Here's a quick story for discussion, since I've written about the topic of the gray line of insider trading before. In November, 2008, I was minding my own business, driving around the Berkshires looking for a house to buy, when I got a call from an old headhunter we used to deal with on my trading desk. This time, she had a job she thought I'd be good for, and she was right - it was a position that was tailor made for me, if only I'd been eager to jump into the fray. I interviewed with the firm, and went back at the end of December to discuss more details with them.
I was sitting in the cafeteria with the head of trading, talking about the state of the financial crisis, which was in full bloom at that point. Markets were getting crushed. I made a comment about how I wasn't a fan of extend and pretend and abandoning mark to market, and this guy told me, verbatim, "If we had to mark to market we'd be bankrupt." My jaw, literally, dropped. Dude - if you want me to come work for you, especially in a trading capacity, that's not the kind of thing you tell me. Especially since I come from a background trading instruments which were always marked to market daily (equities, options, futures). My counterparty quickly backpedaled, clarifying what he meant, explaining "held-to-maturity" classifications, etc - I don't really want to debate mark-to-market, although Barry Ritholtz has a thread on it today, if that's what you're interested in. In any case, this wasn't the kind of thing I'd expect to hear from someone in a head trading role. Market prices are the life blood of a trader, in my opinion.
Anyway, we left it with "we need to clean up our year end stuff, and we'll settle this in the New Year." Basically, I assumed that the job was mine if I wanted it, and I was agonizing over if I actually wanted it! Less than three weeks later, this firm reported earnings, wrote down marks on billions of dollars of assets, and saw their stock price get cut in half. That was the end of those job discussions - I never even followed up. But I was kicking myself and shaking my head that morning saying "Jeezus - the head of trading basically TOLD me that the stuff was worth way less than they were pretending it was worth - this was the easiest short in history." But would it have been legal if I'd traded on that?
Let's review important criteria that we discussed in my prior pieces on this subject: 1) Did the Tipper, my interviewer, have a fiduciary duty? Yes, of course - to his bank. 2) Was he violating that duty by telling me this? And was it even non-public information? Hmmm... Who knows - it was probably common knowledge that all the banks were pretending that their pile of balance sheet crap was worth a lot more than it really was - almost every bank continued to write down their assets further, quarter after quarter, for several quarters in a row starting in mid 2008. He didn't tell me "In three weeks, when we report earnings, we're going to write down the value of our fixed income portfolio by $5B."
Since many of my readers have expertise in this matter, I'll leave the question for the comments: could I have legally gone out and shorted this company's stock based on what my interviewer said to me: "If we had to mark to market we'd be bankrupt" ?
-KD
19 comments:
I'm not a law guy, but wouldn't call that insider knowledge. As your are obviously not an insider and you couldn't also be sure the information is actually acurate.
"And was it even non-public information?"
If enough homework was done, it was indeed public information. After all, isn't discovering things like this how Einhorn, Paulson, etc. have killed it?
Anon - talking to the head of trading and having him tell me this isn't "doing homework" though. I wonder if it's such a hyperbolic statement that it would fall under MNPI, as it's not really "fact." On the other hand, it may be true!
Kid,
Happy New Year, hope your holidays treated you well.
You know by that I am personally quite conservative on such matters, but with that said this looks to me to be a fairly textbook case of potential for insider trading. As you highlight and we have discussed previously the information must be both material and non-public in order to qualify as insider trading. The following points should illustrate this was the case:
a) There is some merit to the argument that a rationale investor may have already assumed that marking such holdings to market would drastically change market value, but such an assumption can rarely be made without fulsome disclosure from the target firm. If details of portfolio holdings were publicly available then the non-public nature would have to be reconsidered, but in absence of detailed data to apply such logic (apply haircuts to holdings) to this would not be possible. Also, given the position of the contact as head of trading, it would be reasonable to assume that he had intimate knowledge of company portfolio bookings relative to market value (the head of HR would have been different). Therefore, as was demonstrated after public disclosure of holdings, this information would have been very valuable in advance to a rational trader, and a reasonable investor could rationally assume that such statements from the head of trading were material.
b) As you mention this information was delivered from a company insider, with a requisite fiduciary duty, at a private meeting between the two of you. This has two implications. Firstly, you recognized that this was a private disclosure of information, and to your knowledge this specific information was not publicly available (ignoring the potential for analyst inference from a) above). Secondly, you also recognized that in disclosing such information in this fashion and given his position, this contact was violating his fiduciary duty to his firm. As such, acting on information where the recipient is or should be aware that a violation of duty has occurred opens the potential for insider trading infractions (if the information is material). As we’ve discussed previously this is generally known as ‘duty to source’ and falls under ‘misappropriation theory’.
As such, in my opinion your refrain from trading was entirely suitable given the market-moving nature of the information (as was clear ex post facto) and the knowledge of a fiduciary duty violation, due to the method of disclosure (private meeting).
However, changing the scenario slightly purely for educational purposes, if it was a shared cafeteria and someone from another firm who didn’t realize the position of your contact (i.e. wasn’t aware of the extent of fiduciary duty violation) overheard this information that may well change the situation. This would only be because the materiality of the information to this listener could not be confirmed (assuming the listener had no way to verify how value such information would be).
Depends...
Insider trading generally requires the trade to be a violation of a duty of loyalty owed by the trading party. The duty violated could be to the traded company itself (a CEO or other insider front-running her own company's news), or to another company (a journalist trading on news he gathered for an article, where the journalist's employer has a prohibition on such trades).
In the SEC's Mark Cuban case, it appears the prosecution wants to expand the duty owed by the insider-tipper, so that the duty is IMPUTED to the tipee even if the tipee has no connection to the insider's employer and thus no traditional interpretation of duty would attach to the tipee. Many commentators think this is an excessive and broad interpretation of the duties owed by unrelated parties to a corporation.
However, per Wikipedia quoting a authoritative source: "Liability for insider trading violations cannot be avoided by passing on the information in an "I scratch your back, you scratch mine" or quid pro quo arrangement, as long as the person receiving the information knew or should have known that the information was company property. For example, if Company A's CEO did not trade on the undisclosed takeover news, but instead passed the information on to his brother-in-law who traded on it, illegal insider trading would still have occurred."
So the quid-pro-quo fact is critical, as it makes this more of a mutli-transactional conspiracy involving the insider, not simply a one-off trade where the insider doesn't receive anything in return.
Trading on overheard conversation is generally not prohibited, as the over-hearer probably doesn't know enough about the circumstances of the inside information or insider's postion to have even an imputed duty of loyalty to the corporation he is trading.
A newer legal theory holds that making trades based on MNPI, even if not trading YOUR company's stock, is a misappropriation of that MNPI if obtained from your employer via your employment.
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KD - so, assuming you are not an insider (D+O or 10%+ owner) - if you knew or suspected that the insider was telling you MNPI, and you had any sort of quid pro quo arrangement with the tipper, then you shouldn't trade. If you did suspect it was MNPI, but didn't have any arrangement with the tipee, it's probably safe. If you overheard it, or otherwise had no reason to suspect the tipee owed any duties of loyalty to the traded company, then you are OK.
IANAL, this is not legal advice, etc. In fact, mostly sourced from https://secure.wikimedia.org/wikipedia/en/wiki/Insider_trading
KD - I didn't mean your conversation was the homework, I was saying that there was potentially someone out there that knew through diligence of studying the company / reports that his balance sheet was crap and was positioned accordingly, even without being told by the head of trading. Basically just saying that what he told you most likely could have been figured out independently and therefore would not be considered "insider information".
Anon - ok - I hear you. Interesting. I kinda mentioned that in the post, similar line of thinking...
Steve - I deleted your duplicate comment, FYI, after I released the first from the SPAM filter it was erroneously caught in.
I don't think that is insider trading as you've described it, KD. The statement made to you sounds more like a semi tongue-in-cheek generalized exclamation that an actual specific statement of fact, and I don't think there is much there to support being any real material information that was not at the time available to the public. While there is no doubt that the safest path would be not to trade on it because anybody could make out a case against anyone if they were so inclined, I do think the story specifically as you have presented it would not rise to the level of insider trading if you had shorted based on that advice.
You're a lawyer and your client says to you: "I distinctly remember my conversation with X. It was on a Monday in July and X told a, b, c."
Two months later the same client says to you: "I never talked to X in my life. If I had, I would have remembered."
Trial is coming up and the client will definitely be asked about his dealings (or lack thereof) with X. Do you have an ethical duty to act to prevent your client from committing perjury in court? Obviously, you know one of the client's statements is a lie.
A: No, you don't have a duty. Why? Because you do not know which statement is true.
Relevance? Yes, your interlocutor blurted out a strong statement about mark-to-market and the company's finances. But then you downplay the fact that he made subsequent remarks where you say he backpedaled. If, for example, he retracted the original statement and said, "Okay, that's an exaggeration. Mark-to-market definitely improves the appearance of our financial condition but we wouldn't be bankrupt without it."
Then what you have are two contradictory statements from an insider. The first is definitely market-moving/material, the second not so much. You have no independent way of verifying the truth of either statement. Your directional bet would be based only on a hunch that the first statement was the truth.
Hoyazo: "The statement made to you sounds more like a semi tongue-in-cheek generalized exclamation that an actual specific statement of fact,"... yes! that's another fantastic twist to this, which I thought I had actually written about in the post, but, rereading, I must have edited it out... It brings up all sorts of other issues. It was a tongue in cheek exaggeration.. and yet - that doesn't mean it was incorrect! I guess the real question is "could I have figured that out on my own?" (As Anon was getting at) we might no have enough information to answer that question.
Transor - Great angle. I love it.
ok - let me switch the scenario: what if he hadn't backpedaled... what if my jaw had dropped, and he's just raised his eyebrows and whistled... or nodded... would that change it for you?
I may be misremembering this a little, but wasn't' one of Mark Cuban's latest suits with the SEC along these same lines? Whatever company's executive told him they were going to try a private stock placement to raise money, then asked Cuban not to sell his stock based on the conversation. Cuban sold and the SEC went after him. Again, I may be wrong, but didn't he get off due to the fact that he didn't seek out this information, and told the exec that he didn't want to hear it?
The comments by Hoyazo (hyperbolic or sarcastic tone) and Transor (flip-flopping on statements) both speak to the credibility of the statements of the insider and subsequently the materiality of the information itself. These are interesting ideas as they do add grey area to the debate based on how comments are interpreted by the recipient, but the overriding determinant should be whether the recipient deems the statements credible enough to warrant the information being material.
In this case it seems as though the contact could have been being hyperbolic (especially given the market environment at the time), in which case on balance the recipient may not deem the information material. However if the contact was clearly flip-flopping to cover up a leak of too much information this may actually make the information more credible and thus material.
Also worth noting that the degree of credibility assigned to the statements by the recipient seems to often be inferred by authorities through major deviations from trading patterns. It is hard to argue against a the cross examination statement of ‘if you didn’t think this information was material or credible, why did you open your first margin account and make your first ever investment in options on this specific company to the tune of 50% of your asset-base?’.
@UrbanAnalyst:
My understanding is that a key aspect of materiality is whether the information would move the market if generally disseminated. But the Information here, I would argue, should be defined as both statements, not just the piece KD chose to believe.
KD's assessment of credibility is a gamble. Hopefully he would have been smart enough to short his prospective employer and several similar institutions simultaneously. ;-)
@KD:
Yes, I think the information contained in the second part you wrote at 2:04 pm changes things. First, it's non-verbal and although there is ambiguity, I wouldn't want to have defend you against the head nod!
Kid Dynomite - If in 2008 you went to an interview and were told potential insider information, then 3 weeks later the company went bust.
Now two years after the fact you are wondering if trading on that conversation would be insider trading, I am curious as to where you just finished interviewing as I would like to short that company :)
I do not have any thing close to a law degree so legally I have no clue where things would fall had you traded on that, plus even if it went to court, it would probably depend on how well your attorny could make the case.
But my scrammbled thinking goes like like.
If you were taking a math class and before a test the teacher works through an equation on the board, so that all the steps and answers are there. She then gives out the test with the exact same equation on it, but forgets to erase the answer.
Are you cheating, if you use the above given answer?
Mangy Mutt
KD,
The SEC loves cases like this for two reasons: 1) you are small fry that can be easily broken, not GS with its legions of white shoe law firms and DC lobbyists 2) it will let them push inside trading laws further in the direction of baning trading for any individual to trade on anything remotely insidery [when big boys do it, its ok, because of the lawyers/lobbyists]
I say this as someone who has learned/watched the evolution of insider trading lawss from just targeting company employees to just some random guy.
Heck I can imagine how some gungo SEC lawyer recently hired from his federal clerkship would try to do you in by arguing that by interviewing with this firm you implicitly entered a shroud of fiduciary obligation to this firm.
I'm sure his complaint would have many many law review citations and other such rubbish.
If you even have to ask the question, isn't it better not to do it? Wouldn't it be wrong in spirit?
Analysis of Elements:
1) Duty? He definitely has one to his employer. This guy knows what's going on there and shouldn't be talking about it -- question I use to analyze this is whether his bosses would be cool with his saying it on CNBC. Answer here is most defintely no.
HOWEVER, question is whether you developed any similar duty. Unless you agreed to keep it confidential and, in view of district court in Cuban case also agreed not to trade, you don't have a duty and you would be good to go. HOWEVER (again, now in other direction), all that said, the clearly correct advice here is NOT to trade, because SEC would argue that you should have known he was telling you on the QT, because he wanted to impress you, entice you to come, etc., and as a result you basically adopted the duty of confidentiality but diregarded it.
1) Non-public? Here, almost certainly non-public; there is a big difference between marketplace speculation and analysis and words straight from the head trader of the place. Speculation/analysis might be public; insider's confirmation is not.
3) Material? Yes indeedie. Again because it is coming from horse's mouth. Also, if you traded, that would answer the materiality question from the regulators' persepctive (ie a hindsight analysis).
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