Michael Strauss, the founder and chief executive of American Home Mortgage Investment (AHMIQ), has faced a swarm of problems in recent months. One of the biggest, fastest-growing mortgage lenders in the country, its shares had slipped from a high of $36.40 last December to $10.47 by late July as the housing crisis deepened.
On July 31, things got decidedly worse. After the Melville (N.Y.) company announced that it would delay its dividend amid growing cash woes, panicked investors fled, sending the shares tumbling $1.04 by the end of the day. Six days later, American Home Mortgage filed for bankruptcy in Delaware (see BusinessWeek.com, 7/30/07, "American Home's Credit Crisis").
Now, could Strauss potentially face civil insider trading charges as well?
Timing Draws Scrutiny
On Aug. 1, with the stock trading at $1.17, Strauss sold 2.97 million shares worth $3.5 million, according to filings with the Securities & Exchange Commission. With American Home's bankruptcy filing on Aug. 6, those shares—along with another 1.57 million shares Strauss did not sell—became virtually worthless.
Such a well-timed sale would typically draw regulatory scrutiny, since it raises the question of whether the CEO would have possessed material, nonpublic information. The CEO would reasonably be expected to know about deteriorating financials and the possibility of a pending bankruptcy at the time of any stock sale.
Yet Strauss, 47, may have a compelling reason for his sizable sale. According to his SEC filings, the shares were sold by a third party to satisfy a margin call. They had been pledged as collateral for a margin loan Strauss had taken out in October, 2005, and were liquidated during the stock's sharp plunge. They were the only shares he had sold for at least the past three years.
Neither Strauss nor the company returned calls for comment.
Parsing a Margin Call
Securities lawyers say that if the decision to sell was totally out of Strauss' hands, then he's unlikely to face legal risk. If his broker actually made the call, then the timing of the sale wouldn't matter, says Jesse Fried, co-director of the Berkeley Center for Law, Business & the Economy at the University of California, Berkeley. Even if Strauss possessed material insider information at the time, such a sale wouldn't violate insider trading laws.
Yet Fried and others argue that Strauss' position may not be as clear-cut as it first appears. Much will depend on whether he exercised any discretion over how the margin call was met. "It's a gray area of the law," says Fried. "The core issue is whether he had a choice."
One key question is whether Strauss had any other collateral in the account that he could have sold to meet the margin call or any other liquid assets outside of the account that he could have used to shore it up. If that were the case, Fried argues that Strauss may have had a responsibility to use those funds to meet the margin call, rather than allow the company shares to be sold.
Parallel with Martha Stewart Case
Equally critical is whether Strauss had any warning that the broker was going to sell. If the broker simply forced the sale amid the stock's sharp plunge, then it wouldn't have mattered if he had any other collateral. But if he was forewarned of a looming sale and actively chose to allow the shares to be sold rather than put up other funds, his legal risks could rise.
"If he had no other liquid assets to cover the call and there was really nothing he could do, it's hard to imagine anyone would allege insider trading," says Jacob Frenkel, a former federal prosecutor and SEC enforcement lawyer now with Shulman, Rogers, Gandal, Pordy & Ecker.
"But if he made a decision to let the shares be sold when he could have provided new collateral, then there is an argument that regulators would consider—that if he could have prevented the sale, he should have."
Securities lawyers say they know of no other cases where an executive who sold shares to cover a margin call has faced insider-trading allegations. But Frenkel sees a parallel with the Martha Stewart case; the trading at issue in that case also did not fit the profile of a traditional or typical insider-trading case. Nevertheless, the SEC pursued a civil insider-trading case against the domestic doyenne in part to clarify what appeared to be a gray area of the law. If regulators found evidence to suggest that the circumstances surrounding Strauss' trade demonstrated that he had discretion over it, Frenkel believes they could take a similar one-off case to clarify the law around margin sales.
Defining the Gray Zone
"The kind of fact scenario we're looking at here with near certainty will invite regulatory scrutiny," he says. Depending on what regulators find, he says, this "could potentially expand or better define the gray zone of insider trading."
Of course, there is one prominent case where the stock sales an executive made to meet margin calls gained notoriety: the criminal case against Enron CEO Kenneth Lay. While Lay was not charged with insider trading, the issue of his stock sales figured prominently in the securities fraud case against him. Lay tried to fight the allegation that he was selling shares even while making materially false statements about Enron publicly by arguing that his sales had been forced by margin calls. But prosecutors demonstrated that Lay had considerable other assets with which he could have met those margin calls. Lay was convicted of securities fraud, although the verdict was later voided following Lay's July, 2006, death from heart disease.
John Hueston, the lead prosecutor in the Enron case who is now practicing with Irell & Manella in Los Angeles, said that regulators would also look closely for evidence of precisely when Strauss—who founded American Home in 1991—might have learned that a bankruptcy filing was planned. They would also assess what information might have already been in the public domain, such as whether analysts already were discussing the possibility of a pending bankruptcy.
Another consideration would be the long-term pattern of his sales, and the fact that he appears to have made no other sales before Aug 1. "Was this the only significant sale during the precipitous final decline of the stock? If so, it would appear to be a rather belated and inept attempt to profit from insider information," Hueston wrote in an e-mail to BusinessWeek. "On the other hand, $3 million is a significant sum, especially to jurors who will hear from investors who lost everything. That fact alone will keep regulators on the hunt."