The SEC’s role policing insider trading continued with a complaint filed in federal court in San Diego freezing the accounts of unknown call option purchasers of Petco before the leveraged buy-out announced on July 14 at $29 per share, a nearly 50% premium over its market price. The SEC complaint (currently unavailable) alleges that purchasers through accounts in the United Kingdom and Switzerland accounted for more than 70% of the trading volume in July $22.50 and August $20 call options, and the purchases began at the end of June. The July $22.50 options are particularly aggressive because they would expire in less than a month, were well out of the money, and the buying was into a down market at the time. A Bloomberg story (here) notes that the district court issued a temporary asset freeze to keep $862,000 in proceeds from leaving the country, where it likely would have disappeared. This is the second case in a little over a month involving call options purchased by overseas traders, similar to the Maverick Tube case involving purchasers in Argentina and Uruguay (see earlier post here). Like all unknown purchaser cases, the SEC will have to link the purchasers to the inside information about the deal, so stay tuned for further developments. (ph)
Category: Securities
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A Wall Street Journal article (here and Law Blog entry here with access to the article) discusses the response of major law firms to the current spate of SEC and grand jury investigations of companies related to the timing of their options awards. Not surprisingly, the firms have viewed this as a marketing opportunity, informing current and potential clients that the best strategy is, of course, to consult with competent counsel. For example, national law firm Latham & Watkins is touting its "Options Timing Working Group" that comes complete with a page on the firm’s website (here) and offers missives written by Jim Barrall in The Executive Comp Insider that tout, again not surprisingly, the need to obtain legal counsel. The burgeoning investigations have already touched over fifty companies, and that’s just the ones publicly disclosing pending investigations. The number of companies conducting their own internal reviews is much higher than that, and we will see more disclosures of problems in the coming months. With all the lawyers getting involved in these cases, the interesting question will be whether firms are conflicted out of certain representations, either because they were involved in the drafting of the stock option agreements or their conduct of an internal investigation means they cannot defend individual officers or directors in subsequent cases. As Peter Lattman notes in the WSJ article, this is another instances of lawyer full employment — not that there’s anything wrong with that. (ph)
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The "free money" that can be made when trading in the options of a company about to be acquired is just too darn tough to resist, at least for some. On the heals of last month’s SEC filing alleging insider trading by purchasers of call options in Maverick Tube right before it announced it would be taken over (see earlier post here), the Enforcement Division is now looking at trading in the two companies — Western Gas Resources and Kerr-McGee — that Anandarko Petroleum Corp. announced on June 23 it agreed to acquire. A Denver Post article (here) confirms that Anandarko Petroleum is cooperating with an informal SEC request for information related to the two acquisitions, and a study of the call options in both companies shows suspicious spikes in the volume right around the days when executives of each were working out the final details of the acquisitions. The story gives the example of the purchase of 322 July 50 Western Gas call options, which were slightly out of the money, the day after executives met to discuss the merger and the day before the board held a special meeting to consider the transaction; over the prior two weeks, the average daily volume for that series was 17. A similar pattern is shown in the Kerr-McGee call options, and each transaction involved a substantial premium that sent the shares of both well above the call option strike prices, meaning the purchasers realized substantial gains.
Needless to say, the SEC doesn’t view winners of the call option lottery in the weeks before the announcement of an extraordinary transaction to be just lucky, and we should expect to see an insider trading action filed in the none-too-distant future. As always, the key issue for the traders is whether the U.S. Attorney’s Office is in the vicinity, and the safe bet is that federal prosecutors will be monitoring the SEC investigation. (ph)
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An earlier post (here) discussed the July 15 auction of the property of former Patterson-UTI CFO Jody Nelson to recover some of the $77 million he embezzled from the company. Some of the property of Kirk Wright, founder and former CEO of hedge fund firm Investment Management Associates (IMA), will go on the block on July 28 as part of the firm’s bankruptcy. Wright disappeared in early 2006 amid accusations from the firm’s clients, which included a number of former NFL players, that their assets had disappeared from the firm’s funds. Wright was found in a hotel in Miami in May, and remains in jail while the government appeals an order granting him bail. A grand jury issued a superseding indictment on June 28 charging Wright with 24 counts of mail and securities fraud, on top of a single mail fraud count charged in a May 25 indictment, related to the disappearance of virtually all the money invested in the firm, which the government alleges had effectively devolved into a ponzi scheme (see U.S. Attorney’s Office press release here). Wright supplied investors with reports indicating the funds had over $180 million in assets, but when the government finally seized its accounts there was less than $500,000 there.
The upcoming auction (property description here) involves a 9600 square foot home in East Cobb, Georgia, a luxury loft near the Georgia Aquarium, all the equipment and furnishings from IMA’s offices in East Cobb, and three cars from Wright’s collection, described as follows: "The Aston Martin is a gray 12 cylinder 2003 Vanquish 2 door coupe with blue interior and only 4,266 miles. The Bentley is a blue 12 cylinder 2005 Continental 2 door coupe with tan interior and only 7,890 miles. The BMW is a classic silver 1967 2000CS in excellent condition, with 98,000 miles." Unfortunately for the victims of IMA’s collapse, even if these items fetch top dollar — which is unlikely in a fire-sale situation — that will be a drop in the bucket compared to the losses the investors have suffered. The NFL players have sued the league and the players union for certifying IMA and Wright as part of its Financial Advisors Program, a seal of approval that does not appear to have included much protection; they are seekig to recover the $20 million they invested in the firm’s hedge funds (see Atlanta Journal-Constitution story here). (ph)
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SEC Commissioner Paul Atkins set off a bit of a controversy when he praised so-called "spingloaded" options granted to corporate executives in advance of the disclosure of good news and said that they cannot constitute insider trading. In his remarks to the International Corporate Governance Network (here), he stated:
A scenario that has drawn much attention is the colorfully named “springloading,” which has been defined as the practice by which a company purposefully schedules an option grant ahead of good news, or purposefully postpones an option grant until after bad news. I am not sure where the term springloading came from, but it certainly has an ominous ring to it.
Not only are there difficult factual issues that need to be proven, such as the nexus between the grant decision and the subsequent news event, but there are also substantive legal issues that need to be addressed. Specifically, we need to ask ourselves whether there has been a securities law violation even if a nexus can be identified between the grant and the news event. Isn’t the grant a product of the exercise of business judgment by the board? For example, a board may approve an options grant for senior management ahead of what is expected to be a positive quarterly earnings report. In approving the grant, the directors may determine that they can grant fewer options to get the same economic effect because they anticipate that the share price will rise. Who are we to second-guess that decision? Why isn’t that decision in the best interests of the shareholders? We also need to remember that predicting the stock price effect of an upcoming event is difficult, let alone predicting the trajectory of the stock price over the next twenty quarters until the options vest.
Also swirling about are accusations of insider trading by corporate boards in connection with options grants. Again, one has to ask whether there is a legitimate legal rationale for pursuing any theory of insider trading in connection with option grants. Boards, in the exercise of their business judgment, should use all the information that they have at hand to make option grant decisions. An insider trading theory falls flat in this context where there is no counterparty who could be harmed by an options grant. The counterparty here is the corporation — and thus the shareholders! They are intended to benefit from the decision.
The issue of options-timing has come into focus recently as companies have revealed that documents related to the awards may have been backdated to ensure that the options priced at the low point to enhance their value. Some companies, such as Microsoft, disclosed their practice was to date the option at a low point for the stock, but it stopped that in 1999. Backdating documents does not mean the option grant was itself improper.
It’s an interesting question whether an executive who accepts stock options from a company that "knows" of undisclosed good news and times the issuance of the options to enhance their value can even be termed insider trading, as Commissioner Atkins notes. Aside from his argument that there is no counterparty defrauded by the transaction, there is a question whether the transaction is even a "purchase or sale," an element of any fraud claim under Section 10(b) and Rule 10b-5, the basic insider trading provisions. Similarly, if the option is not exercised immediately but instead only down the road, can it be said the executive traded while in possession of material nonpublic information when that information may have been disclosed months or even years earlier? An interesting article by Professor Iman Anabtawi, Secret Compensation, 82 North Carolina L. Rev. 835 (2004), thoroughly reviews many of the issues related to using options and timing their issuance as a means to compensate management.
Compensation of senior executives is certainly generous, especially when compared with lowly law professors, and there is an almost natural reaction to view any transaction in stock related to undisclosed corporate information as potentially insider trading. A Wall Street Journal article (here) on the issue quotes the reaction of one person to Commissioner Atkins’ statement as "[t]his is just not fair." There is a visceral reaction when well-paid executives appear to game the system to reap even more benefits, but that does not necessarily mean the federal securities laws have been contravened. Pigs at the trough maybe, but securities violators is a much more difficult conclusion to reach. (ph)
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For those of you keeping score over the long holiday weekend, add two more Silicon Valley companies to the list of those who have received grand jury subpoenas from the Northern District of California in the ever-widening stock options-timing probe. Maxim Integrated Products, Inc. — not to be confused with the magazine — and Zoran Corp. disclosed (here and here) that they were served with the grand jury subpoenas and, as usual, will cooperate in the criminal investigation, in addition to providing documents to the SEC in its informal investigation of the issuance of the stock options. On top of Apple’s recent disclosure of possible problems in the grant of options in the 1990s to its executive, including Steve Jobs, these latest subpoenas show that the investigation is still in its growth phase. Given the near-addiction high tech firms have for stock options, look for more announcements of the receipt of grand jury subpoenas and pledges of cooperation. (ph)
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The conviction of former HealthSouth CEO Richard Scrushy on conspiracy and corruption charges is but one step in a line of cases that may well stretch through the rest of the decade. The guilty verdict in Montgomery, Alabama, on charges related to a $500,000 payment to then-Governor Don Siegelman, came 366 days after his acquittal on securities fraud charges related to accounting misconduct at HealthSouth; a grand jury in the Middle District of Alabama returned the corruption indictment indictment during that trial, and it was sealed until a few weeks after the first jury verdict.
The HealthSouth-related cases are not nearly finished. The SEC still has books-and-records claims outstanding in a civil suit that is scheduled for trial in April 2007, and Scrushy will be deposed during discovery in that matter. There are numerous shareholder lawsuits pending, and an earlier order directing him to return a portion of his bonuses and stock awards during the period of the accounting fraud at HealthSouth will likely be litigated along with the fraud claims. Scrushy still has a claim against the company for payment of his legal fees from the 2005 trial, and reports are that he is seeking upwards of $20 million. Depending on how the SEC action turns out, he may seek indemnification of his attorney’s fees in that action, too.
Of course, there remains the appeal of the convictions, and Scrushy is quoted as stating after the verdict, "We intend to continue the legal process until we’re fully vindicated and cleared on all these charges. We believe that our day will come." Don’t look for Scrushy’s appearances in court to end any time soon, barring an unforeseen settlement of the civil claims. An AP story (here) discusses the verdict and other legal proceedings. (ph)
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As if the investigation of Barry Bonds for perjury wasn’t keeping the U.S. Attorney’s Office in San Francisco busy enough, two more grand jury subpoenas have been issued by the Office to companies as part of the ever-widening options-timing investigation. Intuit Inc. and Equinix, Inc., both headquartered in the district, disclosed that they have received grand jury subpoenas dated June 26, 2006, and continuing a pattern seen in numerous other such disclosures, they promise to cooperate in the investigation. Intuit’s press release (here) actually goes a small step further by pointing out that a number of other companies have also been subpoenaed, similar to the playground tactic of blending into the crowd when the principal suddenly appears to investigate the broken window:
On June 26, 2006, Intuit Inc. (Nasdaq: INTU) received a subpoena from the United States Attorney for the Northern District of California requesting documents related to the company’s historical stock option practices. It is our belief that similar subpoenas have been served on many of the companies named in a recent report from the Center for Financial Research and Analysis (CFRA). As disclosed on June 9, 2006, Intuit received an informal request from the Securities and Exchange Commission for information on historical stock option practices. We will fully cooperate with the U.S. Attorney’s office.
Equinix takes the straightforward approach, stating in its 8-K (here) that "it received a grand jury subpoena from the U.S. Attorney for the Northern District of California and that it intends to cooperate fully with the U.S. Attorney’s Office in connection with this subpoena. The subpoena requests documents relating to Equinix’s stock option grants and practices."
The issuance of subpoenas has become almost routine now, and the interesting question is if any cases will move beyond the investigatory stage and result in plea agreements that might lead to additional prosecutions. (ph)
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The role of hedge funds in the securities markets is garnering greater attention because the vast ($2+ trillion) amount of money they manage means that any problems in the industry will be felt widely in the economy, at least in the short term. A recent decision by the D.C. Circuit blocking an SEC rule requiring the funds to register and disclose information only seems to add to their mysterious power. Once there is media attention, that ensures Capitol Hill will jump in front of the cameras, as shown by the "eclectic" hearing held by the Senate Judiciary Committee on June 28 entitled "Hedge Funds and Independent Analysts: How Independent Are Their Relationships?" That title is about as inscrutable as some of my blog posts, and the hearing included testimony from a Department of Justice representative touting the virtues of the corporate fraud task force (statement here), a disgruntled former SEC Enforcement Division attorney complaining about being taken off an insider-trading investigation of a hedge fund because of political pressure (statement here), and a representative from the "Managed Funds Association" (statement here) — i.e. the hedge fund industry’s DC lobbying arm — touting the benefits of shorting stocks. Demonstrating how important the issue is on Capitol Hill, the Wall Street Journal Law Blog notes (here) that there is even a turf battled between the Senate Judiciary and Banking Committees as to which one is the appropriate group to conduct this important investigation. Sounds like the Committees are having a hard time sharing their toys again. (ph)
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The SEC filed a settled civil injunctive action against Raytheon Co., its former CEO Daniel Burnham, and a financial officer at one of its subsidiaries, Aldo Servello, for making misleading disclosures about financial problems in the company’s commercial aircraft subsidiary. According to the Litigation Release (here):
The SEC charged that, in periodic reports filed with the Commission from 1997 to 2001, Raytheon made false and misleading disclosures and used improper accounting practices that operated as a fraud by failing to adequately and accurately disclose the declining financial results and deteriorating business of Raytheon’s commercial aircraft manufacturing subsidiary, RAC. The SEC also charged that certain of these disclosures and accounting practices were undertaken with the knowledge of Burnham in 2000 and 2001 and Servello in 2000. Without admitting or denying the SEC’s findings, Raytheon, Burnham, and Servello agreed to settle these charges by consenting to the entry of a Cease-and-Desist Order by the Commission.
Raytheon agreed to pay a $12 million civil penalty, while Burnham and Servello will disgorge salary and bonuses along with paying a civil penalty totaling $1,238,344 and $34,628, respectively. (ph)
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