The FT today reports that the SEC is looking into whether there was insider trading based on leaks of S&P’s downgrade on Friday. Which is puzzling – who made S&P insiders?
There's something going on here that is not quite an insider trading investigation. For one thing, there probably wasn't insider trading. The SEC helpfully tells you that “Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.”
Let's take a look at that, starting with “buying or selling a security.” What security? Normally, you'd think that advance notice of a downgrade would let you short the subject bonds and make money. Here, not so much. Treasury yields were up on Friday but spiked lower on Monday after the downgrade and closed well below where they started on Friday. So if you naïvely shorted Treasuries when you heard the rumor Friday morning, and closed out Friday afternoon, you could have done okay – but if you waited until the information became public to close the trade, which is the normal way to insider trade, you'd have lost money.*
The next requirement is that the trade come from a “breach of a fiduciary duty or other relationship of trust and confidence.” That is, it’s got to be inside information. Here there are no insiders – S&P had no relationship of trust with the U.S. government, and it knows nothing more about the creditworthiness of the U.S. government than anyone else. Probably less!.
The FT says “If the investigation results in a case, it would not be the first time government-related information leaked or a rating firm employee was charged with insider trading.” But we can’t find cases where a rater was charged for leaking ratings information. Previous ratings-agency charges seem to have been based on more traditional corporate information: an analyst was rating a company and leaked information about an upcoming merger – same as a banker or lawyer or Nasdaq markets intelligence officer who misuses client information.
That said, there is a famous precedent for non-insider trading being treated as insider trading – Wall Street Journal columnist R. Foster Winans leaked the contents of his upcoming columns, which were market-moving, and was arrested and convicted of insider trading. The Supreme Court ultimately upheld his conviction that this could be insider trading because he “misappropriated” information from the Journal, even though he had no inside information about any of the companies that his cronies traded on.
Note what the Supreme Court said about Winans’s column by the way:
Petitioner Winans was coauthor of a Wall Street Journal investment advice column which, because of its perceived quality and integrity, had an impact on the market prices of the stocks it discussed.
So … this would be different then? For this to be illegal insider trading, the downgrade would have to be “material,” and “perceived quality and integrity” is a good starting point for that. Why would you care what the S&P thinks? The agencies’ track record of predicting defaults is quite bad, to the point that an S&P rating creates anti-information by predicting default worse than debt-to-GDP ratios. And again, since Treasuries went up after the downgrade was released, one might reasonably conclude that investors are not all that moved by S&P’s sovereign rating prowess.
Oh, one more thing - the downgrade wasn’t all that nonpublic either. An S&P spokesman pointed out that they were pretty much jumping up and down to tell anyone who would listen about the impending downgrade:
“In our July 14, Credit Watch Negative announcement, we indicated that there was an at least 50% chance of a potential of downgrade if an agreement regarding the debt ceiling is reached, but does not change the trajectory of U.S. debt growth in the medium term. In addition, we published several reports and broadly communicated our views regarding the potential impact on other fixed income securities.”
So no clear trade, no insider information, nothing material or nonpublic - why is there an insider trading investigation again?
There isn't. MarketWatch points us in what looks like the right direction:
At issue, in part, is a 2006 statute — the Credit Rating Agency Reform Act — that says a credit rating agency could have its licence registration revoked if it leaked information about its pending downgrade decision before making that information publicly available.
In other words, the SEC isn’t looking to catch insider traders – it’s looking for leverage to delegitimize S&P if it violated the rules that let it give "official" credit ratings. A telling fact is this, again from the FT:
The inquiry was made by the SEC’s examination staff, which has oversight of credit rating firms, one person familiar with the matter said. The exam staff can make referrals to the SEC’s enforcement division if it believes any laws have been violated, but the inquiry might not result in a referral.
But that's not how actual insider trading investigations work. Market moving events - above all, corporate mergers - are announced all the time, and when they do the SEC regularly does a routine insider-trading check whether or not there's any suspicious activity. They'll ask everyone at the companies, and their banks and law firms, who knew about the deal, and then they'll cross-check those people against the people and firms who traded ahead of the announcement. But as we recall even these routine checks are done by the enforcement division, not (say) the SEC’s corporate finance or M&A offices.
If the SEC were looking for insider trading, enforcement would be doing it. The fact that the credit-ratings overseers are doing the investigation suggests that ... they're looking for credit-ratings shenanigans. Meaning that hedge funds who bought or sold Treasuries or stocks or did whatever else on Friday – even if they had an inkling of the downgrade – shouldn’t be too worried. But Michael Moore should be pleased.
* Or you could have say shorted equities figuring that the downgrade would hurt investor confidence – but an enforcement action on that seems pretty tough since you could literally trade any stock on the leak, and you surely don't have material nonpublic information about every stock. We’re sort of intrigued by this – has anyone ever been prosecuted for insider trading in equities based on leaked macro data?