Insider Trading Archives - That's Not Market

Insider Trading – A Contrarian Take From CNBC

Should insider trading be illegal?

John Carney at CNBC posted an interesting article posing the question about whether insider trading should be a crime. In light of Michael Steinberg’s conviction for securities fraud due to his activities at SAC Capital, Carney asks who were the victims and what was the harm?

SAC Capital has been under fire for alleged insider trading. One trader was recently convicted.

In Steinberg’s case, part of the facts involved trading on early access to Dell’s earnings. Why is this a big deal?

But it’s hard to see how Steinberg’s acquisition of Dell’s earnings a day early hurt the company in any way. His trading may or may not have moved the stock price a bit but the actual release of the earnings moved it more.

Does Dell have an intellectual property right in its earnings? We don’t really recognize all corporate secrets or corporate information as protected intellectual property, much less property whose unauthorized use gives rise to criminal sanctions. There are certain categories—trade secrets, trademarks, copyrights—that are protected. But earnings aren’t trade secrets. Dell released them the very next day.

It is important to remember that Steinberg’s trading did not involve face-to-face arm’s length transactions with the counterparties. They were nameless and faceless people who never met Steinberg, knew Steinberg was in the market to buy or sell Dell shares or placed their orders with any knowledge of Steinberg and what he may have known or not known, disclosed or not disclosed. As Carney points out, regardless of what Steinberg did, each one of them would have acted in the exact same way.

What about the people who bought the shares of Dell on the day Steinberg was selling? Again, they would have been in exactly the same position regardless of whether Steinberg traded or not. Arguably, they were able to buy at a slightly better price because Steinberg’s trades would have pushed the stock slightly in the direction the stock actually moved when the earnings became public.

You’ll sometimes hear it said that the people on the other side of Steinberg’s trades were harmed because they wouldn’t have bought the shares if they had the same information he had. But that’s precisely the wrong test. The question isn’t what would they have done if they also had inside information. It’s what would they have done if Steinberg hadn’t had his information? The answer is: exactly what they did anyway. Steinberg’s possession of inside information didn’t affect them one bit.

Carney comes to a similar conclusion that I have always believed. This type of insider trading is not about protecting people. It is about (1) punishing success and profit [Ed. This is more me than Carney], and (2) a gut reaction that this behavior is wrong and should be punished. It is about addressing moral qualms, not about stopping harm.

In this respect, Carney compares this type of insider trading to blue laws.

In other words, our ban on insider trading isn’t really about protecting investors or making markets function better. It’s about expressing a moral view, much like we do with Blue Laws that ban the sale of alcohol on Sundays.

Here it is important to note that there is a school of thought that suggests insider trading should be encouraged since it makes the market more efficient by sending information about the insiders’ views of the company into the market. There are entire schools of trading based on insider transactions and Section 16 filings.

And here is where he loses me:

There’s nothing necessarily wrong with encoding morality into securities laws.

Yes, there is. We see it everyday in garbage like the ridiculous executive compensation disclosure now imposed on companies. We see it in required environmental disclosure, cybersecurity disclosure and blood minerals disclosure that probably don’t apply to most companies.

We see it every time some activist jumps up to demand that the SEC impose disclosure requirements on all companies that comport with the activists’ agenda, regardless of whether it furthers the mission of the disclosure regime for SEC reporting companies: Do investors have the information they need to make an informed investment decision? End of story.

If those issues are material to the disclosing company, they will have to be discussed. If not, this is nothing more than an extra tax (by way of time and money spent to assess and produce this nonsense) on reporting companies to pay for the whims of some vocal activists, be they outside agitators or Congressmen (who were (and probably still are) able to trade on inside information illegally in a way that would send you or I to prison).

Insider Trading – How Much Of A Factor Must The Material Non-Public Information Play In The Investment Decision?

Spoiler alert: Not much.

Link: United States v. Raj Rajaratnam

Raj Rajaratnam, former billionaire hedge fund manager, appealed his notorious insider trading conviction. If you recall, he was the founder of the Galleon Group hedge funds who received insider information from contacts at McKinsey, Intel, Goldman Sachs and other hedge funds.

Among the issues raised at trial was whether the fraud counts should be vacated because the court told the jury that it could convict Rajaratnam if the “material non-public information given to the defendant was a factor, however, small, in the defendant’s decision to purchase or sell stock. He claimed that this allowed to jury to convict without a causal connection between the inside information and the trade.

The court noted that under the misappropriation theory of insider trading, a person commits fraud “in connection with” a securities transaction in violation of Rule 10b-5 when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information. The Supreme Court in the O’Hagan case enshrined/created this theory to “protect the integrity of the securities markets against abuses by ‘outsiders’ to a corporation” who have access to confidential information that will affect the corporation’s security price but otherwise owe no duty to the corporation’s shareholders.

The court in this case endorsed the “knowing possession” standard* that is consistent with the cardinal rule of insider trading:

If you have a fiduciary or other duty to the company and hold material non-public information, disclose or abstain.

On this basis, the appeals court said that the district court’s instruction was more favorable to Rajaratnam than the legal standard. Rather than merely be in possession of the information, the jury had to find that he used it in some manner to find him guilty of insider trading. As a result, the jury instruction satisfied the “knowing possession” standard.

*The knowing possession standard became the law in the 2nd Circuit in United States v. Teicher and United States v. Royer.

While Feds Increase Insider Trading Enforcement, Other Feds Increase Insider Trading Activity, Part 2

In this previous post, I discussed the federal government’s newly aggressive enforcement of insider trading laws while federal government employees seemed to be providing tips to investors about pending government decisions that impact share prices of health care companies. In the corporate world, this is known as “tipping” material non-public information and has severe consequences. In the government world, “Congress and the executive branch — along with the reporters and lobbyists who track them — are accustomed to a relatively unfettered exchange of information, compared with the more regulated environment on Wall Street.”

This reminded me that in April 2013, Congress passed a bill striking down a key provision of the federal law prohibiting insider trading by members of Congress and their staff and high-level executive branch employees. It is amazing that this was not the law until 2012. However, the STOCK Act provided that securities transactions would be reported within 45 days and filed electronically so people could actually see it.

Congress voted to kill the broad disclosure provisions without hearings or public notice due to laughable national security and personal safety concerns. According to a report on the matter:

“Virtually all the cybersecurity, national security, and law enforcement experts interviewed during this study noted that making this information available in this fashion fundamentally transforms the ability (and the likelihood) of others — individuals, organizations, nation-states — to exploit that information for criminal, intelligence, and other purposes.”

In addition, several groups representing the interests of federal employees have criticized the law.

Let us not forget that directors, officers and holders of 10% or more of a public company must disclose transactions in that company’s stock:

Publicly on EDGAR, and
Within 2 business days of the transaction.

I guess those people don’t have the same security concerns as federal employees.

60 Minutes confronts John Boehner generally about insider trading rules for federal employees (at 2:08) and Nancy Pelosi specifically about her participation in the Visa IPO (at 3:00 and Pelosi’s hilarious response at 3:15).

While Feds Increase Insider Trading Enforcement, Other Feds Increase Insider Trading Activity, Part 1

There has been much ink spilled about the SEC’s recent aggressive moves on insider trading allegations, from Rajat Gupta and Goldman Sachs to its pursuit of Steven Cohen of SAC Capital fame to calls for scrutiny of Rule 10b5-1 Plans.

However, lost in the shuffle to punish people who made more money than other people in the stock market is the recent news about federal employees engaging in conduct that is far worse.

The Washington Post (who hasn’t objected to the behavior of federal employees since January 20, 2009) today noted that hundreds of federal employees were told of important Medicare decisions weeks in advance of public release, which was also just before trading of shares in firms impacted by the decision spiked. The public shouldn’t be alarmed because “agency officials said they take care to safeguard information and carefully vet which employees have access to it. Employees are educated regularly about he need for confidentiality and CMS documents are often stamped with warnings about early disclosure.”

Sen. Charles Grassley said that this should sound an alarm and should result in better controls to avoid unfair access to information.

Great. More rules that won’t be followed by people who will not be punished for engaging in behavior that will cause the government to destroy the lives of non-public sector employees. So the answer is to talk about more rules for making illegal behavior super-illegal. That should solve everything.

Exchange Offer Qualifies for Exemption From SEC Blackout Period Rules

In a no-action letter, the SEC stated its view that officers and directors may participate in an exchange offer during a blackout period. Pfizer’s request for SEC interpretive relief is here.

Background

Pfizer owns a bunch of shares of Class B supervoting common stock of Zoetis, which recently went public. The companies expect to convert these shares into plain vanilla shares of Class A common stock. Pfizer wants to give its shareholders the chance to own Zoetis shares through an exchange offer without forcing them to take the Zoetis shares, such as through a spin-off. To get the Zoetis shares, the shareholder would have to affirmatively participate in the exchange offer by giving up a certain number of Pfizer shares.

The Problem

Regulation BTR prohibits an officer or director from certain transactions with the company’s stock during a blackout period, a period when the ability to sell to engage in transactions in an individual account plan is suspended by the company or a fiduciary of the plan. Pfizer said it looks like the exchange offer will run headlong into a blackout period. This would prevent Pfizer officers and directors from participating.

Exemptions from Reg BTR include M&A deals and divestitures, but exchange offers are not necessarily included. Pfizer thinks they should be saying that Reg BTR purpose to equalize the treatment of corporate executives and rank-and-file employees and align the interests of directors and executive officers would be served through a transaction conducted pursuant to the SEC’s tender offer rules.

The Result

The SEC agreed, noting that:

the exchange offer is solely for the purpose of divesting Zoetis from Pfizer;
the exchange offer is subject to, and will comply with, Exchange Act Rule 13e-4 or Regulation 14D under the Exchange Act;
a suspension of activity in the plan participants’ accounts (as communicated by the administrators to Pfizer) is imposed by the administrators to enable them to allow participants and beneficiaries of the plans to elect to participate in the exchange offer while maintaining an accurate accounting of the account balances of such participants and beneficiaries; and
Pfizer directors and executive officers would continue to be permitted to tender into the exchange offer during a blackout period, but would not otherwise be permitted to directly or indirectly purchase, sell or otherwise acquire or transfer Pfizer common stock during the blackout period if the shares involved were or would be acquired in connection with service or employment as a director or executive officer.

Sarbanes-Oxley Lowered Standard to Remove Someone From Acting as an Officer or Director of a Public Company, Court Says

Then explains the standards, which really aren’t standards.

The Set-Up

Bankosky was a senior official of a pharmaceutical company. He had inside information on potential deals, and he traded on them.

Aside: As a music student in college, I told my primary professor that I was quitting my music degree and changing my major to pursue a law degree. He replied, “It doesn’t surprise me that people sell out, but how cheaply they do.”

How is this relevant? Bankosky’s illicit trades yielded $63,000.

Among other sanctions, the SEC moved to bar Bankosky permanently from serving as an officer or director of a public company. The court said, “Yep. Sounds good to me.”*

The Arguments

On appeal, the court noted the non-exclusive factors from U.S. v. Patel useful in making an assessment of the offender’s fitness to serve as an officer or director of a public company based on Exchange Act Section 21(d)(2). However, this was before Sarbanes-Oxley, which lowered the standard from “substantial unfitness” to “unfitness.” Results: Fireworks.

Does this mean that Patel no longer applies, as the SEC asked as it was looking for what it considers a more stringent standard? Nope. The court said:

“Moreover, the Patel factors are neither mandatory nor exclusive; a district court may determine that some of those factors are inapplicable in a particular case and it may take other relevant factors into account as it exercises its “substantial discretion” in deciding whether to impose the bar and, if so, the duration, so long as any bar imposed is accompanied with some indication of the factual support for each factor that is relied upon.”

In other words, the court may or may not look at a standard that may or may not apply based on something or other that may have six or seven elements that are probably substantially similar in substance. The court has a lot of discretion when determining what factors to consider in barring someone from acting as a public company director or officer.

SEC v. Bankosky

*Not a direct quote.

Can you “profit” from sale of securities you don’t own, can’t vote or can’t sell?

You would think that the answer would be, “No, of course not. What kind of idiot would believe such a thing?”

And the U.S. Court of Appeals for the 2^nd Circuit would agree with you.

This case deals with additional fallout from the recent Goldman Sachs insider trading scandal, in this case involving short swing trading under Section 16 of the 34 Act. Interesting already, right?

The plaintiffs in the case argued that because the defendant, an insider of Goldman Sachs, provided insider trading tips for money to a fund manager about Goldman Sachs while owning a stake in the fund that was trading in Goldman Sachs. Get it?

The court did, and said:

Getting paid for insider tips is not the same as realizing profits for purpose of Section 16.
Knowing and intending for the tips to be used for insider trading is not the same as controlling the investment decisions over the shares of the fund.
A pecuniary benefit from another person’s trading is not the same as a pecuniary interest for Section 16 purposes as business dealings do not establish beneficial ownership.