When insiders trade

By Felix Salmon
April 4, 2011
audience at Thomson Reuters how he was buying "shadow equity" in Pimco on SecondMarket.

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On Thursday, Pimco CEO Mohamed El-Erian told an audience at Thomson Reuters how he was buying “shadow equity” in Pimco on SecondMarket. On Friday, John Carney put up an intriguing post alleging that deals done on SecondMarket are subject to insider-trading laws. If he’s right, it seems to me that almost anybody buying or selling shares of a private company on SecondMarket would be breaking the law, at least if that company puts out little or no public information about itself. And then today, on Sunday, Zero Hedge picked up on a passing comment in David Sokol’s CNBC interview, where Sokol said that Charlie Munger owned 3% of Chinese auto and battery maker BYD before recommending the stock to Berkshire Hathaway.

We can certainly assume that El-Erian knows material information about Pimco: he is the CEO, after all. And that such information is non-public. Should that then bar him from buying Pimco stock through SecondMarket? And as for Munger, assuming that Sokol’s allegations are true, first read Nocera on Sokol:

How is this not, on its face, evidence of insider trading? A guy buys stock in a company and then talks his boss into buying the company. The fact that his boss is Warren Buffett makes it even more “material,” to use the word the S.E.C. favors when it investigates insider trading. If a company executive trades on material information, knowing that he is privy to stock-moving news that hasn’t yet been divulged to other shareholders, he is likely to be committing a crime. When Warren Buffett buys a company, the stock price goes up. Everybody knows that.

If you apply this logic to Munger, with his monster personal 3% stake in BYD, he looks significantly guiltier than Sokol. Maybe this is why Buffett went so easy on Sokol: he didn’t want to set a precedent which would drag down Munger.

The SEC, when it goes after insider-traders, nearly always looks for trades in which third parties — people like Raj Rajaratnam — trade on information they’ve carefully cultivated from insiders, often taking great care to ensure the utmost secrecy of what they’re doing. But there’s a case to be made that much if not most insider trading is much more overt, and simply never punished. In this sense, pretty much every stock trade by any CEO is a trade done with knowledge of material non-public information. Those trades might well end up being disclosed, but that doesn’t make them any less insidery.

I’m not for a minute saying that all these trades should be prosecuted, although a zealous prosecutor wanting to make a name for himself might well feel like giving it a try. I do think though that people like David Sokol and Charlie Munger should ask themselves why they’re trading stock for their personal accounts in the first place. Is any profit they make ever going to be worth the possible downside in terms of public embarrassment?

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Comments
13 comments so far

As we have read before, cockroaches scatter and hide when someone turns on the light. No one likes roaches, except other roaches, whether they are the Periplaneta Politica species or the Blattella Wallstreeta. Note: the Periplaneta Politica and Blattella Wallstreeta are known to frequently share things with each other, including germs, insider information, food and money.

Posted by GRRR | Report as abusive

How would people trading in private companies be breaking the law? You can’t assume that someone who buys or sells privately traded companies has any inside information – often they buy it just based on hype. And I don’t agree that anyone buying or selling shares in non-traded companies is subject to insider information laws.

I’m not convinced that what Sokol did was insider trading, either. If he had purchased the shares after Buffet told him he was interested, that would be a different story, but he bought them and then told Buffet. If a computer designer at Apple buys stock in a semi company whose products he likes, and then proposes one of their chips in a design (something I have done, but not at a company large enough to impact the vendor’s sales), is that insider trading? (it isn’t).

If Sokol is guilty of anything, it’s his responsibility to Berkshire to disclose the size of his investment. And maybe he is leaving because he didn’t.

Posted by KenG_CA | Report as abusive

My impression has always been that insider trading is just a luxury of the rich. When your golfing buddies are CEOs you are going to pick up tips.

Even though insider trading is illegal it very prevalent among those too small to be under constant scrutiny.

I personally hold the information wants to be free copyleft worldview so a part of me says just make it legal since everyone is doing it anyways. Perhaps the “efficient” market would work things out in the end.

Posted by RyanT | Report as abusive

Agreed with KenG. As long as Sokol and Munger are trading privately at all (as opposed to having 100% of their financial assets in Berkshire), I would EXPECT them to own shares in any company they recommend. If the company is worth buying in its entirety, why wouldn’t they own even a little?

Disclosure of personal interest is always important, even if it is just a few shares. Absence of personal interest is not.

Is this perhaps why hedge fund managers sometimes (always?) put all of their investments in the fund they manage?

Posted by TFF | Report as abusive

On the other hand, isn’t this why CEOs and other very senior executives have in place automatic regular stock selling of their company stock? They have a real need to diversify, yet don’t want to give the appearance of trading prior to significant news.

Relying only on public facts, I suspect that Sokol won’t be in legal trouble, as he could recommend, but not make the decision.

But this only serves to illustrate why the average person increasingly believes that the stock game is rigged against them.

Posted by Curmudgeon | Report as abusive

I’m a bit confused as to why for Sokol and Munger there weren’t very strong restrictions as Berkshire employees on their ability to trade equities. I worked for a large Private Equity firm and we weren’t allowed to buy or sell any stocks without prior approval from the CFO of the firm – these requests were as a matter of course ignored or denied. My wife has worked as an analyst for a hedge fund and a mutual fund and in both instances she was not allowed to buy or sell any stocks either. These restrictions applied to spouses as well.

I know there are a number of reasons other than preventing insider trading that these policies exist, and I know Berkshire isn’t your traditional asset manager. But, I thought that was standard practice across the industry to prevent getting into the ethical gray areas Sokol and Munger have waded into. I thought that these restrictions would be especially strict for high-profile employees. But, maybe they only want to limit the “analysts” and “associates” from doing so. In either case it’s very disappointing.

Posted by AKN2 | Report as abusive

Munger should be vulnerable to a shareholder derivative suit. He ran in front of the company.

Posted by Zdneal | Report as abusive

Like KenG and TFF said, it doesn’t appear that Sokol ever traded on nonpublic information. If he suggested that Buffett buy it believing it not to be a good fit for Berkshire but wanting to profit from his position, that would be a problem, but that’s not insider trading. (In particular, he never had a fiduciary obligation to Lubrizol here.)

I didn’t think insider trading distinguished between publicly traded versus closely held stock, and I would expect El-Erian to go through the same procedures that top executives in publicly traded firms go through to transact in their companies’ shares, but it wouldn’t be per se illegal, and shouldn’t require a new set of rules. The old rules applied to the same thing should work just fine.

Posted by dWj | Report as abusive

If someone at Goldman Sachs did what Sokol did, you would all be tearing into him as an obvious criminal and very bad man. It’s only because of the Buffett halo effect that he gets a pass from so many people. Let’s face it, Buffett was wrong about Sokol’s character. Sokol had the information because he was an insider. He also used his insider status to advance his own interest and was not diligent about disclosing or guarding against the conflict. The difference in scale between the amount of stock he could buy and the amount of stock Berkshire could buy doesn’t morally justify his action – would you defend him if he saw it was a great company based on his work for Berkshire, bought the whole thing, and only then brought the idea to Warren, offering the company to Berkshire at a premium price? Of course not.

It’s very tempting to talk around the illegality and immorality of insider trading, because we all would love to be in a position to make $3m in a month for doing no real work beyond our standard duties. It’s easy to understand why people take the money, but that doesn’t make it right. Consider what the availability of insider trading profits does to insider incentives:

1. Encourages them to conceal all information, positive or negative, for as long as possible so that the public stock price will be as inaccurate as possible and they can position their trades against it. Even very rich insiders are unlikely to trade enough stock to move the price to a more accurate level, particularly when they control the presentation of so much price-moving information.

2. Puts them in a position to distribute lots of money to associates without anyone having to do work, incentivizing various forms of corruption and disincentivizing working on maximizing the value of the company (much more individually profitable to fiddle with the accounting and news flow, buy a bunch of shares, and then report an unexpected huge quarter). Consider how many times a mid-level government worker’s annual salary could be multiplied by finding out that AT&T planned to acquire T-Mobile a week ahead of time. I wonder if that would influence the report he writes on the antitrust considerations?

3. Reduces the ability of stock compensation to align insider incentives with investors, because insiders would always have the chance to parse new information and get out of their positions before the public.

4. Reduces the willingness of prudent outsiders to fund risky projects, because management cannot be trusted to disclose all information or to stick in the stock and take losses if they discover a problem, and therefore might not be as diligent as outsiders would prefer.

Posted by najdorf | Report as abusive

Curmudgeon: The trick is to have such a 10b-5 plan in place to sell stock at a reasonable pace, then cancel the plan if you have private positive news.

Posted by guanix | Report as abusive

I’m re-thinking part of my comment about Sokol: the insider information he did have access to was that Lubrizol was trying to sell itself. Regardless of whether Berkshire Hathaway bought Lubrizol, he figured some company would. If you have been approached by an investment banker for your interest in acquiring a company, then you have inside information. It’s tough luck you know this, but it really should disqualify you from buying shares in the company.

Whether or not he will be prosecuted for that is another story. It’s similar to the case against Mark Cuban, who was told by the board of a publicly traded company that he owned shares in that they were going to do a private sale of shares. cuban sold his shares and avoided a loss because the stock dropped when the news of the impending offering was made public, and the SEC charged Cuban with insider trading. He wasn’t an insider, just as Sokol wasn’t at Lubrizol, but they both had material undisclosed information.

However, in the big scheme of stock market scamming, I don’t think either case warrants criminal prosecution. I figure somebody selling me stock might know something I don’t (or doesn’t know something I do), and it’s hard to stop that kind of activity when there are tens of thousands of publicly traded companies. But I wouldn’t hire Sokol, or even trust him on the other side of a table.

Maybe the way to police this is to levy a higher tax on insider trades. All trades that yield a gain over a specified level (say $1M for now) would be reviewed for insider knowledge. If there is undisclosed information involved, the tax rate is increased to 50% – if the inside information is not disclosed and subsequently discovered during a routine audit, there is a fine (the fine should be a multiple of the gain to discourage hiding the inside trade, and the multiple should be the inverse of the percentage of cases that are audited – so if 10% of all large trades are audited, the multiple should be 10x). Trading by employees of publicly traded companies and their partners should still not be allowed.

Posted by KenG_CA | Report as abusive

Felix, I’d like to know why you think John Carney is correct in alleging that deals done on SecondMarket are subject to insider-trading laws?

I find this highly unintuitive logic. From the SECs own ruling “Final Rule:
Selective Disclosure and Insider Trading” states that Regulation FD only apples “To address the problem of selective disclosure, we proposed Regulation FD. It targets the practice by establishing new requirements for full and fair disclosure by public companies.” Note: PUBLIC COMPANIES.
http://www.sec.gov/rules/final/33-7881.h tm

How could it possibly make sense that investing in private companies can only be done based on publicly available information? Doesn’t investing in private companies almost always rely on non-public info? For instance, every time any VC or angel investor buys equity in a company from a founder, they do so with a gargantuan amount of information not available to the public. This is clearly not “insider trading”. Why would buying equity on SecondMarket from a founder be any different?

Posted by inboulder | Report as abusive

KenG: you wrote “the insider information he did have access to was that Lubrizol was trying to sell itself.”

no – that’s not true – he didn’t have that information when he bought the stock. LZ came up on a screen generated by Citi of potential companies Sokol might be interested in – not companies that were out soliciting bids.

and Najdorf: you wrote “If someone at Goldman Sachs did what Sokol did, you would all be tearing into him as an obvious criminal and very bad man.”

yes, and if the bankers at Citi had done what Sokol did, we’d also be tearing in to them. The same information can be insider trading if one party uses it (the bankers) but not if another party does (Sokol – let me explain:)

see, your next statement highlights the tricky part: “Sokol had the information because he was an insider.”

no – Sokol had the information because “the information” was the thoughts inside his own brain. He decided that LZ was an interesting company. THAT is the information. His own actions were the information – he can’t “un”-know them.

Posted by KidDynamite | Report as abusive
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