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Everything Bad Is Insider Trading

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I was away last week and came back to find Libor scandals, soaring Spanish yields, Italo-Spanish bans on short selling, and also Yahoo!? is still terrible, and it's like I never left. One thing that happened last week that's a little new is an SEC insider trading lawsuit against Manouch Moshayedi, the CEO of a company called STEC that makes electronic doodads of some sort. Here is how the SEC explains the problem:

Washington, D.C., July 19, 2012 – The Securities and Exchange Commission today charged the chairman and CEO of a Santa Ana, Calif.-based computer storage device company with insider trading in a secondary offering of his stock shares with knowledge of confidential information that a major customer’s demand for one of its most profitable products was turning out to be less than expected.

"Insider trading in a secondary offering of his stock shares" sounded to me like he was doing nefarious secret trading around the secondary offering - maybe telling a friend to short before the offering was announced? - so I clicked through to the complaint. But, nope, the insider trading was just that he announced he was selling shares, and then sold them. You knew he was selling shares because he did a public offering, diligenced and underwritten by JPMorgan and Deutsche Bank, with a prospectus saying he was selling 9mm shares. (Actually he and his brother and COO were selling that much, combined.) And because when you know you are buying from the CEO of a company, you tend to want some sort of discount to last sale - because he probably knows some stuff you don't about the company's prospects - those shares went at a 9.2% discount to the previous close.

The problem is that he did in fact know something you didn't, and didn't tell you, and it seems to have been worth more than 9.2%. Apparently shortly before the deal he gave EMC, a big customer of STEC, undisclosed discounts to make it move up its orders of STEC products so he could affirm next-quarter guidance. Also it seems EMC told him there would be no orders after that, and he neglected to mention that in his guidance (because the guidance didn't extend past that). So the guidance that he gave in the earnings statement kicking off the offering was ... as far as I can tell accurate, but still Bad, because of the thing where you're not supposed to "omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading." I'm a little unimpressed by the fraudiness here, but the stock did go down a lot later after EMC's nonrenewal came out, so, yeah, call it fraudy.

But why call it "insider trading"? Insider trading, classically, is what Raj Rajaratnam did: trading in anonymous markets on inside information obtained in some secretive way, with counterparties who could not have known that you had the inside information. That's why it's profitable: you buy from people who think that you're evaluating the same information that they have, but you actually have better information. (That's also why prosecutors don't like it: there's the illusion of a level playing field, without the reality.) "Insider trading" is not, typically, used to refer to cases like this where you have disclosed that you are an insider, have sold only to people who knew you were an insider, have put out a prospectus claiming to contain everything material that you know, and then there's a dispute over whether that disclosure actually contained everything material.* Nobody could be surprised to learn that the CEO knew more about the company than they did - that's why they charged a 9.2% discount - they're just surprised that he knew so much more than they did, and that what he knew turned out to be so unpleasant. If this is insider trading, then every time a company sells securities with incomplete disclosure, that's insider trading - as opposed to what I thought it was, which is like "regular old securities fraud."

This is just boring nomenclature, yes, but I read it in conjunction with the insistence by the SEC and prosecutors that insider trading prosecutions restore confidence in the market. This insistence seems rather quaint. Raj Rajaratnam made a few bucks here and there trading on Goldman earnings information he wasn't supposed to have but, y'know, Liborgate! Quinquajillions of dollars of derivatives etc. etc. and not an insider trade in sight - and regulators knew about it since 2007 and were cool with it until recently. Which thing should make you more worried about the integrity etc. of markets: that sometimes hedge fund managers learn of deals a few hours before they are publicly announced and make profits of up to tens of millions of dollars on that knowledge, or that eight hundred trillion dollars of loans and derivatives have an interest rate that a handful of banks (1) make up every day and (2) make up every day with evil in their hearts and their derivatives profitability in their minds? The priorities of a regulatory system in which prosecutors worked for months to set up wiretaps on a few equity insider traders, while nobody blinked at the emails that a Libor panel bank sent to regulators and all of its clients every day saying that Libor was manipulated, seem ... odd?

They look better, though, if you classify any failure of disclosure - any sort of deception or information asymmetry in financial transactions - into "insider trading." (Which, I mean, it's not not that: you have material nonpublic information and you trade without disclosing it, boom, insider trading, it's not wrong, it's just not the customary use of the term.) Thus for instance Liborgate: banks entered into swaps contracts where they knew, and their counterparties (uniquely!) did not, that they were manipulating Libor: insider trading! (Also these things? Sure!) Mortgage-related synthetic CDOs in which banks sold deals without fully disclosing who was picking the reference portfolios: insider trading! Lehman Brothers: insider trading! (They were selling bonds etc. etc. you know the deal.) Mortgage fraud: insider trading! Anything bad: insider trading!

And why not? If you lack confidence in the financial system, which seems sensible enough, it's probably because someone isn't telling you something about whatever bit of that system they're peddling to you. If every time someone fails to tell you something about what they're peddling, you call it "insider trading," then insider trading is in fact the main problem with financial markets, and the regulators are doing a good job by focusing on it. Sure, maybe they don't always go after the most important specific types of insider trading, but close enough, right?

SEC Charges CEO With Insider Trading in Secondary Offering of Company Stock [SEC]
SEC charges STEC chief with insider trading [Reuters]

* There are partial exceptions - Jeff Skilling was convicted of insider trading for directly selling stock while Enron's public accounts were maybe not so true - but those were 144 transactions in anonymous public markets, not marketed offerings with a prospectus where buyers knew that they were buying from the CEO.