Category: Insider Trading

Tipping and Insider trading

I didn’t follow the trial of former Goldman Sachs Group Inc. director Rajat Gupta. It seemed like a fairly straight-forward case under the current jurisprudence for insider trading. He possessed material, non-public information. He had that information because he sat on the board of directors of Goldman Sachs. Because he was a board member he had a duty not to disclose the information. He disclosed the information in violation of that duty.

The interesting part is that Gupta did not receive a direct financial benefit from tipping the information. He did not trade on the securities and did not get a piece of the financial reward gained by the person he gave the information to. The government put some indirect benefit into evidence and that was enough.

The easy lesson is to make sure that your policies and training point out that tipping material, non-public information can have the same consequences as trading on that information.

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Image of Rajat Gupta by Sebastian Derungs

You Scratch My Back, I’ll Scratch Yours

Back scratcher

The Securities and Exchange Commission charged Robert W. Kwok, who was Yahoo’s senior director of business management, and Reema D. Shah who was a former mutual fund manager at a subsidiary of Ameriprise, with insider trading on confidential information about a material business combination partnership between Yahoo and Microsoft Corporation. The SEC alleges that Kwok breached his duty to the company when he told Shah in July 2009 that a deal between Yahoo and Microsoft would be announced soon. The SEC further alleges that a year earlier, the roles were reversed. Shah tipped Kwok with material nonpublic information about an impending acquisition announcement between two other companies. This seems to be a classic case of executives trading inside information for personal gain.

Kwok and Shah pled guilty and acknowledged the facts in the complaint. Not the typical “neither confirm nor deny” settlement of the SEC’s charges. Financial penalties and disgorgement will be determined by the court at a later date. Under the settlements, Shah will be permanently barred from the securities industry and Kwok will be permanently barred from serving as an officer or director of a public company.

In July 2009, Kwok tipped Shah that an internet search engine partnership agreement between Yahoo and Microsoft would be announced soon. Shah was a portfolio manager for multiple mutual funds and hedge funds at RiverSource. Based on the inside information she received from Kwok, Shah caused the funds to purchase approximately 700,000 shares of Yahoo. Two weeks later, she sold the shares for a profit of almost $400,000.

Previously, in April 2008, Shah tipped Kwok material, nonpublic information she had received concerning an upcoming acquisition of Mold flow Corp. by Autodesk, Inc. Based on that inside information, Kwok purchased 1,500 shares of Mold flow in a personal account. After the acquisition was publicly announced on May 1,2008, Kwok sold those shares, realizing profits of $4,754.

It looks Kwok got the better end of the deal financially. Although she ran the benefit through her funds, instead of through a personal account. At least she respected her firm’s policy on personal trading.

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Image of Man scratching back with a Backscratcher by Archos

Insider Trading and Restricted Lists

These are my notes from the “Insider trading and restricted lists” session at the Private Fund Compliance Forum 2012.

Two items affect insider trading: federal securities law (10b5) and a firm’s code of ethics under the Investment Advisers Act.

The panelists do not circulate a restricted list. The SEC will ask for the restricted list and ask employees if they know where the restricted list.

Given your firm’s profile, you can tailor the restrictions to the profile. The SEC does not have specific limitations.

It is important to use the insider trading list to explain why companies end up on the restricted list.

It’s also important to get companies back off the restricted list. If you signed a Non-Disclosure Agreement you need to at least respect the term of the NDA. If you lose the auction, then wait for the deal to be announced. Review the list on a regular basis to make sure it stays up to date.

What about extending the code beyond employees? Most of the panelists extend the restrictions to any relative living in the household.

If you are using paper statements, mark on the statement that you reviewed the statement. Date and initial works. Also put a check mark next to the trades shown on the statement indicating your review.

The panel also spent a fair amount of time discussing expert networks. Paying any individual for information could make them an expert network. Keep in mind that the new STOCK Act that prohibits Congressional trading also creates a duty of confidentiality when it comes to Congressional actions and makes more legislative information gathering subject to insider trading limitations.

Policies need to be reasonable designed to prevent violations of the federal securities laws.

At a minimum you need to do what you say you will do, even if that may not be enough. Document decisions and discussions about trading decisions.

Smells Like Insider Trading

Apparently Blue Horseshoe loved Zhongpin Inc., a China-based pork processor whose shares trade in the U.S. The SEC jumped on the accounts of six Chinese citizens and a British Virgin Islands entity. (Apparently the Chinese prefer to use British Virgin Islands entities. It’s the second largest investor in China after Hong Kong.) The facts stink of insider trading, but I would wager the SEC will lose this one.

According to the SEC’s complaint, the seven defendants bought substantial quantities of common stock and call options in Zhongpin between March 14 and March 26. Zhongpin’s stock price jumped 21.8% on March 27 when the company publicly announced a management buyout.

The SEC alleges that the purchases were inconsistent with the defendants’ financial situations and prior investment behavior.  In particular:

  • The defendants’ trades made up a significant portion of the trading in Zhongpin between March 14 and March 26, over 41% of the common stock trading in this period.
  • Only one of the defendants had traded in Zhongpin before March 14.
  • The purchases of Zhongpin securities equaled or exceeded their stated annual income.
  • Yang identified himself to his broker as an accountant in
  • Each of the defendants placed at least some of their trades from computer networks and hardware that other defendants also used to place trades.

“The defendants in this action – all with seemingly limited resources – suddenly and inexplicably purchased more than $20 million in Zhongpin securities just before an important public announcement,” said Merri Jo Gillette, Director of the SEC’s Chicago Regional Office. “The SEC’s swift action to secure a judicial freeze order prevented millions of dollars from moving offshore.”

At least temporarily.

What’s missing from the insider trading complaint is the insider. The charge is for trading while they were in possession of material, non-public information. The SEC needs to find that information and its source. That’s going to be very hard when the defendants all live out of the country.

We saw this recently in the SEC case against Luis Martin Caro Sanchez for trading in shares of Potash. The SEC failed to find the insider. No inside information, no insider trading.

The one hope for the SEC is that one of the defendants was employed at Baron Capital, Inc., a registered investment adviser. If Siming Yang was foolish enough to document the inside information in one of the Baron systems, the SEC may be able to find some evidence.  Yang’s position was terminated at Baron on March 30. I assume for violating the firm’s policy on personal security trading.

Perhaps the SEC is hoping the defendants will merely default. Some might. But Yang made over $7.6 million on the trades. I assume he will invest some cash in getting a lawyer and fighting the charge, leaving it up to the SEC to find the source of the inside information.  Unfortunately, the SEC will also be up against a language issue, given that the communication was likely in Chinese.

The SEC needs to try and hope the smoking gun is lying around. The trades stink of the insider trading. Perhaps the SEC can find a bigger case of insider trading in the company’s shares. You also have to wonder where Yang got $20 million to make the trades.

I have my doubts that the SEC can win this case. But you can’t win if you don’t play. The SEC can’t win if it just lets the cash go overseas.

As with the Sanchez case, Interactive Brokers held the accounts for three of the seven defendants.  It sounds like its compliance group is spotting suspicious trades, holding the cash before it goes overseas, and alerting the SEC.

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Informants and Insider Trading

The cooperation of a single Wall Street trader has led directly led to the prosecution of 10 individuals. That makes David Slaine one of the most productive informants in the history of US financial crimes.

In a sentencing memorandum (.pdf), the US Attorney’s office states that “Slaine’s cooperation has been nothing short of extraordinary” and “truly exceptional”. It lays out the series of of prominent insider trading cases that came from his information: Rajaratnam, Goffer, Kimelman, Drimal and others.

This all came from Slaine’s actions back in 2002. According to the information filed by the prosecutors, Slaine starting getting tips from a UBS analyst. The analyst was leaking information in whether UBS was going to change its securities recommendations. Slaine was then trading ahead of the upgrades and downgrades.

To reduce his sentence, Slaine agreed to help prosecutors and helped unravel a huge ring of traders using inside information. One of the startling aspects of the cases was the widespread use of wiretaps. This was a technique not often seen in insider trading cases.

1:09-cr-01222-RJS USA v. Slaine in the Southern District of NY

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When Red Flags Are Not Enough

Purchase out of the money call options set to expire in two weeks, do not have any activity on that stock before, exclusively use options when you have rarely traded options in the account before, purchase those options just before the announcement of the company’s acquisition, and then quickly try to move the money off-shore.

Those red flags were enough for the Director of Compliance Operations at Interactive Brokers to put a hold on the account of Luis Martin Caro Sanchez. After reviewing the trades, the information was forwarded to the Securities and Exchange Commission for investigation. It reeked of insider trading, so the SEC obtained an immediate freeze on the account and charged Sanchez with insider trading.

Sanchez had bought several hundred of the risky Potash call options on August 12 and 13, 2010. A week later, the acquisition was announced causing a dramatic rise in the price of Potash stock. Sanchez managed to reap nearly $500,000 in profits at a handsome 1046% return. The actions seemed to be so blatant that I labeled it the perfect way to get caught insider trading. Of course one of the key elements of insider trading is having access to inside information.

Suspicious trades alone are not enough. In order for the SEC to win an insider trading case against a company outsider, the SEC must prove that an outsider made his trades based on material nonpublic information given to him by an insider. The SEC failed to find a connection.

Sanchez claimed he made became interested in Potash based on a technical signal “when he observed a crossover signal in the exponential moving average for the price of Potash stock.” He made the buy after

“there was a consolidation of the impulse of the cross of mediums, average, and that consolidation is known as pull-back, and consists of a slight drop in the price after a push for a higher price. And there was a hole that was filled – a gap that was produced during the increase – the previous increase.”

In fairness to Sanchez, he is from Spain and the interview was conducted without a certified, neutral translator. But to me, his explanation is just a bunch of mumbo-jumbo spewing out to make the SEC think he is a trading expert.

As much as the SEC tried, they could not link Sanchez to an insider. They could not even link him to his co-defendant, Juan Jose Fernandez Garcia. Both Garcia and Sanchez lived in Madrid and both made suspicious trades on Potash stock using accounts at Interactive Brokers. That was the only connection.

Garcia also happened to work at Banco Santander, who was an adviser to BHP in connection with its purchase of Potash. Garcia quickly settled with the SEC and forfeited his $576,032.00 in trading profits.

Sanchez was willing to fight for his windfall and challenged the SEC to prove he had inside knowledge. The SEC failed and Sanchez gets to keep his cash.

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Red Flags is Rutger van Waveren

Private Company Shares, Valuation, and Employee Stock Repurchases

There has always been a theoretical discussion that there could be insider trading on private company shares. I have not seen the theory tested in court. However, a recent enforcement case by the SEC gets close to the theory. The case involves a company re-purchasing shares from employees at a discounted price.

The SEC makes the bold charge that from November 2006 through April 2009, Stiefel Laboratories Inc. defrauded shareholders out of more than $110 million, at the direction of Defendant Charles W. Stiefel, its then chairman and CEO. For example, in late 2008 and early 2009 while purchasing shares for less than $16,500 a share, Steifel did not inform them that the company was in the midst of negotiating the sale at a price of more than $68,000 per share.

The Stiefel family founded Stiefel Labs in 1847 and began to develop some of the world’s first medicated soaps and dermatology products in 1946. The Company has been privately-held, and since 1952 the Stiefel family has been the majority shareholder. Beginning in approximately 1975, Stiefel Labs’ employees began acquiring Stiefel Labs common stock as part of a defined contribution plan. All Stiefel Labs employees located in the United States became participants in the Plan after their first year of employment. Each year, Stiefel Labs made discretionary contributions to the Plan in the form of Stiefel Labs stock or cash. From 1975 to 2008, the Company made contributions of stock, but in 2008, for the first time in its history, the Company contributed only cash. At the time the company was the world’s largest private manufacturer of dermatology products. Charles W. Stiefel also served as the trustee of the plan.

Each year, the company would engage a third-party accountant to determine the price the company would pay shareholders for stock buy backs. According to the SEC complaint, this is where the trouble began. The SEC alleges that accountant used a flawed methodology and was not qualified to perform valuations. The SEC also alleges that Stiefel failed to disclose crucial information about offers and valuations the company received from investment firms. The valuation was only conducted once year.

According to the SEC complaint, the real trouble began in October 2008 when the company was at risk of violating some debt covenants. A part of the austerity measures, the company started buying back stock from current employees, not just from former employees. It’s also around this time that the company started seriously entertaining offers to purchase the company or at least a big chunk of the company.

From December 2008 to April 2009, while seeking bids for its sale the company purchased stock from employees at a price of $16,469 per share. An April 20, 2009 the company announced its sale to Glaxo and closed on July 22, 2009 resulting in a price of $68,131 for shares held in the retirement plan.

Assuming the facts in the SEC complaint are correct, I have some sympathy for the Stiefel. The negotiations with buyers had non-disclosure provisions that likely prevented them from disclosing the purchase price. On the other hand, some of the messages disclosed in the complaint indicate a grab for cash.

This does show that the SEC’s anti-fraud rule in 10b-5 of the Exchange Act can apply to private company transactions. That would prevent a party with material, non-public information from buying or selling those securities. In this case the private company had the information and the employees in the plan did not. Reliance on a third-party valuation is not enough.

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The Leaves Say You Will Go Free

The insider trading case against Raj Rajaratnam seemed very tight. The prosecutors had him on tape discussing the inside information from wiretaps.
So why did he fight his insider trading charges and get a lesser sentence than the 11 years that was handed down last week?

Ola Leaves.

Suketu Mehta in the Daily Beast discussed the rational and irrational explanations.

A Sri Lankan diplomat close to Rajaratnam told me that she’d met him shortly before he was convicted. “He’d gone to the ola-leaf readers. They told him he’d be acquitted.”

Not tea leaves. Ola leaves.

Three thousand years ago, seven rishis (sages) in India set themselves a mission. They would write down the fate of as many people in the world as they could.

These forecasts are said to have been originally written on goatskins, later transcribed onto copper plaques and then onto ola leaves.

Maybe Rajaratnam’s inevitable appeal will mean the ola leaves were right.

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I Wonder if We Will Laugh at his Phone When He Gets Out?

You could watch the movie Wall Street and many things may still ring true. Of course its the 1980s, so the clothes and the women’s hair stick out. But the icon is the big brick cell phone. It was huge and expensive for its time. And all it did was makes phone calls. It was enough of an iconic image that it carried over to the sequel, with the prison guard handing Gecko back his belongings one by one, including the big cell phone.

With Raj Rajaratnam receiving the longest prison sentence ever for insider trading, I wonder which of his personal belongings will be the most iconic in next decade? Rajaratnam 11 year sentence was short of the 19 to 24 years that prosecutors sought. If you look to the movie for inspiration, Gordon Gecko was released from prison after serving eight years.

Of course his phone will be horribly out of date, assuming we still use phones and don’t have chips implanted or whatever the next Steve Jobs-like innovator thinks we should have in our pocket.

Insider trading will still be something that people go to prison for. Not lots of people. Just a few criminals who push too far and whose actions are too nefarious. Plenty more get hefty fines and have to return their ill-gotten gains.

It’s easy to look at these criminals for causing the 2008 financial crisis and the financial mess. Many people are clamoring for more Wall Street heads on pikes. However, insider trading did not cause the 2008 financial crisis.

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More on the Massachusetts Regulations on Expert Networks

The Massachusetts Secretary of State issued a new regulation that would affect the ability of investment advisors to use expert networks. This was a direct result of Risk Reward Capital Management being based in Massachusetts. Since the management company was registered as an investment adviser in Massachusetts they are subject to examination and enforcement by the Secretary of the Commonwealth.

The regulation highlights the continuing split between the state-lvel and federal-level of regulation of investment advisers. Dodd-Frank only widened that split by kicking thousands of advisers out of registration with the Securities and Exchange Commission and over to the various states.

Risk Reward Capital Management had just under $25 million under management. Dodd-Frank raised that level.

To clarify its new regulation, Massachusetts issued this policy statement:

The Securities Division has received several questions regarding the applicability of the expert or matching services regulation to investment advisers that are under the authority of the Securities and Exchange Commission. This notice is to restate and clarify information included in the Division’s adopting release for the regulations adopted on August 19, 2011.

The expert or matching services regulation will not be deemed applicable to investment advisers subject to Securities and Exchange Commission authority, consistent with the requirements of Section 203A(b) of the Investment Advisers Act of 1940. The Securities Division retains its authority to take enforcement action against an investment adviser or any person associated with an investment adviser with respect to fraud or deceit, consistent with Section 203A(b)(2) of the Investment.

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