(Bloomberg View) — One thing that I like to say about insider trading is that people think it is illegal because it is unfair, but it is actually illegal because it istheft. Unfairness is just a fact of life, and of markets: People who are better at research will do better research,smarter people will have smarter insights, people with faster computers will trade faster, etc. Random individual hobbyist investors are not entitled to trade on a level playing field with people who invest billions of dollars for a living. Much regulatory lip service is paid to the idea that they are, for reasons that elude me, but it is obviously untrue.
The reason that insider trading is illegal is that nonpublic financialinformationbelongs to someone, and if you use information that belongs to someone else without their permission, then you are stealing it. A company’s information — about earnings, or a merger, or whatever — belongs to the company as a whole, and it is generally illegal for the company’s executives or agents to trade on that information if it has not been made public.This distinction is at the root of many insider-trading facts that people find confusing. For instance there is the “personal benefit” test that has confounded prosecutorsand politicians since the Newman decision: It is illegal for insiders to sellinformation from their companies(because that looks like theft), but it is not clearly illegal for insiders togive awaythat information (because that doesn’t). Or there is the fact that activist hedge funds canlegally tip other hedge fundsabout their next target: The other fundscan trade on that information because the owner of the information gave it to them as a present, so no theft was involved.
Here’s a good insider-trading case from the Securities and Exchange Commission. The SEC charged”a former day trader living in California, Steven Fishoff,” and a fewof his buddieswith insider trading ahead of public companies’ stock offerings. These companies –there were 13 of them, all pretty small — raised money through what the SEC calls”confidentially marketed public offerings.” A company would engage an investment bank, which would call up potential investors and ask if they wanted to buy shares in the company.The bank would do thisbeforethe companypublicly announced the offering, and would “wall-cross” the potential investors, making them agree to keep the information about the offering secret until it was announced publicly.
The theory here is that by wall-crossing someinvestors before the public announcement of the deal, you can test demand in relative safety. If you wall-cross 20 investors and get a lot of big orders, then you launch the deal publicly and build on strong demand to try to bring in moreinvestors. If you wall- cross 20 investors and none of them are interested, you probably abandon the deal, with less embarrassment (and less impact on your stock price) than if you’d launched publicly and failed to get any buyers.There is also, perhaps, some psychological benefit to making investors feelthat they’re in a special club thatgotan early look at the deal, a benefit that might encourage the wall-crossed investors to come into deals that theymight otherwise have passed on. And by keeping the public marketing period of the deal short — you do the wall-cross, build an order book, and then announce the dealandprice it within a day or two of announcing– you can reduce its impact on your stock price:If you’re not publicly marketing the deal for a week, traders have less time to pound down the stock price.
Butafter you do the wall-cross, you publicly announce the offering, and then the stock price pretty much automatically goes down. This is especially true for small companies, and is just a matter of supply and demand: The company is diluting its current shareholders and is raising money from new investors who will demanda discount to the previousmarket price tocommit more money to the company. The companies in this casewere generally down by double-digit percentages afterthey announced their offerings.
So here’sa predictable stock-market pattern and an easy way to exploit it: If a company calls you up to ask you to invest in its upcoming public offering, you should (1) say yes, (2) sell the company’s stock short before the public announcement, and then (3) buy the stock back in the public offering, generally at a 10+ percent discount, a few days later.
This is of course not legal advice! It is a great trade, but it is also double superillegal, insofar as: * There is a specific SEC rule against short selling stock just before a public offering and then buying back the stock in the offering, and
* There is a general, and much more important, ruleagainst trading on purloinedmaterial nonpublic information, and this is that.
The reason it’s purloinedinformation is that you agreed to take the wall-cross: In getting the information about the deal from the investment bank, you have to agree”to keep confidential, and not disclose to others, the offering information provided by the investment banking firm and refrain from trading the issuers securities or using the information for any reason other than determining whether to purchase securities in the offering.” And by trading in breach of that agreement, you are clearly violating not just the contract, but also insider trading laws, which make it illegal to trade”in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.”
But, you know, who will check? The SEC claims that Fishoff and his associates made at least minimal efforts to cover their tracks, by usingmultiple investment funds (with names like Featherwood Capital, Gold Coast Total Return, Brielle Properties, Seaside Capital, etc.). Some of the funds would get wall-crossed, and then they’d tip each other and trade in the other funds to try to obscure what was going on:
Fishoff and, under his direction, Chernin and Costantin cultivated contacts at investment banks with the goal of ensuring that they would be on the list of prospective investors contacted to participate in securities offerings of the type described above. Fishoff, Chernin and Costantin used these contacts to seek out confidential information about, and get brought over the wall on, upcoming follow-on and secondary offerings. When they were successful in obtaining such information, Fishoff shorted the issuers stock in advance of the offerings, directed trading by Chernin and Costantin in those instances when he did not place the trades on his own, and tipped Petrello, who then also shorted the stock through Brielle and Oceanview.
In many instances, the Fishoff-controlled entities for which Chernin and Costantin were fronting also participated in the offering, with the stock going to Featherwoods account and often being used to cover the short sales.
But it was all, allegedly, one operation:
Since at least late 2010, Chernin and Costantin had their business emails automatically forwarded to Fishoffs personal email account. As a result, emails that investment bankers sent to Chernin and Costantin confirming that they had been brought over the wall on an offering subject to a confidentiality agreement went instantly to Fishoff during this period. In addition to confirming the confidentiality terms and the prohibition on trading before the offering was announced, these emails typically identified the issuer, the type of offering and its anticipated timing.
I feel like that probably violates the wall-cross agreement? Though I have to say that the investment banks’ relationship with their customers does not seem to have been impressively deep:
To obtain access to confidential information about upcoming offerings, Chernin and Costantin, and in some instances Fishoff himself, deceptively established relationships with investment banks by separately cold-calling banks and posing as portfolio managers of legitimate investment funds. For example, Chernin and Costantin separately emailed multiple banks after making scripted cold calls to the banks, including to Investment Bank A, a leader in this segment of the market by deal count, and to Investment Bank B.
Chernin and Costantin both made the same pitch to the banks, falsely presenting themselves as portfolio managers at firms with as much as $150 million in assets under management.
And:
To further the deception, many of the Featherwood DBAs and other entities controlled by Fishoff, including Featherwood, Gold Coast, Seaside and Cedar Lane, maintained identical, though purportedly unrelated, websites falsely proclaiming, among other things, that they were full service financial management firms involved in Wealth Management, Private Equity Services, Investment Banking, [and] Real Estate Investments.
Maybe if your customers have identical websites there’s something up with them?
Anyway these guys allegedly made $3.2 million onthe fourteen deals, and are now in trouble. As well they should be! (If the allegations are true, etc.) Insider trading often looks like a victimless crime, but here there were clear victims — victims oftheft, not ofunfairness. The companies here were trying to sell stock. They knew that they’d more or less have to price the stock at a 10 or 20 percent discount to the market price, but they wanted to limit the damage that their offerings would do to themarketprice. One way to do that was by wall- crossing investors and limiting trading in front of the deal. By cheating on their wall-cross agreements and shorting the stock, these guys had the effect of driving down the stock price, which probably reduced the price in theoffering. These companies probably got less money for their stock because their nonpublic information was (allegedly) used against them.
Though you could have a more cynical view ofthis sort of thing. Acompany needs to sell stock, butworries that announcing a public offering will drive downits stock price and not produceany takers. So it calls someinvestors up privately and tells them it’s doing a deal. Those investors agree to invest in the deal, but before the deal is announced they lay off their risk by shorting the company’s stock. Then the deal is announced and the investors buy shares from the company to (illegally) cover their shorts. The investors get their 10 percent, or whatever, discount to the market price as a commission; their real function is not to invest in the deal but to intermediate between the company (which can’t sell stock without a publicly disclosed offering) and the unsuspecting public (which buys from the “investors” before the public disclosure). The wall-cross agreement creates deniability for the company.No one’s stealing from the company; they’re helping the company get a deal done that would otherwise be much harder to achieve. The victims are the public who buy from the insider traders at the inflated, pre-announcement price.
That doesn’t seem to have happened here: These guys didn’t end up actually buying much stock in many of these deals, so the issuers couldn’t really have been using them to illegally distribute stock.But it is a classic feature of penny-stock financingthat we’ve discussed before, and if I were defending Fishoff and friends it’s an angle that I might explore. These guys didn’t steal from the companies whose stock they insider traded: They helpedthose companies raise money that they otherwisewould have had a harder time raising. Sure, they did so in a way that was really unfair to public investors. But remember: Fairness isn’t the goal of insider trading law.
We talked about this recentlyin the context of John Coffee’s remarks on hedge fund “wolf packs”: The hedge fund leading the pack can tip its allies of its intent to initiate an activist campaign because it is breaching no fiduciary duty in doing so (and is rather helping its own cause); thus, insider trading rules do not prohibit tipping material information in this context. If one can legally exploit material, non-public information, riskless profits are obtainable, and riskless profits will draw a crowd on Wall Street. We’ve talked about it before too. And the Valeant-Pershing Square-Allergan situation has some important similarities: Pershing Square (arguably) traded ahead of (arguably) Valeant’s bid for Allergan, because that was what Valeant wanted, and Valeant was the owner of its own information.(Because of tender-offer insider trading rules the case was more complicated than that, but that settles the basic 10b-5 insider-trading question.) There’s also a more boring traditionalcharge ofinsider trading, in which the SEC alleges that”Fishoff, Petrello and Chernin unlawfully traded in advance of a January 9, 2014 announcement of a lucrative licensing agreement between two pharmaceutical companies, Sangamo BioSciences Inc. (‘Sangamo’) and Biogen Idec Inc. (‘Biogen’), on the basis of material non- public information about the transaction.”
From the SEC: Accordingly, when investment banking firms seek to market a secondary or follow-on offering to potential investors in advance of the public announcement of the offering, the investment banking firms must obtain confidentiality agreements from the potential investors before sharing confidential information about the offering, such as the identity of the issuer, the likely timing and size of the offering and the anticipated pricing terms. Before public announcement of the offering, all such information is considered by the issuer and the investment banking firm to be highly confidential and to be material non-public information, and the misuse or improper disclosure of such information can result in significant harm to the issuer and the integrity of the securities markets. The confidentiality agreements described above typically require, among other things, that the potential investor agree to keep confidential, and not disclose to others, the offering information provided by the investment banking firm and refrain from trading the issuers securities or using the information for any reason other than determining whether to purchase securities in the offering. The process by which an investment banking firm secures a prospective investors agreement to keep non-public offering information confidential and, in exchange, provides that information to the prospective investor is commonly known as bringing the prospective investor over the wall or wall-crossing.
According tothe SEC complaint: This is Rule 105 of Regulation M, which the SEC says that Fishoff and friends violated “in connection with eleven of these fourteen offerings, and two additional secondary public offerings, by causing Featherwood, Brielle and Cedar Lane to purchase shares in the offerings after executing short sales in the same stocks during the 5-day restricted period preceding the pricing of the offerings.”Big investment companies periodically get in trouble for violating this rule inadvertently, and it is certainly a more boring and administrative rule than the one against insider trading. Incidentally, Investment Bank A seems to be Roth Capital Partners:According to the SEC complaint, Investment Bank A marketed deals forSynutra,Telestone,Lannett,Solitario, Quantum Fuel Systems, etc., all of which share Roth as an underwriter.
To contact the author on this story: Matthew S Levine at mlevine51@bloomberg.net To contact the editor on this story: Zara Kessler at zkessler@bloomberg.net
