October 8, 2021
True or false? The rules for us – normal folks – are different than the rules for them… that is, the people whom we put in positions of power.
Let me give you some real-world examples to help you better answer this question…
Exhibit 1: One of these true-life episodes of insider trading resulted in the perpetrator winding up in handcuffs. Which one?
No. 1 The Dumb Analyst: In April 2019, digital printing company Electronics for Imaging (“EFI”) was bought by a private equity company for around $1.7 billion, at a 26% premium to the last closing price. The acquisition was in part funded by debt provided by Canadian bank RBC Capital Markets – where a junior analyst named Bill Tsai, who was aware of the deal, had days before bought EFI call options (which increase in value when the price of the underlying share rises). Tsai, who’d joined the bank less than a year before, made around $100,000 on his options.
No. 2 The Savvy Senator: On January 24, 2020, Centers for Disease Control and Prevention Director Robert Redfield and National Institute of Allergy and Infectious Diseases Director Dr. Anthony Fauci privately briefed a group of senators, including Sen. Richard Burr about the coronavirus. (The first case of the coronavirus in the United States was confirmed three days earlier.) Two weeks after the briefing, Burr wrote in a Fox News opinion piece that “the United States today is better prepared than ever before to face emerging public health threats, like the coronavirus.”
On February 13, Burr sold shares – including of lodging companies Wyndham Hotels & Resorts (WH) and Extended Stay America (its stock ticker then was STAY, but in June 2021 the company was acquired) – worth somewhere between $628,000 and $1.72 million. The shares of Wyndham proceeded to fall nearly 60% over the following five weeks… And shares of STAY declined 50% over the next three months.
No. 3 The Fed Traders: Over the course of 2020, Dallas Fed President Robert Kaplan bought and sold shares of the iShares Floating Rate Bond Fund (FLOT), an exchange-traded fund (“ETF”) that tracks bond prices. He also made multiple trades for more than $1 million each in a number of individual securities, including Apple, Delta Airlines, Alibaba, and Amazon. Meanwhile, his colleague Boston Fed President Eric Rosengren owned stakes in four different real estate investment trusts – including at least one that holds mortgage-backed securities.
As senior Federal Reserve officials, Kaplan and Rosengren played a key role in policy decisions that resulted in the Fed purchasing bonds and mortgage-backed securities. Their share purchases were revealed in annual disclosures well after the fact.
All three of these episodes smell like sour milk. Using privileged information to make money is against the law. So, the individuals involved were all perp-walked while the cameras were rolling, right?
Are You an ‘Insider’?
Insider trading – similar in (only) this way to pornography – evades easy definition, except for that you know it when you see it. (Or, at least, you think you know it when you see it – except when we’re talking about American government officials.) As the Financial Times explained in July, “There is no precise U.S. law describing the criminality of improperly buying or selling stock upon the possession of material, non-public information.”
In the world of public securities – stocks, bonds, ETFs, and the like – an “insider” is a company officer, director, big (10%-plus) shareholder, or anyone else who for whatever reason has nonpublic material information about a stock. (Nonpublic material information is something that hasn’t been released to the general public – and which is potentially relevant to the share price.)
And “insider trading” is when someone buys or sells a security when in possession of nonpublic material information about the company or stock. Of course, company directors and senior management almost always have insight on their company that is material and which outsiders aren’t aware of. So they’re subject to timing restrictions (not too close to earnings releases, for example) and transparency requirements (transactions have to be lodged with the regulator).
But there is still a lot of gray area in the definition of insider trading, which is where the “I know it when I see it” factor comes into the picture.
One of the most (infamous) insider-trading cases was the sale in 2001 by household diva Martha Stewart of nearly a quarter of a million dollars’ worth of shares of biotech stock ImClone… after the founder of the company, a friend of Stewart’s, told her to sell – based on his insider insight. Stewart went to prison for five months and spent another five months under home confinement.
(Now, there’s a big difference between insider information… and having insight on a company or sector and investing based on that research. If you’re a senior accountant at Widget Maker Inc. and you see in the draft quarterly financials that the company is going to miss its forecasted earnings, you’re in possession of insider information. If you’re a gumshoe investor and you visit dozens of venues where widgets are sold, and talk to suppliers and buyers and consumers and learn that the latest version of widgets just isn’t moving off the shelves… that’s not insider information: It’s just good research.)
To step back… who cares? If someone happens to know something insider-y and can make money from it (by, say, buying or selling the shares or options)… well, why not? It’s a free country, after all.
The problem is that insider trading – unlike, say, smoking weed, jaywalking, or taking candy from a baby – is not the victimless crime that it might first appear to be. That’s because for every share that’s sold, there’s a buyer… And for every buyer, there’s a seller.
Our crooked accountant friend at Widget Maker, armed with the knowledge that the company is going to miss earnings (and that, as a result, the share price will likely decline), sells some of his shares in the company to avoid taking the loss. (Or he may sell the shares short or buy put options – both of which are a way to profit from the decline in a share price.) And on the other side of that trade is an unsuspecting regular (non-insider) dummy, who’s buying the shares of Widget Maker – unaware of the dastardly fate awaiting them.
Our unsuspecting dummy loses money on the trade. If this happens often enough – the insider passing on the hot potato to poor schlubs like you or me – we’re going to lose faith in the way the market works. If I know that the market is rigged against me… am I going to participate in it? More likely, I’ll buy a CD that yields 0.001% instead and kiss my Robinhood account goodbye.
And that attitude of (hard-earned and understandable) risk aversion – spread across an entire population of would-be investors – can cripple an economy, stymie innovation, and starve companies of capital.
From our quiz at the top of this essay… two points if you guessed that it was “The Dumb Analyst” who paid for his crime…
No. 1 The Dumb Analyst: In August 2019, Bill Tsai – who in a 2017 college interview urged his fellow students to “hold on to [their] values” and to “stay humble” – was arrested for insider trading. He was later forced to disgorge his gains, plus interest. And he was barred from working in the brokerage industry.
Why did Tsai think that he could get away with such a transparent, and transparently illegal, maneuver? Perhaps for the same reason that people speed on the highway… they think they can get away with it.
There’s no evidence that regulators sought to make Tsai’s case an example to other potential insider traders. But if you’re in a position – as a banker or as a company official – to have access to insider information, there’s at least some deterrent effect in the story of the 23-year-old New York University undergraduate business school student body president tossing his career onto the trash heap… over buying some call options.
Let me tell you what happened with the other two examples…
No. 2 The Savvy Senator:Burr – who was joined by a number of other senators in suspiciously timed share sales – later explained that he’d relied upon public news reports to make his well-timed sales… so of course the coronavirus briefing had nothing to do with it.
And that’s just the tip of the iceberg, in a Titanic kind of way, of congressional insider trading. There’s an entire website dedicated to tracking the stock trading activity of congressmen (most-traded stock: Microsoft, with 71 trades for $47 million… biggest profiteer buyer: Republican Rep. Michael McCaul from Texas, with 1,138 trades worth $78 million (!) over the past year alone, including $35 million in buys… Apple: The fifth most-popular stock for both buys and sells…).
Speaker of the House Nancy Pelosi – who has unique insight on the priorities of Congress – and her husband own around $6.5 million worth of shares of chipmaker Nvidia (NVDA), and much of that includes a hefty gain. In July, Pelosi’s husband made $5.3 million, according to Business Insider, by exercising call options in Alphabet (the parent company of Google).
Members of Congress are prohibited by law from trading on “material, nonpublic information” derived from their positions. The Stop Trading on Congressional Knowledge Act of 2012 requires congressmen (and their spouses and dependent children) to disclose any buys and sells of stocks, bonds, commodities, and other securities within 45 days of the trade. The enforcement of these rules, though – as demonstrated by the copious volumes of shady stock-trading activity by Congress with apparently no repercussions – is terrible.
No. 3 The Fed Traders: Soon after the disclosure of his trading activity, Boston Fed President Rosengren announced that he’d be stepping down from his position, nine months earlier than planned. He cited health concerns – Rosengren is hoping to receive a kidney transplant – as the reason for his departure.
Hours later, Dallas Fed President Kaplan announced that he’d also be leaving the Fed, in early October. Unlike Rosengren, he cited the trading-activity controversy, saying that he was concerned it might become a “distraction” for the Fed. Neither (apparently) broke the law, though, as the Fed’s ethics policies prohibit senior officials from owning the shares of banks but allow other trading.
Days later, Federal Reserve Chairman Jerome Powell – glancing at the open barn door after the horse ran away, got married, raised a stable of foals, and got a job as a greeter at Walmart – ordered a “fresh and comprehensive” examination of the rules governing financial activities by senior Federal Reserve officials. (Powell also said that in his own personal portfolio, he owns at least one municipal bond fund… and explained that Fed compliance officers had signed off on his holdings around the time that the Federal Reserve started buying municipal bonds in March 2020.)
The story isn’t going away anytime soon, though. Late last week, it was reported that Federal Reserve Vice Chairman Richard Clarida had traded millions of dollars of a bond fund the day before Powell issued a statement on February 28, 2020, hinting at policy action because of the worsening pandemic.
Earlier this week, Sen. Elizabeth Warren – who has repeatedly hammered Powell for his limp approach to banking sector regulation – called for stock market regulator Securities Exchange Commission to investigate whether Fed officials had engaged in insider trading. And adding to her previous characterization of Powell as a “dangerous man” for weak banking oversight, she said that Powell had “failed as a leader” of the Fed.
(To her credit, Warren practices what she preaches… She doesn’t have a single trade on capitoltrades.com. When she was elected in 2012, she owned only one stock – IBM – which she sold soon thereafter.)
After months of extraordinary gains, the U.S. stock market is now looking off. Investors worldwide now ask, “Is this the beginning of the end of the most epic stock rally in history?” All eyes were on September 28 for the answers. Here’s the entire story.
What Will Change: Null Set
Powell, who was named Fed chairman by former President Donald Trump, is facing renomination early next year. The evolving Fed trading scandal – and Warren’s merciless grandstanding – is hurting the chances that the White House will reappoint him to what the Washington Post calls “the most powerful economic official on the planet.”
Also, the composition of the senior circles of the Fed is critical to how policy is devised. Both Rosengren and Kaplan were among the senior Fed officials keener to hike interest rates sooner (in 2022) than official Fed statements are suggesting. Their departure might slightly tip the balance of opinion internally. That might not matter when a rate-hike decision is made… but it could, with enormous consequences for markets and the global economy.
Questions over the future leadership of the Fed come at a delicate time, as the New York Times explains…
Millions of jobs are still missing compared with before the pandemic, and inflation has jumped higher as strong demand clashes with supply chain disruptions, presenting dueling challenges for the Fed chair to navigate. The Fed’s next leader will also shape its involvement in climate finance policy, a possible central bank digital currency and the response to the central bank’s ethics dilemma.
Warren will push to tighten trading rules for Fed officials. She’s also sponsoring legislation to prohibit lawmakers from trading individual stocks. And this isn’t her first rodeo… In 2018 and 2020, she introduced legislation that would have engineered greater ethics scrutiny on Congress and other federal employees. The measures had zero cosponsors in the Senate, and failed.
Will it be different this time? Even the greed-is-good Financial Times thinks that “Federal Reserve stock trading is dangerous” and that officials shouldn’t be transacting in individual company shares. Legislation to prevent this “should happen,” wrote one columnist.
But will it? People in positions of power, throughout history, have never been particularly good at governing themselves. Clubby congressmen, faced with the prospect of legislating themselves out of trading income worth their public servant salaries many times over, will come up with Escher-like explanations to justify their financial infidelities. Reluctant to disrupt the Fed – and the global economy – over a few Fed officials padding their retirement accounts, the Biden White House will renominate Jerome Powell, who will announce slightly tweaked trading rules for Fed officials that will have as much impact as an umbrella in a tsunami.
There are rules for them – and the rest of us. Just ask Bill Tsai.
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Executive Editor, American Consequences
With Editorial Staff
October 8, 2021