Category: Insider Trading

Private Investment Funds and Reporting Requirements Under the Ethics Code Rule

As I wrote about yesterday on the code of ethics for an investment adviser, one of the requirements of registering with SEC as an investment adviser is implementing a code of ethics. The most involved part of the code is the extensive reporting requirement on securities activities to the chief compliance officer.

Rule 204A-1 under the Investment Advisers Act of 1940 takes the approach that extensive reporting of trading activities by employees of an investment adviser will been a strong deterrent from getting involved in insider trading.The rule breaks the reporting into two baskets: holdings report and transaction report.

Holding Report Under Rule 204A-1

Annually, each access person needs to submit a report of their securities holdings. The report needs to include the following:

  • title of the security;
  • type of security
  • as applicable, the exchange ticker symbol or CUSIP number
  • number of shares
  • principal amount of each reportable security
  • The name of any broker, dealer or bank
  • The date of the report

The rule does not require this to be a calendar year.

Transactions Report Under Rule 204A-1

Quarterly, each access person needs to submit a report of their securities trading activity. The report needs to include the following:

  • date of the transaction
  • title of the security
  • as applicable the exchange ticker symbol or CUSIP number
  • interest rate and maturity date for bonds and debt instruments
  • number of shares
  • principal amount
  • nature of the transaction (i.e., purchase, sale or any other type of acquisition or disposition)
  • price of the security
  • name of the broker, dealer or bank who effected the trade
  • submission date of the report

The report is due within 30 days after the end of the calendar quarter.

Access Person Under Rule 204A-1

The reporting obligations are limited to “access persons” at the investment adviser. These are every employee that

  1. has access to nonpublic information regarding any clients’ purchase or sale of securities
  2. has access to nonpublic information regarding the portfolio holdings of any reportable fund
  3. is involved in making securities recommendations to clients
  4. has access to securities recommendations that are nonpublic

Those are some very broad categories. For most private funds, I would guess that most of their employees could be considered “access persons.” It’s probably easier and less likely to get you in trouble if you consider all employees to be access persons and require all employees to submit reports. Not easier on the compliance officers, but easier on employee understanding.

Exceptions From Reporting Requirements

Rule 204A-1 has some exceptions to personal securities reporting. No reports are required:

  • With respect to transactions effected pursuant to an automatic investment plan.
  • With respect to securities held in accounts over which the access person had no direct or indirect influence or control.

Plus there is also a group securities that are not reportable:

  • Direct obligations of the Government of the United States;
  • Bankers’ acceptances, bank certificates of deposit, commercial paper and high quality short-term debt instruments, including repurchase agreements;
  • Shares issued by money market funds;
  • Shares issued by open-end funds other than reportable funds; and
  • Shares issued by unit investment trusts that are invested exclusively in one or more open-end funds, none of which are reportable funds

Preclearance for IPOs and Limited Offerings

Rule 204a-1 requires an access person to obtain approval before they any security in an initial public offering or in a limited offering. A “limited offering” is a private placement and would include the purchase of an interest in a private investment fund.

What About Alternative Investment Fund Advisers?

These rules make sense for an adviser focusing on tradable securities, but make much less sense for advisers to funds that focus on alternative investments. Venture capital is an obvious example, but it seems they have escaped from the registration requirement imposed on other private equity firms under the financial reform bills.

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Image of 100 dollar bill is by mokra from RGBstock.com

Nobody Saw It Coming? Magnetar Saw it Coming

After reading Michael Lewis’ The Big Short this weekend, it’s clear that some people saw the collapse of the residential mortgage market coming.

This American Life had a story this weekend about another investor who also saw it coming: Magnetar Capital.

(A magnetar is a neutron star with a magnetic field 100-1000 times stronger than that of an ordinary neutron star.)

The story paints the picture of Magnetar buying the most risky tranche of subprime CDOs while at the same time buying credit default swaps against less risky tranches of the same subprime CDOs.

The equity tranche is the last to get paid, the riskiest portion of the CDO and the hardest to sell. Without someone to buy the equity a CDO was less likely to be put together in the first place. Also keep in mind that CDOs were often composed of the equity and junkier pieces of mortgage backed securities as a well as a kitchen soup of mortgage securities.

Pro Publica and This American Life interpret Magentar’s trade as one to sustain the volume of subprime CDOs, which sustained the volume of subprime mortgage backed securities, which sustained the origination of subprime mortgage loans, which sustained the bubble in housing prices. They claim that Magnetar’s trades made the bubble worse. By buying the equity tranche, they enabled the creation of the entire subprime CDO and had more to bet against.

Magnetar denies that was their intent. They were merely combining long positions with short positions.

I assume they saw a weakness in the pricing of CDOs and CDO CDSs and made trades to exploit the weakness. Others, like the people in The Big Short saw weaknesses in CDOs and took bets on their downfall. I doubt any of them realized that the collapse of the CDOs would result in something as catastrophic as the Great Panic.

That didn’t stop This American Life from comparing the Magnetar trades to the plot of The Producers. In the movie, a theatrical producer and his accountant attempt to cheat their investors by deliberately producing a flop show on Broadway. They realize they can oversell the shares in the production and make more money if it the show flops than if it becomes successful.

They even made a song parody based on the Broadway musical adaptation of the movie: Bet Against the American Dream.

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Ethics of Congressional Stock Ownership

The Washington Post published a story using Congressman John Dinghell as an example of the ethics issues involved when you have an investor lawmaker: Dingells and GM illustrate limits of congressional conflict-of-interest rules. Kimberly Kindy and Robert E. O’Harrow Jr. use Congressman Dinghell because of his financial connection with General Motors. This connection was one both of capital and income. His wife was an executive at General Motors and they held a significant amount of GM stock. (She no longer works for GM and old GM stock… well you know what that is worth.)

I did not find the Dinghell example to be compelling. Congressman Dinghell represents metropolitan Detroit. His constituents are just as interested in the future of the automotive business as he is. It seems to me that his personal interests are aligned with those of his district. He and his wife were up front about their ownership of GM and their connection with the company.

That is not to say that legislators’ ownership of stock is not a problem. Uncertainty created about lawmakers’ motivation undermines confidence in Congress and the political process. It is often impossible to know whether the lawmaker is acting in the interest of citizens or their own portfolios.

Insider Trading

On top of that, the lawmakers on Capitol Hill are not prevented from trading on stock with inside information. Congressional portfolios have regularly outperformed those of average Americans over the years. There

Availability of Records

Over at the Sunlight Foundation they decided to drill down further at look at the availability of Congressional ethics filings. Daniel Schuman found that many ethics filings are required to be publicly reported, but are not available online and that many ethics filings are not publicly reported. A cynic would say that Congress does not want this information to be widely available.

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Insider Trading Debates

Raj Rajaratnam

Insider trading is back in the news. The SEC has shown heightened interest in prosecuting these cases, evidenced by the high-profile arrest of Galleon hedge fund manager, Raj Rajaratnam, on civil and criminal charges.

One thing to keep in mind is that insider trading is not defined in the federal securities laws. The SEC has developed insider trading through an interpretation of Section 10(b) of the Securities Exchange Act of 1934 that insider trading is a “deceptive device” under that section and and the anti-fraud provisions of Rule 10b-5.

Given that, there has always been some academic discussion about whether insider trading should be illegal. That discussion moved to the front burner after an opinion piece by Donald J. Boudreaux in the Wall Street Journal: Learning to Love Insider Trading. Donald J. Boudreaux is Professor of Economics at George Mason University and a Senior Fellow at the Mercatus Center.

Mr. Boudreaux latches on to the argument that insider trading allows better information into the markets, allowing for greater economic efficiency. “When insiders trade on their nonpublic, nonproprietary information, they cause asset prices to reflect that information sooner than otherwise and therefore prompt other market participants to make better decisions.” He thinks the capital markets will reward companies that self-impose restrictions on insider trading and punish those that don’t. So, market discipline is better than government regulation and prosecution.

I see some interesting things in this argument. Obviously, we would need prompt and transparent information on when insiders make trades. Delayed reporting undercuts this efficient market argument.

The bigger problem is the shifting of rewards to individuals. It seems inherently unfair that an insider could get a windfall profit from information that is not available to a wider audience. The insider is always going to have better information and should always be ahead of the market.

I could see the perverse effect of insiders purposefully delaying the public release of information to increase their own personal reward. Even worse, they could give false signals to the public in order to sell their shares at a higher level or buy at a cheaper price.

In the end you prosecute companies for poor disclosure, while individuals inside the company profit. You still end up with the government looking over the corporate shoulder at the information they disclose and who benefits from it. Then the government decided whether or not to prosecute.

Regardless, the arguments are purely academic. Insider trading is illegal and compliance officers need to be vigilant to make sure it does not occur. The downfall of Galleon and Raj Rajaratnam should be a stark examples. The indictment on insider trading charges sent them plummeting into the abyss. Galleon has gone from managing billions to possibly going out of business in the course of a week.

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Insider Trading Enforcement

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Either the Securities and Exchange Commission has stepped up its enforcement of insider trading or it’s doing a better job of publicizing its enforcement.

Earlier this week, the SEC announced its case against Raj Rajaratnam and his New York-based hedge fund advisory firm Galleon Management LP.

On September 23, they charged Reza Saleh with insider trading in connection with Dell’s tender offer for Perot Systems. These charges were filed just two days after the date of the merger.

Last month, the SEC brought charges against Melissa Mahler for insider trading activity that happened in 2004. Ms. Mahler made the stupid mistake of lying to the feds about whether she had purchased the shares. That turns the insider trading case from a civil case to a criminal case. It’s also easier to prove, since all the feds can pull up the brokerage statement showing that she had purchased the shares.

There is also the SEC’s insider trading case against Mark Cuban. Even though the initial charges were thrown out in district court, they are appealing that decision to the Fifth Circuit Court of Appeals.

According to reports there are 10 More Insider Trading Arrests Coming Against Securities Professionals.

Perhaps the SEC is finding insider trading cases to be some easy wins? After being raked over the coals, maybe they see insider trading enforcement as an area that can get them some good publicity?

As we heard on The Wire: “We want dope on the table for the six o’clock news.”

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SEC Case Against Mark Cuban is Dismissed

The SEC alleged that Dallas Mavericks owner Mark Cuban was involved in insider trading when he sold shares in an Internet search engine company, Mamma.com Inc., after receiving confidential information about a private offering in 2004. The SEC said Cuban avoided a loss of $750,000 by selling his 600,000 shares, which represented a 6.3 percent stake in the company.

U.S. District Judge Sidney A. Fitzwater granted Cuban’s motion to dismissed an civil insider trading lawsuit. Judge Fitzwater gave the Securities and Exchange Commission 30 days to file an amended complaint.

Judge Fitzwater found that the SEC needed to allege that Cuban entered into an agreement (a) not to disclose material, nonpublic information about the offering, and (b) not to trade on or otherwise use the information. In his ruling, Judge Fitzwater wrote that the SEC didn’t accuse Mr. Cuban of promising not to trade based on the confidential information he received. So, the SEC couldn’t hold him liable for illegal insider trading. It is not enough that the person who gave Mr. Cuban the information expected him not to disclose it or act on it.

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SEC Implements New Compliance Program (On Itself)

After the embarrassing news that two of its attorneys are accused of insider trading, the SEC has decided to strengthen its internal compliance program to guard against inappropriate employee securities trading.

“It only makes sense that we have a world-class compliance program – just as we expect from those we regulate,” said Chairman Schapiro. “The employees at the SEC have a well-deserved reputation for integrity and professionalism. These measures will further bolster our standing by helping to prevent not only an actual impropriety, but the appearance of one as well.”

There are some common sense controls being put in place:

  • Employees must pre-clear all their securities transactions to ensure, among other things, the company whose stock they are trading is neither being investigated by the SEC nor is involved in an offering.
  • Prohibit ownership of securities in publicly-traded exchanges and transfer agents, in addition to existing prohibitions against owning securities in broker-dealers, registered investment advisers and others directly regulated by the SEC.
  • Require that all employees authorize their brokers to provide the agency with duplicate trade confirmation statements.
  • As part of the pre-clearance and compliance process, periodic reviews will be conducted by supervisors to compare transactions against the employee’s work projects to guarantee compliance with the rules.
  • A new computer system to automate employee reporting of personal securities transactions which would simplify the reporting process for employees and ensure accurate pre-clearance checks. (The new system would also provide for easy verification of transactions by comparing reported trades against confirmation statements provided directly by each employee’s brokerage firm.)
  • Consolidating the compliance and reporting responsibilities within the SEC’s Ethics Office. Previously, responsibility within the SEC for ensuring staff compliance was spread between two offices.

Insider Trading at the SEC

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A report from the SEC’s Inspector General has publicized that two attorneys at the Securities and Exchange Commission are under “active” criminal investigation by the FBI for trading stocks based on inside information. Bad news for an agency that is still under fire for missing the Madoff fraud.

Besides the salacious news, there are some items in the report that I think are interesting for a compliance professional.

According to some undated material, there was a thought in the early days of the SEC that its employees should not be permitted to trade in securities at all. That position was not finally adopted, but there is along history of limiting the ability of SEC employees to trade in securities. The restrictions are designed to ensure public confidence that Commission staff are not benefiting personally with respect to their information about securities. There is also an important need to prevent real and apparent conflicts of interest.

Rule Five of the Commission’s Conduct Regulation, 17 C.F.R. 200.735-5, contains the limitations applicable to all SEC Commissioners and employees. Some key limitations are:

  • Carrying securities on margin, purchasing securities with borrowed funds, and selling short
  • Purchasing securities of a company that to the employee’s knowledge is involved in current Commission investigations or proceedings
  • Purchasing or selling options, futures, or options on futures
  • Selling a security that has been held for fewer than six months

The SEC has a detailed reporting structure that employees must follow when buying and selling securities. It sounds like the structure doesn’t work.

“Our investigation revealed that the Commission lacks any true compliance system to monitor SEC employees’ securities transactions and detect insider trading. In addition, the OIG found that there is a poor understanding and lax enforcement of the Rule 5 reporting requirements.”

The SEC requires the investment advisers it regulates to have strict controls to avoid insider trading. It seems they lack the control themselves.

CBS News video story:

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Insider Trading on Credit Default Swaps

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The Securities and Exchange Commission brought its first insider trading enforcement action involving credit default swaps. Renato Negrin, a former portfolio manager at hedge fund investment adviser Millennium Partners L.P., and Jon-Paul Rorech, a salesman at Deutsche Bank Securities Inc., are charged with insider trading in credit default swaps of VNU N.V., an international holding company that owns Nielsen Media and other media businesses.

The SEC’s complaint alleges that Rorech learned information from Deutsche Bank investment bankers about a change to the proposed VNU bond offering. This change was expected to increase the price of the CDS on the VNU bonds. Rorech tipped Negrin about the contemplated change to theVNU bond offering, and Negrin then purchased CDS on VNU for a Millennium hedge fund. When news of the restructured VNU bond offering became public, the price of VNU CDS substantially increased. Negrin closed Millennium’s VNU CDS position at $1.2 million profit.

“This is the first insider trading enforcement action involving credit default swaps,” said Scott W. Friestad, Deputy Director of the SEC’s Division of Enforcement. “As alleged in our complaint, Rorech and Negrin checked their integrity at the door and schemed to engage in insider trading of CDS to the detriment of investors and our markets.”

James Clarkson, Acting Director of the SEC’s New York Regional Office, added, “CDS may still be obscure to the average individual investor, but there is nothing obscure about fraudulently trading with an unfair advantage. Although CDS market participants tend to be experienced professionals, there must be a level playing field with even the most sophisticated financial instruments.

It should not come as no surprise that the buying and selling of Credit Default Swaps is subject to the insider trading laws.

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Trading in Distressed Debt

Richard G. Mason, Steven A. Cohen, Ian Boczko, Sarah A. Lewis, and David Gruenstein of Wachtell, Lipton, Rosen & Katz, have prepared a memorandum concerning the possession and use of information when buying and selling distressed debt (an abridged version of which was published in The New York Law Journal): Trading in Distressed Debtpdf_logo .

  • Although bonds are generally considered securities, interests in bank debt are typically not considered securities. (see Banco Espanol de Credito v. Security Pacific National Bank, 973 F.2d 51, 55–56 (2d Cir. 1992). There is not universal agreement on this position.
  • Knowledge of bank debt can lead to insider trading in other securities.