Category: Insider Trading

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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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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