Menachem Brenner, the New York University professor whose study found evidence that leaked information pervades derivatives markets, says regulators are either too poor or too busy to chase every insider-trading lead.
Options on U.S. companies that are being taken over have higher volume, prices and bid-ask spreads than other contracts in the 30 days before purchases are announced, according to the May 2014 paper by Brenner, his New York University colleague Marti Subrahmanyam and Patrick Augustin of McGill University. Compared with what the study showed, the number of insider cases brought by the U.S. Securities and Exchange Commission “appears small,” they wrote.
“The SEC has a limited budget, and now they have to decide upon a set of priorities -- where they’ll invest their time and money,” Brenner said in a phone interview on June 19. “They may be viewing some of these trades as small-time compared to all the big things out there, and they might not want to waste their time.”
Option have long been a focus of SEC investigators probing trades before takeover announcements. Brenner’s study, “Informed Options Trading Prior to M&A Announcements: Insider Trading?” says sophisticated investors trying to hide themselves might be attracted to the market’s greater opacity.
Judith Burns, a commission spokeswoman, declined to comment on the study or insider trading prosecutions.
Because the market is too big for examiners to assess every trade, the commission focuses on instances where indications of possible wrongdoing stand out, according to Brad Bondi, a partner at law firm Cadwalader, Wickersham & Taft LLP who leads its securities enforcement group and previously worked at the SEC. It also conducts investigations that are never made public, he said.
“The SEC cannot possibly look over the entire market,” Bondi said in a phone interview yesterday. “There are systems in place that will flag abnormal trading, and if there appears to be indicia or suspicion of insider trading, the SEC will conduct an investigation.”
The commission has about eight examiners per trillion dollars in investment adviser assets under management, down from 19 in 2004, commission chair Mary Jo White said to the House Financial Services Committee in a prepared testimony on April 29. She requested a budget of $1.7 billion for fiscal year 2015 so the SEC could “hire additional staff in critical, core areas and enhance information technology and training.”
On June 18, a House committee began consideration of a spending bill that would provide $21.3 billion to financial services and general government agencies, including the SEC, in fiscal 2015. That’s $566 million less than what was given in 2014 and $2.3 billion less than the Obama administration’s request, according to a press release.
“The SEC does a much better job than pretty much any securities regulator in the world,” study co-author Subrahmanyam, a professor of economics and finance at the New York University Leonard N. Stern School of Business, said in a June 18 phone interview. “That said, we can always improve. The sophistication of the market has gone up tremendously in the last few years with technology, as well as the speed at which people process information.”
Around one-fifth of companies being taken over had options volume in the 30 days prior to takeover announcements that the researchers considered abnormal. It was unusually heavy in bullish calls, especially ones whose payoff was dependent on big rallies in the underlying stock, and in contracts nearer to expiration.
In one part of the study, the authors examined options suited to takeover bets: low-priced contracts that ended up expiring right after an announcement, among other characteristics. The trading had odds of three in a trillion of being explainable by chance.
“We can talk just about statistically unusual activity,” Augustin, an assistant professor of finance at McGill University, said by phone on June 18. “We’re not able to pinpoint any case where there’s insider trading or illegal trading. We can conclude where there’s strong unusual activity that’s pervasive, and look at if the characteristics there are similar to cases that have been litigated by the SEC.”
According to the authors, their interest in the options market was piqued by the government’s investigation following the leveraged buyout of H.J. Heinz Co. by an investor group including Warren Buffett’s Berkshire Hathaway Inc. and Brazilian private-equity firm 3G Capital in February 2013. The SEC froze assets in a Swiss account on Feb. 15, 2013, that it said were used to make $1.7 million before the deal was announced.
“Irregular and highly suspicious options trading immediately in front of a merger or acquisition announcement is a serious red flag that traders may be improperly acting on confidential nonpublic information,” Daniel M. Hawke, the chief of the SEC division of enforcement’s market abuse unit, said in a statement at the time.
Two Brazilian brothers agreed to pay $4.8 million in a settlement with the SEC. In the options study, the authors found 88 cases involving insider trading in options ahead of takeovers during their sample period, from January 1996 to December 2013.
Deals paid for in cash, announced with large premiums and initiated by foreign bidders are the most likely to attract an inquiry by the SEC, according to the study’s authors, who looked at 8,000 litigation releases concerning civil lawsuits brought by the commission. About 59 percent of those cases were cash deals, while a transaction valued above the median deal size is 2.35 times more likely to be pursued, the study showed. An acquisition undertaken by a foreign bidder is roughly twice as likely to be prosecuted, according to the data.
The SEC is in the process of developing a market oversight system known as the consolidated audit trail that will track all securities orders and trades in the U.S. from start to finish.
“A lot of people have interpreted the study as saying the SEC isn’t prosecuting enough or is doing a bad job, but something we clearly highlight is that there might be various explanations,” Augustin said. “We’re not prepared to judge the SEC’s work.”