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The Government Would Prefer It If You'd Stick To Stupid Insider Trading

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Here is a thing no one says: "we really need to reduce the penalties for [unpopular crime]." And nobody said it again last week:

Under proposed amendments to the Federal Sentencing Guidelines announced last week, recommended punishments for insider trading are likely to increase in response to Congressional pressure to ratchet up sentences for securities fraud. That will put even more pressure on defendants to cooperate with the government in the hope of receiving a reduced penalty. ... The proposed amendments to the insider trading guideline would increase the “offense level,” which determines the recommended sentence, by two points if the violation involved “sophisticated insider trading,” and four points if the person was an officer or director of a public company or affiliated with a brokerage firm or investment adviser.

Notice no enhancement for being affiliated with Congress or a regulatory agency! Funny how these things work.

So one theory of insider trading goes like this:
1. Some people get inside information and trade on it.
2. Most people don't.
3. The ones that do are evil! Send them to jail forever!

You could I think - maybe I'm totally off on my own on this one - have another theory which goes more like this:
1. Some people trade on no information. (This is me!)
2. Other people trade on information in the newspaper and SEC filings and stuff.
3. Other people also read sell-side research.
4. Other people do channel checks, talk to customers and suppliers, go to conferences, try to get meetings with management, and otherwise do work that tries to get them an edge over the schmoes who only do 1 - 3.
5. Other people do all of that and occasionally hear hints dropped, or read body language, that maybe suggests that there's a chance that the company will do something interesting, or have something interesting done to it, and that this interesting thing might make the stock go up, or down.
6. Other people get phone calls from lawyers saying "hey we're working on a takeover of Company X" and buy Company X stock based on that.

You'd have to say that most fundamental equity hedge funds and mutual funds fall around a 4.5 on that scale - they do a lot of research, some of which you and I don't have access to, and some of which involves talking directly to humans who know things - insidery things. This is actually okay! It's their job! It would be bad if all investment decisions were based solely on the public pronouncements of companies! Companies sometimes lie!

Similarly it's okay that CEOs are talking to them. If I'm the CEO of a company that's 9% owned by Fidelity, and the Fidelity analyst wants to meet with me, I meet with him. No problem. I'm not supposed to tell him things that are material and that I'm not telling everyone else. But "material" is a word that you can drive a lot of vehicles through. I might well talk general strategic stuff with him, as long as I don't say anything that my lawyer thinks is "material."

In any case, if you're using my, whatever, 6-point scale, you tend to think that "insider trading" is a continuum of factual questions. At one extreme is just the guy who never trades stocks, gets a call from a corporate insider saying "we're going to be acquired in February for $42 a share," and goes out and buys a shitload of February $40 calls. At the other extreme is someone who develops a mosaic of information about the company that includes competitors and market research saying that the company is a good acquisition target, legs into a long position over time, and maybe at some point gets material nonpublic information from someone who wasn't supposed to share it with him, and uses that in further sharpening his thesis. If you have that scale, the guy who just blatantly insider trades seems like ... y'know, a criminal. The guy who possibly has some inside information that informs the view that he's worked hard to develop, by mostly legitimate means, seems like ... well he doesn't seem as bad, does he?

Anyway the definition of "sophisticated" insider trading is I guess not that offensive:

For purposes of subsection (b)(2), "sophisticated insider trading" means especially complex or intricate offense conduct pertaining to the execution or concealment of the offense. The following is a non-exhaustive list of factors that the court shall consider in determining whether subsection (b)(2) applies:
(A) the number of transactions;
(B) the dollar value of the transactions;
(C) the number of securities involved;
(D) the duration of the offense;
(E) whether fictitious entities, corporate shells, or offshore financial accounts were used to hide transactions; and
(F) whether internal monitoring or auditing systems or compliance and ethics program standards or procedures were subverted in an effort to prevent the detection of the offense.

But you should probably read it the way Peter Henning at DealBook sort of implicitly does: "sophisticated insider trading" is a way to bludgeon people engaged in activities that don't fit the easy pattern of "get phone call about acquisition, buy stock." You do dumb, obvious, first-trade-in-your-life-is-short-dated-out-of-the-money-options-on-merger-target insider trading, you get regular jail. You use some inside information as part of a long-standing, sophisticated, mostly legitimate trading business - you get jail plus 2. You arguably had some inside information from conversations with third parties that you think were entirely legitimate but where maybe they hinted something that you shouldn't have known? Still jail plus 2.

I guess you can't argue with this too much on its face. Hiding your insider trading with offshore accounts and stuff is probably worse than just doing it out in the open where the government can catch you more easily. Big-time insider traders probably cause more of whatever nebulous harm insider trading causes than do small-time insider traders (though note that insider trading punishment is already overwhelmingly driven by the sheer amount of money involved - which allowed us to reasonably accurately predict Raj's sentence in September based just on that number). But the focus on number of trades, duration, etc., as well as just the use of the word "sophisticated," suggests that this enhancement will be of most use against the people who are least conventionally "guilty" of insider trading - the people who skate a little too close to the line, as opposed to those who just jump way over it. Maybe - probably - that's the intent. But if you're not a big booster of the current popularity of insider trading prosecution, this feels like a way to make things worse.

Greater Penalties for Insider Trading [DealBook]


After The STOCK Act It Will Still Be Legal To Trade On Congressional Inside Information*

Here's a sort of touching monologue from David Einhorn's call with Punch: If you’ve done the analysis, and come to the conclusion that on it’s own, the company is not going to make it, it makes all of the sense in the world to raise equity at whatever the price is, so that you can know that the company, you know, is – is going to make it. Now, what that brings to my mind though is, you know, obviously we haven’t done your analysis, we haven’t done -- signed an NDA; I don’t know that we’re going to sign an NDA, because we prefer to just remain investors, but from my perspective, and I’ll be just straight up with you, is that gives a lot of signalling value. And the signalling value that comes from figuring out the company has figured out that it’s not going to make it on it’s own is that we’ve just grossly misassessed the -- you know what’s going on here. And -- and that, that will cause us to have to just reconsider what we’re doing, which is not the end of the world to you. You will continue on even if we don’t continue on with you. You could sort of see why the FSA read that to mean that he was insider trading. Like ... (1) You have told me something with signalling value. Sorry - "a lot of signalling value." (2) I will now act on that signal. (3) Don't be mad. "Signalling value" sure sounds like it means "material nonpublic information," doesn't it? Now as we've discussed before, trading on that information would not be enough to make Einhorn guilty of insider trading in the US, though maybe it wouldn't be exactly a great idea here either. Why? Because in our weird but sort of sensible insider trading laws, it's just not illegal to trade on material nonpublic information. It's only illegal to trade based on material nonpublic information that was obtained in violation of some sort of duty of confidence. Since Einhorn didn't sign an NDA, he had no duty of confidence. And since the Punch CEO and bankers weren't tipping him for nefarious purposes, but were instead sounding him out on the company's behalf as a shareholder and potential investor in a new capital raise, they weren't breaching their duty of confidence. You could quibble with the details of that but it's basically the law here. In England not so much. That also seems to be the law for our friends in Congress, who recently passed a law making it illegal for them to insider trade, which is worrying some people who make their living from trading on Congressional inside information: