Category: Insider Trading

Phone Calls Can Get You Caught Insider Trading

The insider trading prosecution of Raj Rajaratnam was centered around phone calls. Prosecutors were able to get a recording of those calls. Can you get a conviction merely by tying phone calls to trades, without knowing the content of the calls? The Securities and Exchange Commission is hoping that old-fashioned phone call logs will be enough.

In bringing an insider trading case against John Femenia and group of his friends, the SEC merely lays out a series of trades made after Femenia called his friends. Pursuant to the complaint, Femenia was the source of information based on his position in the Investment Bank Group of Wells Fargo Securities.  Femenia and his friends have not had a chance to publicly respond to the charges, so I just looking at what the SEC is saying and why the SEC thinks there is enough evidence for insider trading charges.

Femenia Tips Wens Who Trades on the Inside Information.
96. Prior to May 27, 2010, Wens had no history of trading in ATC.
97. On May 27,2010 at approximately 12:04 a.m., Femenia called Wens. The call lasted approximately 32 minutes.
99. On May 27,2010 at approximately 9:31a.m., Wens made his first purchase of ATC in a TD Ameritrade brokerage account.
100. Between May 27,2010 and June 29,2010, Wens bought thousands ofATC shares. During this time  period, Wens exchanged frequent telephone calls with Femenia, including calls often on the same day or the days before the trading in A TC securities.

Wells Fargo provided financing to GENCO to help in its acquisition of ATC. The complaint goes on and on linking phone calls to the times the group made trades.

The complaint charges Femenia with knowledge of the underlying capital transaction, but does not link it to specific pieces of information or internal emails. Similarly, the SEC does not have recordings of the phone calls. (At least Femenia and his group were smarter than these guys who communicated about insider trading on internal IM that gets archived.)

Will it be enough?

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Image of a 1896 Telephone is from Wikimedia

Airport Use as Illegal Inside Information

I’m a bit confused by the big story in Bloomberg about David Slaine, a key informant for the recent crackdown on insider trading. It starts off with Slaine trying to claim that a money manager was illegally using airplane flight information into Teterboro Airport to profit on stocks. The claim was that his tipsters would let him know when bankers came in and out of the airport, presumably to talk to one of the numerous pharmaceutical companies in the area.

Let’s start off with whether the information is even non-public information. Perhaps the FBI has not heard of the internet. The FAA aircraft registration database is available online. You can easily search for a company’s planes. There are databases and services like FlightAware.com that will track flights based on the plane’s tail number.

There has been some privacy added back to the databases. You may be surprised that privacy push and concerns came from sport teams. Avid fans had been tracking owners’ plane flights to see who they are trying to sign as free agents or coaches.

If you lost the fight over whether the information was non-public, you also need to pass a materiality standard. You have no way to predict how the travel activity will relate to stock activity. If you mix up the target with acquirer you may get a drop in stock price. The Slaine story talks about bankers. Those bankers could just easily be coming to offer bankruptcy financing as they could be to trigger an event that would increase the stock price.

Lastly, you need to prove some obligation to keep the information confidential. I don’t see how that obligation exists for airport personnel.

The information sounds a lot like the old story of fund managers who would count cars in a retailer’s parking lot as a way to estimate sales. Lots of cars would likely mean better sales numbers.

This leads back to the tricky part of expert network firms. At one extreme, fund managers were explicitly paying for and extracting confidential, material, non-public information from company insiders. The complaint against Martoma is an example of the illegal kind. On the other extreme is a fund manager merely trying to get a better understanding of the industry, the issues, the opportunities, and the companies involved in an area. This is perfectly legal. From this side, the fund manager may be able to find some external factors of correlation that could lead to movements in a company’s stock price. The retail parking lot is an example.

But airport use? That does not seem to offer much insight. I guess the FBI was desperate to get any sort of insight into insider trading, even if it was not insider trading.

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How to Get Caught Insider Trading

Thomas C. Conradt and David J. Weishaus were brokers at Euro Pacific Capital when they came across a golden source of information. IBM was getting ready to purchase SPSS, Inc. for $50 per share. Now the SEC is charging them with illegally trading on that inside information.

Both are challenging the complaint, so we will need to assume the SEC’s complaint is accurate. It has some bad evidence for the two defendants, like these messages:

Weishaus: we should get [RR3] to buy a f***load
Conradt: jesus don’t tell anyone else
Weishaus: like, [RR3] buy 100000 shares
Conradt: we gotta keep this in the family
Weishaus: dude, no way
i don’t want to go to jail
f*** that
Conradt: jesus christ
Weishaus: martha stewart spent 5 months in the slammer
Conradt: does [a friend] know?
Weishaus: and they tried to f*** the mavericks owner

Unfortunately, the two seemed to have forgotten or not realized that their firm captures email and IM communication. They do so for exactly this purpose.

Conradt purchased a bunch of SPSS stock. He had never traded in the stock before. He must have been short on cash because he only ended up with $2500 of gain.

Weishaus leveraged his bet and purchase call options as well as stock. He ended up with $127,000 in gains. At one point, 99% of his account was in SPSS securities.

The key to the inside information with Conradt’s roommate, an unnamed “Source” who is an Australian citizen. The Source had a friend who worked for the law firm on the IBM side of the merger, the unnamed “Associate.” According to reports, Cravath, Swaine & Moore represented IBM in the acquisition.

The Associate told the Source about the transaction and the merger price. The Source bought some SPSS securities and told Conradt. Conradt told Weishaus. They told three other brokers who are unnamed in this complaint. I expect we will hear more about them in the future.

All the trading activity in SPSS prior to the merger caught the attention of the Securities and Exchange Commission, who contacted Euro Pacific. Of course trading on inside information is a violation of the firm’s policy. When the Source found out about the SEC investigation he apparently exercised his Australian citizenship and returned home instead of facing the SEC inquiry.

The SEC challenge will be push the duty not to trade on Conradt and Weishaus. It seems clear that the Associate had a duty and the knew enough about the source of the information to impute a duty on the Source to not trade. According to the complaint, the Source clearly knew that the information was held in confidence by the Associate and had a duty to keep it confidential.

But did Conradt and Weishaus know of the illicit source? From the IM traffic it seems that they thought is was illegal. That may be enough to convince a jury.

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Now We are Talking About Real Money – SEC Brings $250 Million Insider Trading Case

On Tuesday, the Securities and Exchange Commission released news of an alleged insider-trading scheme that reaped profits and avoided losses of more than $276 million. The SEC brought the charges against (1) CR Intrinsic Investors LLC, (2) its former portfolio manager, Mathew Martoma, and (3) a medical consultant for an expert network firm, Dr. Sidney Gilman. The insider trading scheme involving a clinical trial for an Alzheimer’s drug being jointly developed by two pharmaceutical companies. The illicit gains generated in this scheme make it the largest insider trading case ever charged by the SEC.

Dr. Gilman has agreed to settle with SEC and cooperate. The Department of Justice has brought criminal charges against Mr. Martoma and tossed a non-prosecution agreement to Dr. Gilman.

According to the complaint, Dr. Gilman chaired a committee that oversaw a clinical trial for an Alzheimer’s drug that Elan Corporation and Wyeth were developing. Dr. Gilman, a professor of neurology at the University of Michigan Medical School served as the chairman of the Safety Monitoring Committee overseeing the clinical trial of the Alzheimer’s drug. Elan and Wyeth selected him to present the final clinical trial results at a July 29, 2008 medical conference. This would coincide with the after-market hours public announcement of the trial results by the two companies.

CR Intrinsic is a unit of Steven A. Cohen’s SAC Capital Advisors LP, the firm at the center of the expert network cases being brought by the SEC. Mr. Martoma met Dr. Gilman through an expert network firm. During consultations, the SEC alleges that Dr. Gilman provided Martoma with material nonpublic information about the ongoing clinical trial, including the actual, detailed results in advance of the July 29 Announcement.

According to the complaint, Mr. Martoma used the information to reposition almost a billion dollars in Elan and Wyeth stock, reaping profits and avoiding losses of over $276 million. At one point Elan and Wyether wer over 10% of the fund’s portfolio. At the end of 2008 Mr. Martoma pocketed a bonus of $9.3 million. CR Intrinsic paid Dr. Gilman $100,000 for his information.

The complaint does not identify the expert network firm, but the Wall Street Journal points to Gerson Lehman.

The facts look very bad for the parties. I assume that is why Dr. Gilman settled. Why is Mr. Martoma fighting the charges? He is subject to criminal charges and I assume the prosecutors wanted more prison time than Mr. Maroma was willing to serve.

The big question is whether the trades were illegal insider trading. The prosecutors will need to prove that Dr. Gilman had material non-public information and had a duty to keep that information confidential. They will need to prove that Mr. Martoma knew or should have known that the information should not be traded upon. That will be the test of this case and other expert network cases. These are likely to be the key issues to prove in this case:

61. Martoma knew, recklessly disregarded, or should have known, that Gilman owed a fiduciary duty, or obligation arising from a similar relationship of trust and confidence, to keep the information confidential.

63. Martoma and CR Intrinsic each knew, recklessly disregarded, or should have known, that the material nonpublic information concerning the Phase II Trial that each received from their respective tippers was disclosed or misappropriated in breach of a fiduciary duty, or similar relationship of trust and confidence.

There is no doubt that fund managers were using expert networks to gain an information edge on the markets. As Gordon Gecko said: “The most valuable commodity I know of is information.” The issue is finding the line between legitimate information gathering and illegally using material non-public information.

According to the SEC press release: “Since October 2009, the SEC has filed more than 170 insider trading actions charging more than 410 individuals and entities. The defendants in these actions are alleged to have made more than $875 million in illicit gains comprised of profits and the avoidance of losses.”

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No Language Barrier to Prosecuting Insider Trading

The Securities and Exchange Commission alleges that Waldyr Da Silva Prado Neto, a citizen of Brazil who was working for Wells Fargo in Miami, learned about an impending acquisition and profited illegally from insider information. The SEC was apparently undeterred by the language barrier in filing its action.

The SEC claims that Prado, while a registered representative at Wells Fargo, traded on material nonpublic information. Prado is contesting the charges, so the SEC allegations may not be accurate, but I’ll assume they are for trying to learn some lessons from the prosecution.

Prado had a large customer who put $50 million into a 3G Capital partners fund. That fund ultimately took Burger King private. The Customer and Prado met several times. A short time later Prado began trading in Burger King securities. Then another customer of Prado began trading in Burger King securities.

The SEC produced excepts of email in its complaint against Prado, translating from the original Portugese.

“Prado’s emails and other communications may have been sent from Brazil and written in Portuguese, but our commitment to prosecute illegal insider trading on U.S. markets knows no geographic or language barrier.”

– Sanjay Wadhwa, Deputy Chief of the SEC Enforcement Division’s Market Abuse Unit and Associate Director of the New York Regional Office.

Prado’s e-mail translated from Portuguese: “I’m in Brazil with information that cannot be sent by email. You can’t miss it….” Prado later placed a phone call to this friend on a phone call that night that he heard 3G Capital was going to take Burger King private. That friend was a hedge fund manager. Instead of trading on the information, he warned Prado that he should not trade on this information and should not encourage any of his customers to trade either. That did not deter Prado.

The difference in this case, compared to the Well Advantage case of foreign traders or the Sanchez case for Potash, is that Prado was a US based registered representative. So his communications are likely well preserved for the SEC to find the smoking gun linking him. You can see the emails in the complaint. The SEC got to use Prado’s words against him.

The SEC could not find the emails in the Sanchez case and I would guess they will also fail to find the smoking guns of insider trading in the Wells Advantage case.

Missing from this fact pattern is what happens to the Customer who breached his confidentiality agreement and told Prado about the upcoming transaction.

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Don’t Trade Stock in Your Friend’s Company, Illegally

Ladislav “Larry” Schvacho purchased approximately 72,000 shares of Comsys IT Partners, Inc. stock between November 9, 2009 and February 1, 2010. On February 2, 2010, Manpower, Inc. and Comsys publicly announced a merger, resulting in a 31% percent increase in the share price of Comsys from its prior day’s close. As a result of his trading in Comsys stock, Schvacho obtained profits of  over $500,000.

The SEC thinks Schvacho made those trades because he was a friend of the CEO of Comsys and was illegally trading on inside information. At this time, Schvacho is contesting the charges so the allegations may or may not be true. I’m assuming they are true to see if we can learn some lessons from this case.

Schvacho and Larry Enterline worked at several companies together starting in the 1970s, including an investment fund. They also developed a close personal relationship and Enterline named Schvacho as executor of his estate. Enterline was the CEO of Comsys.

According to the SEC complaint Enterline was not cautious in speaking about the company’s business when Schvacho was around. Enterline spoke on the phone to other Comsys executives about the merger in the presence of Schvacho. The SEC also alleges Schvacho had access to merger-related documents during a vacation with Enterline.

The transactions smell like insider trading. The easiest problem for the SEC will proving that Schvacho knew about the confidential merger information. From the statements in the complaint it sounds like Enterline has provided the SEC with some specific information about what was said in the presence of Schvacho.

The tough battle for the SEC will be proving that Schvacho had a duty to keep the information confidential and not trade in the stock. Schvacho himself was not an insider. He was merely the friend of an insider. The SEC contends that “Enterline reasonably expected that Schvacho would refrain from disclosing or otherwise misusing the confidential information.” The SEC will have to show that Schvacho violated a fiduciary duty to Enterline based on their long friendship. That duty is part of the law of insider trading cases under 10b-5.

Even if the SEC cannot show insider trading, the SEC also accused Schvacho of violating Rule 14e-3, which prohibits insider trading on information about a tender offer. Unlike insider trading, Rule 14e-3 does not require proving a breach of a fiduciary duty, The SEC will merely need to prove that the person knew the information was confidential. This was just luck for the SEC in this case. The Comsys transaction happened by a tender offer instead of the more traditional merger or reverse merger.

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Will They Contest the Freeze?

It looks like the SEC has stopped a big insider trading scheme. At least for the moment. But can the SEC find the evidence to prove its suspicions about Well Advantage? I doubt it.

The case involves trading in shares in advance of the announced $15 billion acquisition of a Canadian oil producer, Nexen, by the state-owned Chinese oil company, China National Offshore Oil Corporation, or CNOOC. On Monday, July 23, 2012 CNOOC offered to acquire Nexen for $27.50 per share, a 60% premium over the Friday closing price. Three series of trades had lots of red flags, generating profits in excess of $13 million. The SEC obtained a freeze on those accounts, preventing the owners from getting their suspicious gains.

One series of trades involved accounts at Citigroup and UBS held by Well Advantage. Well Advantage purchased 831,033 shares of Nexen at a cost of about $14.3 million. The buys were made just two trading days prior to the announcement. Well Advantage had not traded in Nexen shares since at least January 2012. The Citigroup account had been dormant for six months. On the Thursday following the Monday deal announcement, a sell order was placed to liquidate the Nexen position in the account for a gain of $7.2 million. (That’s a nice piece of change for a week’s work.)

Another account was at Phillips Securities in Singapore. From July 12,2012 through July 20, 2012, the Phillip Account purchased 597,990 shares of Nexen stock for approximately $10 million. Prior to the July 2012 purchases, the Phillip Account had engaged in only negligible trading of Nexen stock since August 2010. By the end of trading on July 24, 2012, the account had sold 582,990 of its shares realizing profits of approximately $5.1 million.

The third account was at Citibank. That account only purchased 78,220 shares on July 17, realizing a profit of $721,000 when they were sold on July 23.

The SEC’s problem will be proving that the trades were made based on inside information. So far, the only link is in the first series of trades, Well Advantage’s beneficial owner, Zhang Zhi Rong, is a controlling shareholder of Rongsheng, a company that, according to its own public statements, maintains a close business relationship with CNOOC. The SEC will still need to find the smoking gun that proves Well had inside information. Given that the accounts likely involve foreign nationals it will be hard for the SEC to prove its case.

Of course the SEC may be hoping that it does not need to prove its case. The defendants will have to get relief from the asset freeze. That means allowing the SEC access to their communications and files to look for the smoking gun.

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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