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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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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