Category: Insider Trading

Pillow Talk at Playboy Leads to Insider Trading

playboy logo by Kaptain Kobold

The headline was too hard to ignore. I suppose there must be some compliance lessons to be learned. But first, the facts:

William A. Marovitz, who is married to former Playboy Enterprises Inc. Chief Executive Officer Christie Hefner, made $100,952 on the trades, according to an SEC complaint. The SEC alleges that on five occasions between 2004 and 2009, Marovitz traded based on confidential information that he misappropriated from Hefner, in his own brokerage accounts ahead of public news announcements. In November 2009, Marovitz learned about Iconix’s potential acquisition of Playboy and used that confidential information to buy Playboy stock in advance of a public announcement of a potential merger, which caused a 42% increase in Playboy’s stock price. When Iconix ended its efforts to acquire Playboy in December 2009, Marovitz sold Playboy stock before the news became public, resulting in a 10% decrease in Playboy’s stock price.

The case illustrates a tough area for compliance officers: family securities trading. According to the complaint:

Hefner also asked Playboy’s general counsel, Howard Shapiro, to talk to Marovitz about the implications of any trading by him in Playboy stock. Shapiro complied with Hefner’s request by faxing a memorandum to Marovitz’s home and office on September 4, 1998 warning Marovitz of the “serious implications” of Marovitz trading in Playboy stock. Among other things, Shapiro warned Marovitz that “all SEC rules governing Christie’s sale or purchase of stock are equally applicable to you, particularly the rules governing insider trading” and “your purchase is imputed to Christie.” Shapiro requested that Marovitz consult with him before executing any trades in Playboy stock. Marovitz never contacted Shapiro to discuss any of his trades in Playboy.

There are two main reasons for clearing trades. One is to avoid insider trading. The other is to avoid the appearance of insider trading. The trade could be done because he learned of material, non-public information or could be done without having obtained it. (Either way, it looks bad.)

On the adviser side, with the pre-clearance you could be alerted not to trade because of something you are not aware of. If the material, non-public information is in the building your trade is automatically going to be suspicious.

With a public company, like Playboy, there are generally narrow windows of trading to avoid the same set of problems.

The rules are in place to prevent you from accidentally having the appearance of trading on material, non-public information.

The other item in the case that caught my eye was the origination of the case. It came during a SEC examination of a broker-dealer, with assistance of the Internal Revenue Service. It sounds like the different parts of the federal regulators are doing a better job of sharing information.

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Image is by Kaptain Kobold

Who Caught Them? Compliance or the SEC?

The SEC announced they had obtained an emergency freeze against three Swiss-based traders under an allegation of insider trading. The SEC claims that Compania International Financiera S.A., Coudree Capital Gestion S.A., and Chartwell Asset Management Services purchased more than a million common shares of Arch Chemicals just prior to the announcement that it was going to be purchased by Lonza Group Ltd.

It does not take much detective work to look at this chart and see that there was some suspicious trading leading up to the July 11 announcement date.

You see the stock price rising and an increase in trading volume. According to the SEC complaint, about 1 million shares in that increased volume came from three defendants. The average trading volume for Arch leading up to the merger announcement was just under 200,000 shares per day.

The hard part will be the SEC proving that the defendants had material, non-public information and used it in breach of some obligation. Clearly, their trading looks suspicious. Proving it was illegal will take more work.

The big question I have, and that compliance professionals that deal with insider trading should have, is how did the trades get flagged?

The SEC has said they are increasing market surveillance and market intelligence to spot suspicious activity. Did the SEC catch this on their own?

Was it compliance? It would seem that the activity coincided very closely with the merger and could easily have been flagged as suspicious by a vigilant broker/dealer compliance department. When a stock usually only trades 200,000 per day, seeing hundreds of thousands of shares being purchased with big public news should be a red flag.

Was it a whistleblower? The SEC has created a new bounty program. Perhaps an insider discover the activity and alerted the SEC in hopes of a financial windfall.

Was it a wiretap? It’s clear from the case against the Galleon Group and Raj Rajaratnam that the government is suing wiretaps to investigate insider trading.

To me the most interesting part of this case will be finding out how the trades got flagged. The rest of the case tied to proving insider trading is not interesting.

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Insider Trading: A Dirty Business

One of the major tactics of hedge funds is to “arbitrage reality”, operating with a better understanding of a company and its stock price than other participants in the market. In a legitimate operation, that means lots of research. On the wrong side it means getting inside information about a company’s earnings, upcoming deals, and other inside information.

The hedge fund most notably found to be operating on the wrong side was the Galleon Group run by Raj Rajaratnam. On May 11th he was found guilty on all fourteen counts of securities fraud and conspiracy to commit securities fraud. His sentencing is scheduled for July 29th. His appeals will go on for years.

George Packer puts together an insightful look at the Rajaratnam as a lens to explore the difficulties in getting a guilty verdict for insider trading and for prosecutions coming out of the financial crisis in a long article in The New Yorker: A Dirty Business.

I don’t think Rajaratnam’s guilty verdict was a surprise to anyone. Maybe it was a surprise to him and his lawyer. The feds had wiretaps and what appeared to me to be very solid evidence. One of the biggest difficulties is showing the flow of information to show that the trade happened based on material, non-public information. For a company insider or company adviser that is more straightforward than finding that information with a third-party trader. Without the flow of information you can’t show that the use of the information was in breach of a duty.

The death blow in the Rajaratnam trail was Rajat Gupta, a member of the Goldman Sachs’ board of directors. At a board meeting they discussed Warren Buffett’s proposed investment of five billion dollars in Goldman Sachs. The meeting ended at 3:54 P.M. Sixteen seconds later, Gupta called Rajaratnam’s office. At 3:58, just two minutes before the markets closed, Rajaratnam gave an order to buy three hundred and fifty thousand shares of Goldman stock. Fit him for a pinstripe jumpsuit.

Goldman Sachs chairman and chief executive, Lloyd Blankfein was in the witness stand at the Rajaratnam trial. But he was merely there to say that Rajat Gupta had violated the company’s confidentiality rules.

Did insider trading cause the 2008 financial crisis? Did it even play a role?

I’m in the camp with Charles Ferguson, the director of Inside Job, that the financial crisis was caused primarily by shoddy mortgages and trading of those bad loans. But unlike Ferguson, I think the ultimate crisis was caused by greed and stupidity.

The top executives of financial institutions were likely unaware or perhaps willfully ignorant of the low-level players who were originating the toxic mortgages and the packaging of the toxic mortgages into even more toxic mortgage-back securities. Delusion, stupidity and greed are not illegal.

Going back to insider trading, the push for information arbitrage is really a push to the edges of ethical and legal operation. Pushing back from the edge is a person’s morality, their sense of right and wrong. The hammer to that morality is potential prosecution for going past the edge. Packer refers to a 2007 of twenty-five hundred Wall Street professionals.

They were asked if they would use inside information to make ten million dollars if the chances of getting caught were fifty per cent. Seven per cent said yes. But, if there was zero chance of getting caught, fifty-eight per cent said that they would break the law.

That is the real problem with under-funding of the SEC. Without sufficient resources, their hammer of prosecution seems like a negligible risk. If traders see their peers trading on inside information and not getting caught, they are more likely to push past that legal edge. The  Rajaratnam is an important signal that you can get caught.

To be effective the SEC needs more cases, not just bigger cases.

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Raj is Guilty. Nobody Is Surprised.

If you read about the evidence, you can’t really be surprised that Raj Rajaratnam was found guilty of insider trading. That he was found guilty on all counts was mildly interesting, but not much.

We may get some interesting new legal developments in insider trading law from the appellate decisions. But probably not. The case seems solid. It does not pose the more interesting legal analysis seen in the charges brought in some of the expert network case.

The most interesting aspect of Raj’s case is the government’s use of wiretaps and surveillance. The typical insider trading case relies on some extremely timely trades and a clear opportunity to have acquired knowledge about a significant corporate action. With Raj, his own voice betrayed him. The government was willing to spend considerable considerable effort to gather evidence.

Was it a legal victory? How do you measure success from a legal perspective?:

“We started out with 37 stocks, we’re down to 14,” defense attorney John Dowd said today after his client was found guilty on 9 counts of insider trading and 5 counts of conspiracy. “The score is 23 to 14 for the defense. We’ll see you in the Second Circuit.”

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Lawyers and Insider Trading

Even smart people do dumb things. Lawyers presumably know the law, but still break it. That means they occasionally take some short term profits through insider trading and get caught red-handed.

Everyone is focused on the Galleon Group insider trading trial happening in Manhattan, threatening to put Raj Rajaratnam in jail. That case is complicated and big, with wire taps and cooperating witnesses.

The SEC’s case against Todd Treadway seems more straight-forward.

Treadway was an attorney in the Executive Compensation, employee Benefits & Employment practice group at Dewy & LeBoeuf.

According to the SEC complaint, Treadway bought shares in Dewey’s client, Accredited Home Lenders, after reviewing a draft merger agreement for the company’s acquisition by Lone Star Funds in June 2007. He used his office computer to scoop up shares three days before the deal was announced publicly. Not being subtle, he used all of the available cash in the account to buy the stock.

According to the SEC complaint, once was not enough. Later, in May 2008, Treadway bought shares in CNET before the announcement that CBS Corp. planned to buy it. After reviewing various documents as part of his work on the transaction, Treadway bought CNET stock using four different brokerage accounts eight days before the deal was announced.

How did he get caught?

With any public M&A deal where there is a spike in trading activity before the deal is announced, the Financial Industry Regulatory Authority pokes around the accounts that traded in those shares to see if anyone trading was an insider. FINRA began looking into trading around the CBS/CNET deal. They asked Dewey to circulate to people in the firm who had knowledge of the deal a list of individuals and entities, one of whom was Treadway’s fiancée. Treadway responded to the questionnaire by replying “I have no knowledge of such person/entities.”

The complaint does not state that Treadway’s name was on the FINRA list. That seems odd. Maybe that part was left off the complaint and the SEC just wanted to point out that he lied about his fiancee.

Dewey’s enforcement was quicker than the SEC’s enforcement. The law firm fired Treadway in November 2008.

All this for only $27,000 in trading profits. Treadway made only $388 from the Accredit Home/Lone Star merger. That’s small dollars for a lawyer who presumably was making at $160,000 as an associate in a big new York City law firm. I suppose loading up on options would not have been subtle enough for Treadway.

Treadway is merely the latest attorney at a big law firm who has been caught taking a quick buck through insider trading. Two lawyers at Ropes & Gray, Arthur Cutillo and Brien Santarlas, pleaded guilty in 2009 for passing along tips about deals the firm was working on in exchange for kickbacks. Melissa Mahler, a lawyer at Nixon Peabody pleaded guilty in 2010 to making trades on a deal underway at the firm.

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Massachusetts Brings Charges Against a Hedge Fund

You need to worry about more than just the Securities and Exchange Commission when it comes to private fund fraud. State securities regulators generally have the ability to bring fraud charges. Case in point is the Massachusetts’ Secretary of the Commonwealth bringing charges against Risk Reward Capital Management, RRC Management, the RRC Bio Fund and James A. Silverman.

William F. Galvin’s office moved against the parties because the fund allegedly used the “expert network” firm, Guidepoint Global LLC, to gain inappropriate information about clinical trials for biotech drugs.

“The first year returns for the Fund were poor, losing 16.9% of its value. In early 2008 Silverman began to pay $80,000.00 a year from the Fund’s assets to retain the services of Guidepoint Global LLC, (“Guidepoint”) a so-called “expert network” firm, in an effort to make the hedge fund more profitable. With access to Guidepoint, the Fund began a dramatic resurgence, generating returns of over 55% in 2009 and 52% in 2010. These returns were generated, at least in part, upon Silverman’s receipt of material non-public information he received through Guidepoint consultations.”

The complaint focuses on two public companies for which Silverman received non-public information through Guidepoint consultants: Ariad Pharmaceuticals, Inc. and Questcor Pharmaceuticals Inc.

The complaint lays out in detail how the government sees an “expert network” in operation and how it breaks the law.

The Secretary of the Commonwealth is looking not just at the misuse of the information, but also administrative violations of the Massachusetts’ Uniform Securities Act

The Division’s books and records review of Risk Reward also uncovered a widespread pattern of non-compliance with the Act and the Regulations. The Division uncovered violations of minimum financial requirements, document retention requirements, and a myriad of dishonest and unethical business practices, including improper assessment of performance-based fees. The Division observed a disorderly office appearance during the on-site Examination. In addition to leaving client documents including sensitive financial information laying about on tables, chairs, sofas and floors, the Division discovered that the office doors did not lock, leaving client data vulnerable.

This action was brought pursuant to the enforcement authority under M.G.L. c. 110A §§204 and 407A. You may have notice that the operative agency is the Secretary of the Commonwealth, not the Secretary of State. Massachusetts is a commonwealth, not a state. Not that there is a difference.

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Are ETFs Reportable Securities?

As a compliance officer for a registered investment adviser, you need to verify transactions where the account has a “reportable security” to make sure your employees are not violating your insider trading policy. That means checking you employees’ securities accounts at least quarterly. You’re compelled by Rule 204A-1 (b)(2) to do this for access persons.

The big exclusions from the definition of reportable security are US Treasuries and open-end mutual funds (assuming they are not funds where you act as the investment adviser).

The question I had was how Exchange Traded Funds fit into that definition. Index funds fit into the open end fund exclusion. Exchange Traded Funds act sort of like index funds so should they be reportable securities?

The answer turns out to be yes and no.

National Compliance Services asked this same question in 2005, shortly after Rule 204A-1 came out.

ETFs are structured as either an open-end fund or a unit investment trust. The SEC’s response in a no action letter was that the open-end fund variety is not a reportable security and the UIT variety is a reportable security.

Is the UIT variety of ETF rare enough that you don’t need to worry about them? No. Actually, it’s the opposite. Some of the largest ETFs are Unit Investment Trusts: SPY, QQQ, DIA and MDY. That means you should probably just through all ETFs under the “reportable securities” label.

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Don’t Lie to the Feds When Caught for Insider Trading

The “classical theory” of insider trading targets “a corporate insider’s breach of duty to shareholders with whom the insider transacts[, and the] misappropriation theory outlaws trading on the basis of nonpublic information by a corporate ‘outsider’ in breach of a duty owed not to a trading party, but to the source of the information.” See United States v. O’Hagan, 521 U.S. 642, 651-53 (1997). The extra element that the government must prove in a criminal insider trading case, beyond what it is required in a civil action, is that the defendant acted “willfully.” 15 U.S.C. § 78ff.

The Securities and Exchange Commission is limited to fines and injunctions, but when the Department of Justice gets involved they will be seeking jail time for insider trading. Although their enforcement authority mostly overlaps, the DOJ exercises their jurisdiction sparingly. After all, the DOJ generally gets the case when the SEC refers the case to them.

Don’t lie to the SEC when they are investigating an insider trading case against you. It makes them angry and more likely to refer the case for criminal prosecution. You can always be quiet.

Case in point is the indictment filed against Peter Talbot and Carl Binette in connection with trading in the stock of securities for Safeco Corporation. Talbot worked at Hartford Investment Management Company. He saw some co-workers putting in long hours and concluded they were working on a potential acquisition. Talbot snooped around the company’s network and found files from those co-workers identifying Safeco as the target of the acquisition. Talbot told his nephew, Binette.

Talbot instructed Binette to buy call options on Safeco stock for $37,260,85 in a newly opened brokerage account. A week later, a competitor announced it was acquiring Safeco, sending up the stock price. The two sold their call options and realized a 1653% profit of $615,833.06.

The SEC looked closely at Binette because of all the red flags in that account. Binette was a 28 year old finance manager at a car dealership. It would certainly be odd that he would suddenly plop down over $30,000 on a speculative investment. It turns out he had borrowed $10,000 from his home equity line, $10,000 from his aunt, and $10,000 from each of his supervisors.

Binette lied to the SEC about whether he had spoken to anyone else about the Safeco securities. That’s obstruction of justice. That’s what landed in jail. In this case, it sounds like they have good case for actually proving insider trading against Binette and Talbot, something they failed to do for Martha.

Binette even claimed that the trades were based on a dream. That’s another big red flag for the SEC. I could imagine a few chuckles coming from the SEC investigators when they heard that terrible excuse.

It’s  also likely to land him in jail, instead of merely returning his ill-gotten gains and paying a fine.

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How to Get Caught Insider Trading

Purchase out of the money call options set to expire in two weeks, be an employee of the company acting as an adviser in the merger, not have any activity on that stock before, use an account in your name, exclusively use option when you have barely traded options in the account before, and quickly try to move the money off-shore.

The SEC alleges that Juan Jose Fernandez Garcia and Luis Martin Caro Sanchez had material, non-public information and purchased hundreds of “out-of-the-money” call option contracts for stock in Potash Corp. in the days leading up to the public announcement of BHP Billiton’s bid on August 17.

Juan Garcia is (was?) the head of equity derivatives research at Banco Santander which was advising BHP on its bid. It’s not clear how Luis Sanchez is related to Santander or Garcia. The daring duo made nearly $1.1 million in illegal profits based on $61,000 in option contracts.

How did they get caught?

The warning signs are obvious, but who saw them. Daniel M. Hawke, Market Abuse Unit Chief SEC Enforcement Division, gets his face on the press release. That’s some good publicity for the new structure of the enforcement division.

The complaint mentions the daring duo’s attempt to transmit the funds from that brokerage account back to Spain. It sounds to me like the compliance folks at Interactive Brokers are likely the ones who spotted the red flags and froze the accounts. Otherwise that money would be sitting in Spain and harder for the SEC to grab and demand disgorgement.

Let’s hand a glass of champagne to SEC’s Market Abuse Unit and the compliance department at Interactive Brokers

I agree with Felix Salmon that there is probably a much juicier story behind this incident.

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SEC Finally Catches Up With Former Deloitte Vice Chairman

Back in November, 2008, Deloitte sued its former vice chairman for trading in securities of the firm’s audit clients. The SEC has filed its case against Thomas Flanagan and included his son, Patrick Flanagan.

The SEC alleged Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties as a Deloitte partner, resulting in profits of more than $430,000. Flanagan also tipped his son Patrick, who earned profits of more than $57,000 based on the inside information.

“21. Between 2003 and 2008, Flanagan made 71 purchases of stock and options in the securities of Deloitte audit clients. Flanagan made 62 of these purchases in the securities of Deloitte audit clients while serving as the Advisory Partner on those audits.

22. On at least 9 occasions between 2005 and 2008, Flanagan traded on the basis of material nonpublic information. Flanagan traded on the basis of material nonpublic information about Best Buy, Motorola, Sears, and Walgreens. On at least 4 occasions, Flanagan tipped Patrick who also traded based on this material nonpublic information.”

What took the SEC so long?

The insider trading problem had already been uncovered at least eighteen months ago. Flanagan had violated the Deloitte policy on trading on audit clients’ securities. He failed to report his trading activity and failed to include some brokerage accounts in Deloitte’s trade tracking system.

Since he used Deloitte Tax for his personal returns, he falsified the names of the securities on his tax returns. (I wonder if Deloitte tax would have run the tax return’s securities against the restricted list?)

The Flanagans agreed to pay more than $1.1 million to settle the SEC’s charges. Thomas Flanagan paid disgorgement with prejudgment interest of $557,158, a penalty of $493,884, and is banned from appearing or practicing before the SEC as an accountant.  Patrick Flanagan paid a disgorgement with prejudgment interest of $65,614, and a penalty of $57,656.

How could you catch them?

One question is how could you improve your insider trading policy and procedures to stop this?

If someone is going to conceal their trading activity in clear and knowing violation of the insider trading policy, it’s hard to catch them. You can’t find the account if the employee does not tell you about the account. You need to make them aware of the insider trading policy and that their job is on the line for violation of the policy.

The next step is to review tax returns and tie them back to trades. The employee is then at risk for failure to report income to the IRS. (That’s how they got Al Capone.) In Flanagan’s case he went so far as to fake his tax returns.

How Did Flanagan Get Caught?

According to the Deloitte complaint (.pdf) the SEC investigated trading activity for a particular client who had announced an acquisition of a public company in July 2007. I assume the SEC saw an uptick in trading and options activity.  Looking back at the SEC complaint, it looks like that incident was when Walgreens’ purchased Option Care. It’s typical in a public M&A deal for the SEC to question the companies’ advisers when the see unusual trading activity around the time of the deal. That exposed Flanagan’s activity to Deloitte in August of 2008.

Did Flanagan not think that he would eventually get caught? Francine McKenna places the blame a compliance failure at Deloitte.

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