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10/19/2017
10:30 AM
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What's Next after the SEC 'Insider Trading' Breach?

Last month's hack of the Securities and Exchange Commission may prove to be the most high-profile corporate gatekeeper attack to date. But it definitely won't be the last.

Traditionally, insider traders followed the Gordon Gekko roadmap to acquiring illicit information, gaining material non-public corporate information from in-person physical sources, such as company executives or company lawyers and accountants, or even from the printer a company used to print deal documents. As the business world has changed, however, insider traders have updated their techniques and taken advantage of the concentration of digital information to obtain a bounty of non-public information that their analog counterparts in the 1980s could never have imagined.

Today, hackers — many of whom are either traders themselves or sell stolen information — are focusing their data intrusion efforts on corporate gatekeepers such as law firms, newswire services, and other third parties that often possess confidential corporate information for numerous publicly traded companies. Predictably, this trend of "insider trading hacks" has continued, reaching its logical extension last month when the Securities and Exchange Commission (SEC) announced that it had been the victim of a significant breach and was investigating whether this intrusion "resulted in access to non-public information [that] may have provided the basis for illicit gain through trading."

Though the SEC breach will likely prove to be the most high-profile insider trading hack to date, it certainly was not the first. Recent history shows that hackers have been increasingly targeting corporate gatekeepers — entities storing material non-public information for a number of publicly traded companies. For instance, from 2010 through 2014, a group of hackers systematically targeted three newswire services that helped numerous publicly traded companies distribute information about earnings and other corporate transactions.

These hackers collaborated to steal not-yet-published press releases containing material non-public information about hundreds of publicly traded companies. They then passed the information on to a group of more than 30 domestic and international traders who used the valuable intel to trade in the window of time between when the companies uploaded the information to the newswire service and the distribution service published the press releases. Over five years, the hackers stole more than 150,000 news releases prepared by publicly traded companies and used this information to make more than $100 million in illegal trading profits.

The SEC and Department of Justice eventually uncovered the scheme. On August 11, 2015, the SEC charged 32 defendants with securities fraud and froze numerous trading accounts in the United States and abroad. To date, the SEC has settled with 13 defendants and has obtained judgments totaling more than $52 million. Meanwhile, the US Attorney's offices for the District of New Jersey and Eastern District of New York separately brought charges against nine individuals involved in the scheme. All but one criminal defendant has pleaded guilty.

Law firms are another type of corporate gatekeeper targeted for insider-trading hacks. In December 2016, the SEC and the US Attorney's Office for the Southern District of New York announced charges against Iat Hong, Bo Zheng, and Chin Hung, all citizens of China. The government alleged that over a period of 11 months, the three men hacked into the servers of two elite New York City-based law firms — reportedly Cravath, Swaine & Moore and Weil, Gotshal & Manges — and stole substantial quantities of sensitive, non-public information involving potential mergers or acquisitions of the firms' public company clients, which include some of the largest and most well-known companies in the world. The three allegedly then used this information to trade ahead of public merger announcements, generating nearly $3 million in trading profits.

With hackers and traders targeting these critical gatekeepers, the SEC itself, the biggest gatekeeper of all, was an obvious target. On September 20, 2017, the SEC announced that in 2016, hackers exploited a weakness to gain access to the SEC's Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system, which is used by securities industry actors to file more than 1.7 million documents annually with the agency. To date, the SEC either does not know or is not disclosing the amount of information stolen by the hackers, though it has admitted that it is investigating whether the hackers used this information to make illicit trades.

It is also unclear whether the hacked information from EDGAR could be used to make illicit trades because there may not be the same window of time between acquisition of the information and full market disclosure, as in the newswire and law firm hacks described above. But it is clear that the SEC cannot let its guard down. In recent years, securities fraudsters have exploited EDGAR by, for instance, filing fake merger documents for Avon, Rocky Mountain Chocolate, and Integrated Device Technology to create and trade on short-term stock price increases.

As we head into this new era of insider-trading hacks, there remain unanswered questions about who may be liable when data breaches occur. The SEC has already intimated that it will use enforcement actions against securities industry actors who fail to protect investors' information, and public companies that fail to make timely and adequate disclosures about data breaches. It is possible that public companies could also face scrutiny from the SEC (and potentially shareholders) if they fail to take prudent steps to protect their data, even in the hands of third parties. Third-party gatekeepers may also be subject to liability where they acted negligently or recklessly.

Insider-trading hacks are also costly from a resource and public relations perspective; the SEC hack is another large, blinking warning sign for publicly traded companies. These companies must be aware that domestic and international hackers are targeting this valuable and confidential corporate information. As the cases discussed in this article make clear, public companies cannot simply build their own cyber defenses. They must ensure that the third parties they work with every day — law firms, accounting firms, consultant groups, newswire services, and others — are also up to the task of protecting this valuable information by taking proactive steps such as limiting the digital data trail, requiring third parties to use code words when communicating internally about corporate transactions, or requiring newswire services to issue press releases immediately after a company uploads a document to reduce the opportunity to engage in illicit trading.

The SEC hack was the latest gatekeeper insider-trading hack, but it will not be the last.

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David L. Axelrod, Partner, Ballard SpahrBallard Spahr partner David L. Axelrod is a former supervisory trial counsel at the U.S. Securities and Exchange Commission's (SEC) Philadelphia Regional Office. At the SEC, he directed all aspects of litigation, leading complex, ... View Full Bio
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