to work cooperatively with the SEC to seek 
access to information that the SEC has secured, with each 
agency then conducting a parallel investigation--the SEC 
focusing on civil violations and remedies, and the Department 
prosecutors considering whether to bring criminal charges.
    As outlined more fully in my written testimony, in recent 
years the Department has brought a wide variety of cases that 
have focused on the most egregious offenses that promise the 
greatest deterrence. We focus our efforts on those cases where 
the evidence is strongest and where the conduct is most 
serious, whether because the insider had an important 
leadership position or because the criminal ring was well 
organized or because it involved a sector of the market that is 
especially of concern. In doing so, we try to make our efforts 
part of an overall enforcement regime that includes the 
parallel and equally important role played by the SEC.
    In sum, we are determined to use all tools at our disposal 
to attack insider trading, and we appreciate the opportunity to 
appear before you this morning to discuss this in more detail.
    [The prepared statement of Mr. Tenpas appears as a 
submission for the record.]
    Chairman Specter. Thank you very much, Mr. Tenpas.
    We now turn to the Director of the Securities and Exchange 
Commission Division of Enforcement, Linda Thomsen, who has been 
with the SEC since 1995, was Assistant Director of the 
Department, then Associate Director, then Deputy Director--
really right up the ladder, Ms. Thomsen.
    She had been an Assistant U.S. Attorney for the District of 
Maryland, bachelor's degree from Smith, and a law degree from 
Harvard.
    We appreciate your being here, and the floor is yours.

STATEMENT OF LINDA THOMSEN, DIRECTOR, DIVISION OF ENFORCEMENT, 
      SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, D.C.

    Ms. Thomsen. Thank you, Chairman Specter, and I appreciate 
being here. Thank you for inviting me to testify today about 
insider trading. Our laws against insider trading play an 
essential role in protecting our securities markets and in 
promoting investor confidence in the integrity of those 
markets. I appreciate the opportunity to explain the 
Commission's efforts to deal with insider trading and to answer 
any questions you may have.
    I am especially pleased to testify together with Ron Tenpas 
of the United States Department of Justice. The respective 
histories of the SEC and the Department of Justice demonstrate 
our commitment to working with each other to prosecute insider 
trading, civilly and criminally.
    Over the years, investigating and prosecuting insider 
trading violations has remained a steady component of the SEC's 
enforcement mission. Since 2001, the SEC has brought 300 
actions against over 600 individuals and entities for insider 
trading violations and has frozen millions of dollars in 
illicit trading proceeds. Over that same period, insider 
trading cases have consistently made up about 7 to 12 percent 
of our filed caseload.
    At the same time, our enforcement program is, by necessity, 
dynamic. Our priorities and resource allocations must change to 
meet trends in the market and developing misconduct. Even 
within the relatively narrow arena of insider trading, we must 
shift our resources to those areas where the greatest threats 
lie. Most recently, the focus of our insider trading 
investigations has been on globalization, merger activity, and 
hedge funds.
    We have had some remarkable successes. Over the past year, 
we have charged a total of 17 defendants in the Reebok case, 
whom we allege participated in an international insider trading 
ring that netted at least $6.8 million in illicit gains by, 
among other things, stealing information from Merrill Lynch, 
from Business Week, and from a sitting New Jersey grand jury.
    In recent years, the Commission has also brought several 
insider trading cases involving hedge funds or their managers. 
Over the past 2 years, the Commission has brought at least 
three cases involving insider trading by hedge funds and their 
managers in advance of more than two dozen stock offerings 
commonly referred to as PIPEs. The Commission has also recently 
brought cases against hedge funds or their managers involving 
insider trading ahead of mergers and acquisitions.
    The Commission is particularly concerned about insider 
trading by registered broker-dealers and investment advisers. 
Earlier this year, the Commission filed a civil injunctive 
action against a former Merrill Lynch broker and ten former 
A.B. Watley day traders and their managers for participating in 
a scheme that allegedly involved trading ahead of large 
institutional orders broadcast over Merrill's in-house squawk 
boxes.
    A few months ago, we instituted a settled administrative 
proceeding against Morgan Stanley for failure to maintain and 
enforce adequate policies and procedures to prevent the misuse 
of material nonpublic information by the firm or persons 
associated with the firm. Morgan Stanley agreed to pay a $10 
million civil penalty and to engage an independent consultant 
to review its policies and procedures.
    Let me step back for just a moment and make some general 
observations about our insider trading program.
    Our Office of Market Surveillance is in daily contact with 
its counterparts in the various self-regulatory organizations, 
or SROs. The SROs perform primary surveillance, monitoring the 
markets for unusual trading, sudden changes in a security's 
price, or other unusual market activity. Our Office of Market 
Surveillance maintains an open line of communication with the 
SROs.
    Insider trading leads also come to us from other sources, 
including the news media, our own inspections and 
investigations, and tips. When circumstances warrant, we can 
and will act swiftly, using asset freezes to preserve any 
alleged ill-gotten gains.
    Identifying suspicious trading is an essential starting 
point, but it is only the first step in compiling a viable 
case. The challenge is not to establish facts that show 
suspicious trading. The surveillance records alone are often 
sufficient to establish that much. The real challenge is to 
establish that a particular individual was in possession of 
material nonpublic information and traded on it in breach of a 
duty and to establish those facts based on admissible evidence.
    Piecing together an insider trading case can be a complex 
and painstaking process. Because insider trading involves 
secret information and communications, it is rare, as Mr. 
Tenpas said, to find a smoking gun proving that a trader was 
tipped and by whom. Virtually all insider trading cases hinge 
on circumstantial evidence, inferences to be drawn from the 
trading records, the timing of trades, the movement of funds, 
and other facts and circumstances. Building an insider trading 
case based on circumstantial evidence can be frustrating, 
risky, and time-consuming. But our staff has persevered and 
built hundreds of solid credible cases.
    The Commission employs a broad range of remedies to address 
insider trading. The Commission generally seeks injunctive 
relief, disgorgement, and civil financial penalties, which may 
be up to 3 times the illegal profits made or the losses 
avoided.
    In settling cases, we have typically sought and obtained an 
injunction, disgorgement, and a one-time penalty that is a 
penalty equal to the amount of the illegal profits realized or 
losses avoided.
    Chairman Specter. Ms. Thomsen, how much more time would you 
like?
    Ms. Thomsen. I am happy to--I think about a minute.
    Chairman Specter. OK.
    Ms. Thomsen. We believe that the remedies we have, along 
with the threat of incarceration in the event of criminal 
prosecution, give us an effective arsenal for enforcement and 
deterrence.
    Insider trading undermines the integrity and credibility of 
our markets. We appreciate the fact that the markets are 
dynamic, and we understand the power of technology, and we will 
use it all to our advantage. We will continue to work very hard 
to protect the world's finest and fairest markets, and we would 
be happy to answer any of your questions. Thank you.
    [The prepared statement of Ms. Thomsen appears as a 
submission for the record.]
    Chairman Specter. Thank you very much, Ms. Thomsen.
    Mr. Tenpas, as a result of the work of this Committee 
following Sarbanes-Oxley, we passed Section 1348 relating to 
securities fraud. Has that been helpful to the Department of 
Justice? And to what extent has it been used?
    Mr. Tenpas. That has been very helpful to the Department. 
We have at this point successfully prosecuted somewhere 
slightly over 50 defendants.
    Chairman Specter. Has anybody gone to jail under the 
prohibitions of 1348?
    Mr. Tenpas. I believe so. Off the top of my head, I do not 
know the exact sentencing--
    Chairman Specter. It is pretty important determinant as to 
how effective it is, wouldn't you say?
    Mr. Tenpas. I believe it is, but as I say, I do not know 
the exact spread, but, yes, people have gone to jail.
    Chairman Specter. Would you provide the Committee with a 
list of the prosecutions and the penalties which were obtained?
    Ms. Thomsen, on that same subject, I note a $10 million 
fine that the SEC imposed in June of this year on Morgan 
Stanley for failing to conduct surveillance on hundreds of 
thousands of employees to determine insider trading. Is that 
really effective for a company the size of Morgan Stanley? Does 
$10 million really make much of an impact on a company like 
that?
    Ms. Thomsen. Well, I think the proof will be in the 
pudding, but I believe it was the largest penalty for that type 
of violation to date, which is a violation--
    Chairman Specter. Well, that does not mean a whole lot, 
largest penalty and proof is in the pudding. The pudding has 
been made. Where is the proof?
    Ms. Thomsen. Well, I believe that to the extent Morgan 
Stanley is improving its procedures, to the extent we have 
consistently brought cases against broker-dealers and others 
for violations of 15(f), we do see better surveillance and 
better procedures. Our remedies are always civil, so our 
remedies are always limited to injunctive relief, to procedures 
relief, which we obtained in the Morgan Stanley case, as well 
as penalties. I think--
    Chairman Specter. Your testimony says that the SEC has 
experienced recent successes in enforcing insider trading 
activities by hedge funds. We are very much concerned about 
hedge funds. We have had some investigation already, and some 
of it is ongoing. And I note in press reports the city of 
Philadelphia lost a lot of money because of a hedge fund 
failure. And hedge funds, as we all know, are not regulated, 
and that is really the jurisdiction of another Committee.
    Ms. Thomsen. Yes, sir.
    Chairman Specter. But this Committee has jurisdiction over 
criminal law enforcement. Have there been any criminal 
sanctions imposed on any of the hedge funds for violations?
    Ms. Thomsen. Well, I think I would defer to Mr. Tenpas, but 
I did read in the paper this morning that a hedge fund manager 
was indicted for insider trading by the Southern District of 
New York, and that was announced yesterday.
    Chairman Specter. I am interested in indictments. I am even 
more interested in convictions and most interested in jail 
sentences. How about it? Any jail sentences?
    Ms. Thomsen, that is directed to you.
    Ms. Thomsen. I am sorry.
    Chairman Specter. You were talking about recent successes. 
I would like to know how successful you have been?
    Ms. Thomsen. Well, I am sorry, sir, but because we have no 
criminal jurisdiction, we do not prosecute criminally and we--
    Chairman Specter. How many times have you gone for treble 
damages? You have statutory authority for that.
    Ms. Thomsen. We do have statutory authority for treble 
damages. We typically seek treble damages when we are 
litigating a matter. When we settle matters, as I mentioned, we 
typically seek a one-time--
    Chairman Specter. Typically seek them when you have 
litigated the matter.
    Ms. Thomsen. Yes, sir.
    Chairman Specter. How frequently have you obtained treble 
damages in the last 2 years?
    Ms. Thomsen. Infrequently.
    Chairman Specter. Infrequently?
    Ms. Thomsen. Infrequently. Courts are--
    Chairman Specter. Any?
    Ms. Thomsen. There is one case that I know of where we 
obtained treble damages, and I cannot remember--
    Chairman Specter. Only one case that you know of, and you 
are the Director.
    Ms. Thomsen. Yes, sir. Courts are reluctant to impose up to 
3 times.
    Chairman Specter. Would you review those cases for the last 
5 years and tell us what the--
    Ms. Thomsen. I believe it is one.
    Chairman Specter. What the experience has been.
    Ms. Thomsen. Absolutely.
    Chairman Specter. Mr. Tenpas, the Scrushy case raised the 
problem of collaboration between the SEC and the Department of 
Justice, and that case states, ``To be parallel, by definition 
the separate investigation should be like side-by-side tracks 
that never intersect.''
    Would you like to see the statute amended to allow you to 
intersect those tracks?
    Mr. Tenpas. Well, we certainly think it is important that 
we have the ability to intersect those tracks by consulting 
with one another--
    Chairman Specter. Is that a yes, Mr. Tenpas?
    Mr. Tenpas. We have not reached a judgment about whether 
the statute needs to be amended to allow us to accomplish that. 
In the Scrushy case, we were not able to take appeal. In the 
similar Stringer case, we have it under appeal. I think our 
feeling would be--
    Chairman Specter. What are the reasons why you should not 
be able to collaborate with the SEC?
    Mr. Tenpas. We do not think there are any reasons we should 
not be able to collaborate with them.
    Chairman Specter. Well, would you review that matter and 
talk to others in the Department who have higher rank? 
Certainly nobody has a better record in the Department of 
Justice than you do.
    How was it working for Judge Pollak?
    Mr. Tenpas. It was terrific. He is a great man, a great 
judge. I owe him a great deal.
    Chairman Specter. Would it be a fair question to ask you to 
compare working for Judge Pollak with Chief Justice Rehnquist?
    Mr. Tenpas. Obviously they have--
    Chairman Specter. I withdraw the question, unless you want 
to answer.
    [Laughter.]
    Mr. Tenpas. They were both great people to work for.
    Chairman Specter. Very diplomatically stated. Thank you 
very much for appearing. I appreciate the work you have done, 
and I would like you to take a closer look at the effectiveness 
of your work with respect to criminal sanctions or treble 
damages. My own sense is that fines do not do a whole lot, but 
jail sentences do. And I have had a little experience in the 
field.
    One of the ideas which this Committee is pursuing is to 
impose criminal liability on corporate officials who knowingly 
and maliciously put into interstate commerce instrumentalities 
which cause death or serious bodily injury. The Ford Firestone 
case is a good illustration where Congress did legislate to put 
criminal penalties into effect. But if you willfully and 
maliciously act in a way which results in someone's death, that 
states malice and grounds for prosecution for murder in the 
second degree. And typically that carries a jail sentence of 20 
years.
    And you have the Ford Pinto case, which is another good 
illustration. Internal corporate documents showed that they 
could save money by putting the gas tank in one spot as opposed 
to another spot, with an evaluation as to what they would have 
to pay by way of damages. And it seems to me that if it is 
knowing and willful--and that is a tough standard for a 
prosecutor to maintain. You are both former prosecutors. That 
does state malice, and consumers and people ought to be 
protected.
    You are in a field where market integrity is really 
important for this country, and insider trading is insidious. 
And when you have this study as disclosed by the New York Times 
about 41 percent of the cases raise the probability of 
collusion and insider trading, it really ought not to be just 
up to the New York Times to conduct the investigations. But if 
you have the benefit of their investigation--have you taken a 
look at that, Mr. Tenpas, Ms. Thomsen, as to what the Times has 
shown as to whether you ought to pursue that line?
    Mr. Tenpas. We are aware of the study, Senator. We have 
looked at it, and we are addressing it in the way that we 
typically would, which is to work closely with the SEC and the 
SROs. They have--
    Chairman Specter. Do you think that there is a valid basis 
for the conclusion of that study conducted by that outfit?
    Mr. Tenpas. That is a little beyond my purview because it 
involves fairly sophisticated statistical analysis, and that 
is--
    Chairman Specter. Sophisticated statistical analysis? Is 
that tough for a Rhodes scholar?
    Mr. Tenpas. It is tough for me. I was not particularly in 
the math arena, and one of the--
    Chairman Specter. Have you got some sophisticated 
statistical analysts in the Department of Justice? If not, we 
will get you some.
    Mr. Tenpas. Well, we do, but we find that the SROs and the 
SEC have active enforcement entities that have those folks--
    Chairman Specter. Well, OK. Ms. Thomsen, then you have 
looked at the study and you have analyzed it and you are 
sophisticated. What have you done?
    Ms. Thomsen. We have looked at it. We have not had an 
opportunity to study all the underlying data. We have also 
looked--
    Chairman Specter. You have not had an opportunity to study 
all the underlying data? Why not?
    Ms. Thomsen. If I may explain, we also have the data that 
we are getting from the SROs, and I do not think anyone 
disagrees with the notion that there is an increase or there 
has been an increase in anomalous or suspicious trading in 
advance of merger or acquisition activity--
    Chairman Specter. We have to move on, but let me ask each 
of you to give a report to the Committee on what you have done 
to date with respect to that study. I would hope that when you 
see that kind of an analytical study as prominently displayed 
as it was in a Sunday New York Times, you would take a look at 
it. And then I would like you to tell me what you think about 
it. And then the third aspect of the question is: What are you 
going to do in the future to pursue it?
    Ms. Thomsen. Sure.
    Chairman Specter. Thank you both very much.
    We will now turn to our second panel, and our first witness 
is Mr. Robert Marchman, Executive Vice President of the New 
York Stock Exchange Regulation, Inc., oversees the Market 
Surveillance Division, which investigates insider trading in 
securities listed on the New York Stock Exchange.
    Regrettably, I am going to have to excuse myself for a few 
minutes at 10 minutes after 10 because we are having a news 
conference on the immigration question, and the immigration 
bill came out of this Committee, and I am searching to see if 
we can find someone who can replace me for a bit while I absent 
myself for a very brief period of time. But if we cannot, I am 
going to have to ask you to wait. I am sure you will understand 
that a big part of this job is juggling a lot of different 
issues, and right now we are in very heavy duty as a result of 
being the last week we are in session before we break for 
October. And I do not like to ask anybody to wait, and 
especially as prominent, high-powered, and hourly rates as this 
prestigious group. But if I have to, I will have to.
    Mr. Marchman, thank you for joining us. The floor is yours.

  STATEMENT OF ROBERT A. MARCHMAN, EXECUTIVE VICE PRESIDENT, 
  DIVISION OF MARKET SURVEILLANCE, NYSE REGULATION, INC., NEW 
                         YORK, NEW YORK

    Mr. Marchman. Good morning, Chairman Specter. Thank you for 
this opportunity to share my thoughts on insider trading, which 
is an area of serious regulatory concern for the New York Stock 
Exchange Regulation group.
    The mission of NYSE Regulation is to protect the investing 
public and the integrity of our markets. We accomplish our 
mission by zealously monitoring trades in NYSE Group-listed 
securities by regular and ongoing onsite examinations of NYSE 
Group member firms and by proactive investigation and 
discipline of member firms and associated persons for violation 
of NYSE Regulation rules and applicable Federal securities 
laws.
    The history of the securities markets teaches us that 
insider trading is a serious regulatory concern, particularly 
today, where the volume, complexity of trades, and products, as 
well as cross-border transactions are redefining capital 
markets on almost a daily basis.
    The Division of Market Surveillance of NYSE Regulation 
continues to meet these challenges through the use of extensive 
and sophisticated surveillances, systems, and tools that allow 
us to timely review and aggressively investigate trading that 
may constitute illegal insider trading.
    On an ongoing basis, Market Surveillance analysts conduct 
reviews of alerts and investigations. Real-time and exception-
based alerts are mostly generated by advanced electronic 
surveillance systems within our Stock Watch unit. We have 
numerous electronic surveillances that surveill for activity 
that may constitute insider trading.
    In a typical insider trading investigation, sophisticated 
systems complement analysts' requests for trading-related 
information from member organizations, listed companies, and 
other markets. Where, as is frequently the case, an 
investigation indicates possible insider trading by individuals 
or entities outside the jurisdiction of NYSE Regulation, for 
example, hedge funds, employees of listed companies, or 
customers of a member organization, the activity is referred to 
the SEC with whom we enjoy a strong and constructive working 
relationship.
    In addition to our interaction with the SEC on specific 
insider trading investigations and referrals, we have ongoing 
discussions with the staff regarding practices and trends. In 
our view, in addition to our highly advanced technology and 
experienced and professional staff, a strong relationship with 
the SEC and other market regulators in the U.S. and 
internationally is critical to successful surveillance of 
activity that may constitute illegal insider trading.
    To that effect, we continue to strengthen our proactive 
engagement with other market regulators. By way of example, 
this August 18th there was a meeting convened amongst various 
regulators from the SEC, NYSE Regulation, NASD, and the Chicago 
Board of Options Exchange to talk about current developments 
and discuss investigative techniques in insider trading.
    The last 2 years have seen a significant increase in the 
number and complexity of our insider trading referrals to the 
SEC. Referrals to the SEC increased from 68 in 2004 to 111 in 
2005, a 63-percent increase. For 2006, at the current pace, we 
project 140 referrals to the SEC, an increase of 26 percent 
from 2005.
    We have also seen during this period an increase in the 
number of insider trading matters related to hedge fund 
activity that had been referred to the SEC. Penalties and 
disgorgement from Market Surveillance referrals to the SEC have 
also increased. In 2004, penalties were approximately $2.5 
million. In 2005, penalties were about $3.9 million. And for 
the first half of this year, penalties exceeded $3.2 million, 
and we are on our way to surpassing 2005 levels.
    In conclusion, at NYSE Regulation we remain vigilant and 
cognizant of our responsibility to vigorously pursue the 
highest excellence in our regulation of the markets. We also 
remain committed to continue to work with the SEC and with our 
fellow regulators to improve and strengthen the system of self-
regulation that has made the United States the financial center 
of the world.
    I thank you again for this opportunity to discuss the 
efforts of NYSE Regulation in this important area of insider 
trading and invite you and your staff to experience firsthand 
our efforts by visiting us in the near future.
    Thank you.
    [The prepared statement of Mr. Marchman appears as a 
submission for the record.]
    Chairman Specter. Thank you very much, Mr. Marchman.
    I am going to have to take a short recess at this point and 
just a word of explanation as to where we stand and why it is 
important to do this.
    The Senate has reported out an immigration bill, as you may 
know. The House has reported out an immigration bill. And we 
have been unable to go to conference. And they want border 
enforcement and employer verification. We do, too, but we want 
to handle guest workers and we want to handle the 11 million 
undocumented immigrants. And a good part of our work is 
informing the public as to what we are doing so they understand 
why the bill is not being finished and to try to induce the 
House Members to go to conference, which is going to have to be 
after we take the break.
    So I gave you that little explanation because it is not 
something which is incidental to our work to be at a news 
conference, but really very directly tied into getting the job 
done. And everybody is just very, very busy right now. We are 
struggling the Supreme Court ruling in Hamdan and whether we 
are going to have habeas corpus. And we are struggling with the 
electronic surveillance issues. We are struggling with the 
fence and another matter. So that everybody is moving like 
molecules at a high speed in a lot of different directions.
    So I hope you will pardon the brief recess, and I will 
return just as soon as I can.
    [Recess 10:08 a.m. to 10:33 a.m.]
    Chairman Specter. We will resume the Judiciary Committee 
hearing.
    Again, I regret the interruption. This may not assuage you 
much, but this may be the shortest recess in the history of the 
Judiciary Committee to change buildings and have three Senators 
speak and come back.
    We turn now to Mr. Christopher Thomas, President and 
Founder of Measuredmarkets Inc., an analytical research firm 
based in Toronto, Canada. Mr. Thomas had worked as an analyst, 
investment adviser, and broker prior to founding 
Measuredmarkets; bachelor's degree in economics from McGill 
University; studied at Loyola and Marlborough College in 
Marlborough, England.
    Thank you for joining us here today, Mr. Thomas, and we are 
very interested in your study and look forward to your 
testimony.

STATEMENT OF CHRISTOPHER K. THOMAS, PRESIDENT, MEASUREDMARKETS 
                     INC., TORONTO, CANADA

    Mr. Thomas. Thank you, Senator. I am President of 
Measuredmarkets. The firm supplied the underlying data to the 
New York Times for its article of August the 27th on abnormal 
trading activity.
    The analysis we did for the newspaper showed that for more 
than 40 percent of the scrutinized mergers with a value of $1 
billion or more that were announced in the 12-month period, 
deviant trading behavior was evident before the deals became 
public. Therefore, we believe that with the data displaying 
such aberrant activity, it is more than reasonable to ask: What 
prompted this activity? Could it be insider trading?
    The Financial Times of London recently reports: ``Insider 
trading is endemic in the London stock market. The Financial 
Services Authority recently found that almost 30 percent of 
takeover announcements...were preceded by suspicious share 
price movements....'' If 30 percent is considered endemic, what 
would one consider labeling a number greater than 40 percent?
    Our company provides a service that statistically examines 
the trading behavior of individual stocks. We determine if 
today's activity conforms to the particular stock's historical 
patterns or deviates from them. When stocks do wander away from 
their usual pattern of behavior, our process issues alerts 
automatically. If there is no news publicly available that 
might explain this aberration, we deem such activity highly 
suspicious and irregular, going against historical norms.
    Our factual data and experience has shown that very often 
such deviations occur several days before substantial changes 
in the prices of the identified stocks. We have numerous 
examples of such identification of unusual behavior preceding 
the release of material news. Some of these are cited in the 
New York Times article; others are on our website.
    Amongst our clients are a governmental investigatory 
agency, news services, money managers, brokers, and individual 
investors.
    So how does Measuredmarkets use the data? What determined 
abnormal trading? And what is considered suspicious trading?
    We look at some 3,000 data points for each common stock 
each day on the four exchanges, and for some stocks as many as 
5,000 data points. We examine a stock's history of trading 
using three measures: closing price, total volume, and the 
total trades or number of individual transactions. This last 
measure is distinct from volume, albeit related to it. A 
stock's normal behavior pattern for each measure is then 
calculated, covering nine different time periods. We thus have 
what can be 3-D pictures, covering each of the nine time 
periods, to compare against any day's activity. Each stock's 
history mathematically determines what its normal pattern of 
behavior is, automatically adjusting should it change from 
volatile to stable or vice versa.
    Should a day's activity exceed the normal patterns, then it 
can be considered as exhibiting mathematically deviant 
behavior. It is aberrant, having wandered significantly away 
from its well-established normal path.
    Each day, for the four markets that Measuredmarkets 
currently tracks, hundreds of stocks are flagged as showing 
newly deviant behavior. The majority of those so marked are 
actually reflecting news that is already in the public domain. 
The service our company provides becomes useful, important, and 
significant when stocks have deviated from their own norms and 
there is no news generally available that could explain the 
deviations. Such activity we suggest is suspicious. Referring 
to the New York Times articles: ``The companies were not the 
subject of widely dispersed merger commentary during the 
periods of abnormal trading, nor did they make any 
announcements that would seem to explain the moves.''
    The Measuredmarkets service deals with real numbers from 
the real world--hard data that is in the public domain. From 
the immense amount of information that is generated by the 
stock markets, we sift the data so that ordinary investors and 
interested organizations gain valuable information.
    I started this company to level the playing field for 
investors. ``What is the use of living if it be not to strive 
for noble causes and to make this muddled world a better place 
for those who will live in it after we are gone?'' That was 
Winston Churchill, and I have to point out that his mother was 
an American.
    Thank you, Senator.
    [The prepared statement of Mr. Thomas appears as a 
submission for the record.]
    Chairman Specter. Thank you, Mr. Thomas.
    Our next witness is Professor Jonathan Macey, Deputy Dean 
and Professor of Corporate Law, Corporate Finances and Security 
Law, at Yale University; was the Dupont Professor of Law at 
Cornell, and also served as an instructor at the University of 
Chicago, University of Tokyo, and University of Virginia; law 
clerk to Judge Friendly; bachelor's degree cum laude from 
Harvard, and law degree from Yale; editor of the Yale Law 
Journal.
    A very distinguished record, Professor Macey. The floor is 
yours.

STATEMENT OF JONATHAN MACEY, SAM HARRIS PROFESSOR OF CORPORATE 
          LAW, YALE UNIVERSITY, NEW HAVEN, CONNECTICUT

    Mr. Macey. Thank you very much, Mr. Chairman. It is a 
pleasure to be here, and thanks for inviting me. Insider 
trading has been a focus of my teaching and research. Illegal 
insider trading is the theft of valuable information about 
corporate plans that properly belongs to the corporation and 
its investors. Vigorous enforcement is important to protect 
intellectual property rights of investors and corporations.
    However, not all trading by insiders is illegal, and not 
all trading on the basis of informational advantages is 
illegal. Rather, insider trading is illegal when securities are 
traded in breach of a relationship of trust and confidence, 
known as a ``fiduciary duty.'' And it is also, of course, 
illegal to tip information in violation of a fiduciary duty or 
to misappropriate confidential information.
    It is not the case that insider trading is a victimless 
crime. Insider trading is a crime that has victims because 
insider trading deprives people of what is rightfully theirs--
the ability to profit on material nonpublic information about 
their companies or to avoid losses associated with such 
information, and in doing so deprives people of returns and 
undermines legitimate societal trust and expectations about 
market functions.
    The problem with insider trading for personal benefits is 
that it reduces--another problem is that it reduces the 
incentives of legitimate market participants, like analysts, to 
allocate scarce resources to research. And the question that I 
want to turn to is: How much insider trading do we actually 
observe in the U.S., and can we and should we be doing more to 
stop it? And I want to make the following points.
    No. 1, the available empirical research indicates that the 
U.S. has, by far, the most vigorous insider trading enforcement 
program in the world, as well as the strictest laws against 
insider trading. The U.S. is the country in which insider 
traders' profits are the lowest.
    In the U.S., unlike many other countries, there is a 
private right of action for violation of the laws against 
insider trading, and from a causal perspective, the private 
plaintiff's bar generally piggybacks on the enforcement efforts 
of the Securities and Exchange Commission and also self-
regulatory agencies. The evidence suggests that while coming up 
with a benchmark for what is vigorous enforcement is not an 
easy task, relative to any other countries the U.S. does a 
great deal more, and the SEC in particular. For example, over 
the last 5 years, the SEC has brought 260 insider trading 
enforcement actions. By contrast, in the U.K. there have only 
been 14 insider trading actions, and the largest fine, which 
was 25,000 pounds in the U.K., is lower than the average 
penalty in the U.S.
    The enforcement program of the SEC has targeted not only 
corporate officers and directors and their friends, business 
associates, tippees, printing firm employees are common 
targets, also employees of investment banking firms, law firms, 
and accounting firms.
    At the same time, I want to point out that trading that is 
not done on the basis of a violation of fiduciary duty and 
involves making money from investments in legitimate research 
about corporate performance and governance is socially valuable 
and should be encouraged.
    With respect to studies that we have been talking about 
today, studies that show increases in trading volume or share 
prices in advance of merger and acquisition activities must, if 
they are to be useful, do a couple of things that studies that 
have been discussed do not do. No. 1, they do not distinguish 
between legitimate and illegitimate trading activity. For 
example, purchases by a hedge fund or an LBO fund or an 
arbitrageur may actually put a company in play, increasing the 
chances of an outside acquisition attempt, which in turn can 
explain sudden increases in trading volume and share prices of 
target companies, thus suggesting that we need to think 
carefully about the causation that we observe in studies such 
as that reported in Gretchen Morgenson's August 27, 2006, New 
York Times article.
    I also want to point out that, in terms of thinking about 
the allocation of resources in insider trading, there are other 
things on the SEC's plate that one can credibly argue should be 
the focus of sharp attention, such as options back-dating and 
accounting fraud. Thus, one can draw the conclusion, as I have 
done, that the SEC in its enforcement program does an excellent 
job of balancing the policy goal of detecting and punishing 
insider trading with the goal of conducting insider trading 
investigations in a careful way so that we maintain the 
important deterrent effect that we have associated with the 
social stigma that is carried with the act of illegal insider 
trading in the U.S. that one does not see as a matter of norms 
and social deterrent in other countries.
    Thank you very much.
    [The prepared statement of Mr. Macey appears as a 
submission for the record.]
    Chairman Specter. Thank you, Professor Macey.
    We turn now to Professor John Coffee, Columbia Law School; 
holds the distinguished Adolf Berle Chair; taught at Georgetown 
University Law Center, and was in private practice for 6 years 
with Cravath, Swaine & Moore; been a member of the NASD's 
Market Practices Committee and the Legal Advisory Committee of 
the New York Stock Exchange Board of Directors; bachelor's 
degree from Amherst, Phi Beta Kappa; law degree from Yale; 
master in law from New York University.
    We may be overloaded with Yale law grads today-- Professor 
Coffee, Professor Macey.

 STATEMENT OF JOHN C. COFFEE, JR., ADOLF A. BERLE PROFESSOR OF 
    LAW, COLUMBIA UNIVERSITY LAW SCHOOL, NEW YORK, NEW YORK

    Mr. Coffee. Thank you for inviting me, Senator. As a law 
professor, and uniquely for this panel, I teach both criminal 
law and securities law, so I look at insider trading from both 
sides, and I am going to focus my comments not on whether 
insider trading is bad--I assume we all agree on that--but on 
the criminal enforcement of it. And I am basically going to 
submit that criminal enforcement is the one force that will 
truly deter in this field. But there are problems with criminal 
enforcement, and there are new problems looming on the horizon.
    Now, I am going to ask a series of questions and give 
brief, incomplete answers.
    Has insider trading increased? There is no universally 
recognized proxy, but there is pretty probative evidence that 
there has been an increase. The New York Stock Exchange data in 
Mr. Marchman's written submission shows that the number of 
referrals to their Market Surveillance Unit has made to the SEC 
over the last 2 years went up 60 percent in 2005 and 25 percent 
in 2006. That is consistent data because their computers are 
going to be objective and turn out the same criteria and the 
same warning bell each time.
    Now, what is driving this increase that I think exists? 
Usually, it is related to merger and acquisition activity, but 
that is not the story today. I think it is more the intense 
competition among hedge funds where there is tough competition 
for the investor's dollar. They have to get very high rates of 
return to stay in business, and they may do anything to get 
material nonpublic information.
    Second, there are new classes of transactions-- management 
buyouts, PIPE transactions--that are particularly vulnerable 
because large numbers of people know in advance about these 
transactions, and the risk of insider trading goes up 
exponentially. So we have reasons for why it is increasing and 
evidence it is increasing. Is the SEC at fault? I cannot say 
that. I cannot make a case that the SEC has been inattentive. 
They have prosecuted between 7 and 12 percent of their 
enforcement cases, insider trading cases, for the last 10 years 
or so, and basically I cannot tell the SEC or this Committee 
that they should prosecute more insider trading and, thus, less 
accounting fraud or less market timing or less stock option 
back-dating. All of these things deserve the attention of the 
SEC.
    Therefore, I would suggest the focus has to be on making 
enforcement more efficient, and here I want to give one basic 
message. If we look worldwide at what makes enforcement 
efficient, it is effective criminal enforcement, and effective 
criminal enforcement of insider trading is very difficult. It 
is easy enough to find out who traded, but it is very difficult 
to identify whether that trading was based on material 
nonpublic information that was misappropriated. That requires 
evidence that is hard to obtain.
    Thus, many insider trading cases are actually prosecuted on 
other grounds. You will recall the Martha Stewart case where 
she was prosecuted for false statements and conspiracy and her 
co-conspirators for perjury, but none of them were prosecuted 
for insider trading.
    The point I am making is that there needs to be cooperation 
between civil and criminal enforcers because often the actual 
charges brought will not be securities fraud but something 
else. However, it does deter.
    Now, when we look worldwide at enforcement, I have to tell 
the Committee that in the legal systems closest to the United 
States, insider trading has not been successfully enforced 
through criminal law. In Great Britain and in Canada, there has 
been no success with criminal enforcement. I have just served 
on a Canadian commission that has tried to examine why there 
has been little success, and basically we find that there are 
legal barriers between cooperation between the civil enforcer 
and the criminal enforcer, and the cases cannot be made.
    Now, cooperation has never in the past been a problem in 
the United States, but within the last year, two Federal courts 
have dismissed criminal indictments brought by U.S. Attorneys 
because of cooperation between the SEC and the U.S. Attorney. 
The best known of these cases is the Scrushy case you referred 
to, the CEO of HealthSouth. In that case, the U.S. Attorney did 
call up the SEC attorney and suggest some questions they would 
like asked and some questions they would not like asked because 
it would tip off the deponent of the pending criminal 
investment. Also, the U.S. Attorney suggested they move the 
proceeding to Alabama from Atlanta so that they could indict 
the deponent if he committed perjury. Mr. Scrushy was indicted 
for perjury, and the case was dismissed by a court that says 
the Government had laid a perjury trap.
    I think that is a very fallacious logic. I do not accept 
the perjury trap argument. The defendant was not induced to 
lie. The defendant was merely induced to lie in Alabama rather 
than in Georgia, and the defendant has no right to avoid 
prosecution because he was not told in advance that the 
Government was hiding in the bushes waiting to indict him if he 
lied. All defendants should know that they can be indicted if 
they lie before the SEC.
    I suggest that Congress could fix this. This is not a 
constitutional problem. This is a simple problem of supervisory 
jurisdiction, and I think there is a quick fix that is 
possible. And I will leave it at that point.
    [The prepared statement of Mr. Coffee appears as a 
submission for the record.]
    Chairman Specter. Thank you very much, Professor Coffee.
    We turn now to Professor James Cox, Duke Law School; 
appointed to the Currie Chair in 2000; previously taught at 
Boston University and the University of California at Stanford; 
a member of the NASD's Legal Advisory Committee and the ABA 
Committee on Criminal Law; bachelor's degree with high 
distinction from Arizona State University, law degree from the 
University of California, and a master's in law from Harvard.
    We appreciate your being here, Mr. Cox.

 STATEMENT OF JAMES D. COX, BRAINERD CURRIE PROFESSOR OF LAW, 
     DUKE UNIVERSITY SCHOOL OF LAW, DURHAM, NORTH CAROLINA

    Mr. Cox. Thank you, Senator, for inviting me. My testimony 
prepared on a blustery Saturday morning reports a lot of 
studies that document everything that you have heard here this 
morning: that insider trading in our capital markets is 
pervasive and insidious, surrounding almost every event.
    By way of illustration and replicating what Mr. Thomas 
found, you find that, on average, beginning about 12 days 
before takeovers or a merger, roughly 40 to 50 percent of the 
premium that is going to be ultimately paid in that unannounced 
event is already reflected in the stock's price; that the 
deals, earnings reports, listings, delistings, bankruptcy, 
offering of new public securities are not well- kept secrets in 
our capital markets. So insider trading is a problem.
    As Jack pointed out, we do not know whether the right 
number of referrals are the 140 cases anticipated this year by 
the Stock Watch group. Maybe it should be 300 cases or 400 
cases. It is very hard to get a handle on that. What we do know 
is that the evidence of insider trading, as I repeated and as 
captured in my statement, is pervasive.
    The suggestions I make are somewhat consistent with what 
both John and Jack have made, and that is that we need to think 
about enforcement. But enforcement really has two different 
components to it, and I focus in my testimony more on the first 
component, and that is, increasing the likelihood of detection. 
The other component of that is the sanction. In between there 
is the probability of successful prosecution. But let's talk a 
little bit about detection.
    One of the relevant questions I have suggested in my 
written testimony would be an appropriate question for Mr. 
Marchman and his organization is whether they really believe 
that their data base has sufficient inputs as to who are the 
participants in the deal so that when you do find suspicious 
trading going on--and how do we know it is suspicious trading? 
Generally, a suspicious trade is determined just by the size of 
the trade. But maybe we ought to look at suspicious trading by 
who the trader is. Do they have in their data base sufficient 
knowledge about who the lawyers are, the investment bankers, 
the commercial bankers, the accountants that are likely 
involved with these transactions so that they are kicked out of 
the computers even though they may trade a very small amount?
    For close to 20 years now I have studied how the Stock 
Watch group operated and how their data base is constructed, 
what names were in it, the heuristics that were used for 
identifying abnormal volume changes and price changes. And the 
question is: Has that data base kept apace with market 
developments? How transparent is the trading to the Stock Watch 
group of who the traders are vis-a-vis the Stock Watch group, 
not necessarily to the market? As we all know, being able to 
conceal your identity in the marketplace is an important 
attribute of capital markets. We do not want to have it 
necessarily totally transparent to other investors who is 
trading, but that is quite a separate question from whether we 
have a system that allows the self-regulatory organizations, 
the first line of defense for the integrity of our capital 
markets with respect to insider trading, to know who is trading 
and whether those data bases are adequate and sufficient.
    I believe that we could have a method that would be 
designed to provide sufficient data bases in ways that are 
consistent with privacy notions and at the same time enhance 
greatly the surveillance of our capital markets, the detection 
of insider trading, and most likely the apprehension and 
successful prosecution of those who violate their trust by 
trading on material nonpublic information.
    Thank you, Senator.
    [The prepared statement of Mr. Cox appears as a submission 
for the record.]
    Chairman Specter. Thank you, Professor Cox.
    Well, there is certainly a broad divergence of views. That 
is an excellent panel from that perspective, and I compliment 
my staff on assembling them, more so than easel, if I might 
say.
    Professor Cox, you are beating around the bush by calling 
insider trading only pervasive and insidious. Would you 
disagree with that, Professor Macey?
    Mr. Macey. Well, the available data suggests one of two 
things, Senator. One is we could say that insider trading is 
more pervasive in the U.S. than in other countries because the 
data that Jim Cox and Mr. Thomas are referring to suggests 
greater volume increases and bigger price spikes. But I do not 
think with a glancing familiarity with world capital markets 
would agree that insider trading is more pervasive.
    Obviously, with respect to the question how much illegal 
insider trading should be--
    Chairman Specter. He did not say it was more pervasive. He 
just said it was pervasive.
    Mr. Macey. Right. Well, the--
    Chairman Specter. And you say it is less pervasive than 
other places, but--
    Mr. Macey. Fair enough.
    Chairman Specter. Is it pervasive--well, I guess if you say 
it is less pervasive, it is pervasive. How about insidious?
    Mr. Macey. Well, I think by definition it is insidious 
because it is sneaky, to the extent that it is illegal. But, 
you know, I think again we have to look at causation. We have 
to look at the great efficiency of U.S. markets. And Mr. 
Thomas' company does suggest in its study that there is more--
that they have more of this aberrant activity in the U.S. than, 
say, in London.
    Chairman Specter. Well, I think that is a pretty 
comprehensive indictment to call it pervasive and insidious. I 
do not often ask the same question to other panelists, but is 
it pervasive and insidious, Mr. Marchman?
    Mr. Marchman. Chairman Specter, our numbers do indicate 
that in recent years, at least with regard to our referrals, 
activity which could be labeled as insider trading is on the 
upswing. Of course, I agree with all the panelists--
    Chairman Specter. On the upswing. But is it pervasive?
    Mr. Marchman. It is an area of concern for our regulatory 
group given--
    Chairman Specter. It is a matter of concern for your 
regulatory groups, but is it pervasive?
    Mr. Marchman. It is a conduct that we are attempting to 
ascertain the extent of the pervasiveness of the--
    Chairman Specter. Conduct attempting to obtain an 
evaluation of the pervasiveness. OK. I am not going to ask it a 
fourth time.
    Mr. Thomas, is it pervasive and insidious? Mr. Thomas, is 
illegal insider trading pervasive and insidious?
    Mr. Thomas. Well, certainly insidious if it is illegal. 
There is no doubt about that at all, and--
    Chairman Specter. Well, it is illegal, so we now know it is 
insidious. But is it pervasive?
    Mr. Thomas. Certainly it seems to be pervasive based on our 
studies and the reports out of London and personal experience 
in the past.
    Chairman Specter. Well, I do not have so much interest as 
to whether it is pervasive and insidious in London. How about 
in the United States?
    Mr. Thomas. According to our studies, it would certainly 
appear to be.
    Chairman Specter. Professor Coffee, is it pervasive and 
insidious?
    Mr. Coffee. It is pervasive and insidious enough to need a 
stronger regulatory response.
    Chairman Specter. OK. You have touched a core issue, 
Professor Coffee, on the parallel tracks matter, and what is 
the best rationale to be said in support of the Federal court 
decision striking an indictment because of cooperation? It 
seems to me a telephone call from--
    Mr. Coffee. There are two decisions--
    Chairman Specter. Two cases. Well, one was the perjury trap 
and the other was the coordination--or were they both 
coordination?
    Mr. Coffee. Well, they both involved coordination, which 
created, in the view of one judge--
    Chairman Specter. But was the rationale in both--
    Mr. Coffee. I think the underlying rationale--
    Chairman Specter. The absence of parallel and disconnected 
tracks.
    Mr. Coffee. I think the underlying rationale is the 
defendant is somehow entitled to warning so that he could 
assert his Fifth Amendment rights if he knew that the U.S. 
Attorney was using the SEC proceeding as a way of gathering 
evidence for purposes of the criminal prosecution. However, in 
the past, Congress has written right into the Federal 
securities laws that the SEC can turn this information over. We 
just have a gap as to whether or not the two bodies can consult 
during the process of investigation, and that is where I think 
there could be a further fix, because right now there is 
considerable confusion in the law. And, frankly, any zealous 
defense counsel is almost duty bound to make a motion alleging 
that the Government has violated this perjury trap or somehow 
improperly cooperated between the civil and criminal sides.
    Chairman Specter. I have not been in the prosecution 
business for a while. Is there an evolved doctrine of perjury 
trap? It is the first time I have heard of it.
    Mr. Coffee. Scrushy is the first time I heard it, and I 
think it is very surprising to most prosecutors. But as long as 
we have two decisions out there and no circuit court decisions, 
we are in a state of considerable uncertainty.
    Chairman Specter. Entrapment is a well-accepted doctrine 
for a defense, but perjury--
    Mr. Coffee. Entrapment, as you are well aware, Senator--
    Chairman Specter. Well, come back to the question which I 
have interrupted. What is the best rational for the conclusion 
that the SEC attorneys and the Department of Justice attorneys 
ought to be on totally separate tracks?
    Mr. Coffee. Well, I think the argument implicitly of the 
Scrushy court is that if you knew that the SEC was a stalking 
horse, was working hand in glove with the U.S. Attorney, you 
would have taken your Fifth Amendment rights, assert it at the 
SEC proceeding, and you would have had the case probably 
determined adversely against you because you can take 
inference--
    Chairman Specter. That is the best rationale?
    Mr. Coffee. The rationale is that we should broadly 
protect--I do not agree with this rationale, but the rationale 
would be that we should give the defendant fair notice that the 
Government is going to use this evidence and permit him to 
assert his Fifth Amendment rights knowing the intended use of 
the evidence.
    Chairman Specter. Well, a person ought to be on guard at 
all times for anything which is said which is incriminating, 
because it can be used in an evidentiary way, as we all know, 
by anybody who hears it as an admission, even on a hearsay 
basis, let alone if you have a governmental agency conducting 
an investigation.
    Professor Macey, do you think that criminal sanctions ought 
not to be employed against illegal insider trading?
    Mr. Macey. No. I think criminal sanctions should be 
employed against illegal insider trading.
    Chairman Specter. Professor Cox, Professor Macey has 
emphasized a view that the reputational penalties for insider 
trading are very high. Now, he does not think that they should 
be exclusive, as he just testified, but how meaningful do you 
think reputational penalties are for insider--to discourage 
illegal insider trading.
    Mr. Cox. My sense is not enough, and the reason for that is 
that we still see individuals who are engaged in professions 
which trade on reputation--lawyers, accountants, certain high-
level investment bankers that still cross the line, and they 
must appreciate the fact ex ante that if they get caught, they 
will no longer be a lawyer or an accountant because nobody will 
ever retain them in their firm.
    So I think individuals discount heavily the loss of 
reputation going into it. I think the loss of reputation is an 
important part of addressing--causing people to adhere to a 
norm. But it breaks down in lots of areas, and I suspect that 
the reputation loss for those that are business people, not 
professional people, is not nearly as great because the little 
bit of casual knowledge I know, individuals that have been 
involved in insider trading continue to be executives of firms; 
whereas, those who are lawyers or accountants find another 
profession other than being a lawyer or accountant. So it 
depends upon a little bit about where you came from, but also 
it depends a lot on who you are as well.
    Chairman Specter. Reputational factors are not as important 
to business people as to lawyers or accountants because the 
penalties are not as high. They can keep their jobs.
    Mr. Cox. That is what my surmise would be, sir.
    Chairman Specter. Mr. Thomas, Professor Cox has raised a 
question as to whether the data base is sufficient and wants to 
know if you cross-check lawyers and accountants and other 
professionals who are engaged in demonstrable illegal insider 
trading as a factor to be considered in your studies. Does your 
data base take into account what Professor Cox has asked about?
    Mr. Thomas. Senator, we have no idea who the particular 
parties are doing the trading. Something we do do is analyze 
the individual number of trades, and it usually happens that 
when tippees are involved, the number of individual trades or 
transactions increases significantly beyond the norms, 
independent of the absolute volume. And this is an important 
indicator that something funny may be going on.
    Chairman Specter. Do you think it would be a better study 
if you tracked lawyers and accountants for the reasons 
Professor Cox articulates?
    Mr. Thomas. If someone paid us and gave us the mandate to 
do so, we would be happy to do it.
    Chairman Specter. Well, this Committee is not in a position 
to pay you to do so.
    Mr. Thomas. I am just pointing out, Senator, with due 
respect, that is not the business we are in.
    Chairman Specter. But you might propose it to the New York 
Times. Or they might have heard about it from what we are 
saying here.
    It is a very interesting study that you have conducted, 
beyond any question.
    Mr. Thomas. Thank you.
    Chairman Specter. And you have been commissioned to do so, 
according to the Times, by the New York Times itself. Correct?
    Mr. Thomas. Correct, yes.
    Chairman Specter. Do you know the genesis as to why the 
Times decided to make these inquiries?
    Mr. Thomas. Our company and the New York Times have been 
talking for a while about exchanging--our providing some of our 
information. And then when the Financial Times of London 
reported on the FSA study the 30-percent number out of London, 
the New York Times said, Hey, could you do the same sort of 
study over here for the United States for, say, mergers and 
acquisitions--
    Chairman Specter. So it was inspired by the London Times 
story as opposed to some preconception that there might be 
something rotten in Denmark.
    Mr. Thomas. There might have been that preconception. I 
have no idea. But the London Times, the Financial Times story 
was the trigger that got this investigation going.
    Chairman Specter. Mr. Marchman, your statistics are very 
interesting about your referrals and the significant increase 
in referrals. Do you track what the SEC does with your 
referrals in terms of sanctions?
    Mr. Marchman. We do. We do, and the--
    Chairman Specter. Are they doing a good job?
    Mr. Marchman. With the--
    Chairman Specter. I withdraw that question. You probably 
should not be asked that question. What are they doing? I will 
not ask you a leading question. Professor Macey raised his 
eyebrows on that.
    Mr. Marchman. Well, what they do do, after we referred the 
matter, is that--and, Chairman Specter, I would note that 
before we do refer a matter to the SEC, there is an extensive 
process that is involved by my staff where we do, in fact, have 
an extensive data base which contains information with regard 
to the identities of attorneys, accountants, individuals who 
may have been involved with--
    Chairman Specter. So you pick up some of what Professor Cox 
suggested.
    Mr. Marchman. We pick up almost all of what Professor Cox 
has suggested.
    Chairman Specter. And what has the SEC done with your 
referrals?
    Mr. Marchman. With our referrals, they have instituted a 
number of disciplinary actions, as noted in my written 
testimony, as a result of the referrals. We do keep track with 
regard to the numbers. We have discussions with regard to any 
additional information that they may need as they are going 
forward. And we also are mindful of the evidentiary burdens 
that do confront the SEC with regard to the referrals that we 
make.
    The referrals that we do make, as I noted in my written 
testimony, are indications of potential violations of insider 
trading, not actual evidence.
    Chairman Specter. Mr. Marchman, would you provide to the 
Committee your information as to what has happened on the 
referrals?
    Mr. Marchman. Sure.
    Chairman Specter. And give us an evaluation, if you care to 
do so--I know this is sensitive--as to whether you think what 
the SEC has done is adequate. And we are going to track them on 
the other end with the SEC and with the Department of Justice 
to see what they are doing.
    Mr. Coffee, you have raised the possibility of altering the 
mens rea test but think that that would be unwise to do. Would 
you expound upon that?
    Mr. Coffee. Well, right now, any criminal prosecution for 
securities fraud, which is how insider trading is classically 
prosecuted, requires you to show that the defendant has a mens 
rea of willfully violating the statute, and there are a series 
of decisions by eminent judges, like Henry Friendly, that say 
willfulness in this context requires proof of a conscious 
awareness of wrongdoing on your part.
    That is a very high standard, and it is one of the 
problems. I do not think it is the principal problem. I think 
the principal problem is getting proof that you actually 
possessed material nonpublic information.
    So it would be a move that would simplify the prosecution. 
I do not recommend it because I believe this is an extremely 
regulated and complex area, much like the tax law. And there 
are many people who trade believing that they are permitted to 
trade because they are not breaching a duty. And I think you 
should have some awareness that you are breaching a duty before 
you get criminally prosecuted for insider trading and face a 
penalty of up to 25 years.
    Chairman Specter. You mentioned Judge Friendly and his 
test. What was it like, Professor Macey, clerking for Judge 
Friendly?
    Mr. Macey. He was a brilliant lawyer, particularly in the 
business law, white-collar crime, corporate and securities 
area, and a keen, keen intellect. It was a great honor and 
privilege.
    Chairman Specter. Chief Justice Roberts clerked for Judge 
Friendly, too.
    Mr. Macey. That is correct.
    Chairman Specter. Why didn't you then go ahead to clerk for 
Chief Justice Rehnquist and become Chief Justice?
    [Laughter.]
    Mr. Macey. I like academic life, and one clerkship year was 
plenty for me. I guess Chief Justice Roberts had a bigger 
appetite for clerking than I did.
    Chairman Specter. When you were on the Yale Law Journal, 
did you write a note or comment?
    Mr. Macey. Yes.
    Chairman Specter. What were the subjects?
    Mr. Macey. The Banking Act of 1933, the Glass-Steagall Act.
    Chairman Specter. Well, gentlemen, thank you very much for 
your participation here today. As a final question, I would 
like each of you to give an opinion, if you care to do so, on 
whether there is sufficient criminal law enforcement by the 
Department of Justice on insider trading or stock exchange 
manipulations generally on back-dating options or fraud in a 
variety of ways. Adequate or inadequate, Professor Cox? If you 
care to say.
    Mr. Cox. Well, I think I would like to see more prosecution 
just because I think that captures the attention of lots of 
people who need to have the message. And my sense is that we do 
not have a lot of prosecutions, and I will be very interested 
to see, with back-dating of stock options, whether there are 
criminal prosecutions there. I would certainly hope so.
    Chairman Specter. What is your view, Professor Coffee?
    Mr. Coffee. It has only been in the last couple of years 
that U.S. Attorneys outside of New York have been willing to 
give priority to white-collar criminal prosecutions for 
securities fraud. This is still a developing transition. I 
think that there are many districts where you do not see the 
U.S. Attorney giving any attention to white-collar crime, and 
insider trading can occur anyplace.
    So I think there is need for more enforcement, and there is 
an uneven pattern in the use of criminal sanctions across this 
country, as different U.S. Attorneys have different priorities.
    Chairman Specter. Well, it is something the Department of 
Justice, Main Justice can handle. They certainly should weigh 
in. They have some control there.
    Professor Macey?
    Mr. Macey. Just two quick points. One, I agree with Jack 
Coffee that there is strong evidence of regional asymmetries, 
biases. Some places are much more active--the Southern District 
of New York, for example--in criminal prosecutions.
    But, two, before saying that the Department of Justice or 
the SEC should do more, I would really like to see a few 
factual stories and saying this person did the following, 
engaged in the following trading, and shouldn't that person 
have been prosecuted. Otherwise, I think it is too easy to say, 
gee, I am a good guy, we should be doing a lot more of this. 
And, you know, I think that to the extent that we can identify 
tangible examples of such misconduct, then I would look at 
those on a case-by-case basis.
    Chairman Specter. Mr. Thomas, does the Crown bring enough 
prosecutions?
    Mr. Thomas. Does the Crown bring enough prosecutions?
    Chairman Specter. Well, yes.
    Mr. Thomas. I doubt it. But Professor Laura Beny of the 
University of Michigan Law School has done a study insider 
trading law enforcements around the world, and her thesis is 
that the stronger the restrictions are and the more they are 
enforced, the more liquid and fair the markets become. I think 
that is a worthy goal.
    Chairman Specter. And does Canada bring enough criminal 
prosecutions?
    Mr. Thomas. I doubt it.
    Chairman Specter. Would you care to venture an opinion on 
the United States' criminal prosecutions adequacy?
    Mr. Thomas. I would prefer not to, Senator.
    Chairman Specter. Well, you are not under subpoena so you 
do not have to.
    [Laughter.]
    Chairman Specter. Mr. Marchman, enough prosecutions under 
the criminal statutes in the United States?
    Mr. Marchman. Chairman Specter, I can only comment from the 
interaction that I have been fortunate to have with the U.S. 
Attorney's Office in the Southern District, and they have a 
very vigorous and active program. So from that vantage point, I 
do believe it is adequate.
    Chairman Specter. Without objection, we will admit into the 
record a statement from Senator Grassley.
    I am going to tell my colleagues what a good hearing they 
missed today, and I think next time I am not going to invite 
anybody. I like the current make-up of the panel.
    [Laughter.]
    Chairman Specter. I maintain a record of adhering strictly 
to time limits, and each questioner has 5 minutes, and I am now 
in excess of 20 minutes, 15 minutes over my time, which is a 
first for me. I am prompted to think about one-person grand 
juries, and we may adopt that policy for this Committee.
    [Whereupon, at 11:15 a.m., the Committee was adjourned.]
    Questions and answers and submissions for the record 
follow.]

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