A Sanofi (which makes enoxaparin) factory (with Angela Merkel).

Photographer: Thomas Lohnes/Getty Images.

Hedge-Fund Consultant Bantered for Insider Information

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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The basic puzzle of insider trading is that it is legal to call up corporate executives or government officials and ask them questions, and it is legal to trade stocks, and it is even legal to trade stocks after asking your question and getting an answer, except that sometimes it isn't. You're supposed to be able to ask questions. If you're a shareholder of a company, that company's executives work for you. If you're a citizen of a country, its government's officials work for you. If you have questions, they should help. Transparency is generally thought of as a virtue. Companies shouldn't keep secrets from shareholders, and governments shouldn't keep secrets from citizens, unless they really need to.
QuickTake Insider Trading

Sometimes it's even the official's job to talk to you. Corporate executives regularly meet with big shareholders and potential shareholders. They do this for the same reason that they meet with customers and suppliers: The company's business involves managing relationships with the capital markets, just as it involves managing relationships with customers and suppliers, and meeting with investors -- to pitch financing transactions or get feedback or encourage them to buy the stock -- is just part of the job. Similarly, government officials regularly talk about their work with citizens, not just because the citizens are curious, but also because the officials' work involves getting outside input. If you work for the Food and Drug Administration, approving generic drug applications, you can't really do your job without talking to people outside the FDA. Like, at the very least, you need to talk to the companies that ask you to approve their drugs! But you might also be interested in views from trade groups, doctors, patients, or other people with something to say about drugs. 

And obviously people are allowed to trade stocks; that is our birthright as Americans. We're even supposed to do some research before trading those stocks, so we know what we're buying. Asking questions seems like a particularly effective kind of research.

And yet it's just kind of weird if I call up an FDA official and ask "hey are you going to approve XYZ Corp.'s generic drug" and he says "we sure are" and then I go buy XYZ Corp. stock. Is it legal? Is it illegal? The answer is ... a little murky, honestly. The basic meta-rule is that, if I get the information fair and square, I can trade on it; if I get it in a corrupt way, I can't. But it can be hard to tell the difference. There are some clear cases. If I hand the FDA official a bag of cash, and in exchange he tells me that he's going to approve the drug: probably illegal.  If I am his priest, and he tells me that he's going to approve the drug under the seal of confession: pretty creepy for me to trade on it. If I call him up out of the blue to ask the question, and he answers out of the gratuitous kindness of his heart ... I mean, he might get in trouble for telling me, but under modern insider trading law I can probably trade. In between those extremes, though, there is plenty of murk.

Today's murk is a criminal and civil insider trading case against Sanjay Valvani, a portfolio manager at Visium Asset Management, and Gordon Johnston, a former FDA official (from 1987 through 1999) who, at the time of the alleged insider trading (2010 to 2011), was vice president of the Generic Drug Trade Association.  He was also working as a consultant for Visium, on a retainer of $5,000 a month. Johnston, who has pleaded guilty to the charges, called up an official in the FDA's Office of Generic Drugs and asked him if it was going to approve some drugs. The official told him, and then he allegedly told Valvani. Then Valvani traded in the stocks of companies that made those drugs, or their brand-name competitors. ("Sanjay Valvani is an innocent man whose investment decisions were always based on rigorous and entirely appropriate research and analysis," says his lawyer. )

So: What makes that illegal? It's not a crime, I hope, to ask a government official about his agency's actions. There's no allegation that Johnston bribed the FDA official, or that the official got some other "personal benefit," or even that the official -- who was Johnston's "friend and former mentee" -- meant to do Johnston a favor by giving him information to trade on. Instead, the government claims that the official was talking to Johnston in confidence, and that Johnston had a duty not to disclose his secrets:

It was implicit in their relationship that Johnston would not pass such information to an investor. At the time of this conduct, Johnston and the FDA Official had been friends for over twenty years, during which time they shared both personal and professional confidences. Johnston and the FDA Official confided in each other about their frustrations at work, socialized outside of work, and had met each other's families.

The FDA Official was comfortable sharing things with Johnston that he did not share with others, like frustrations in his work-life and gossip about individuals he worked with and those in the generic pharmaceuticals industry. The FDA Official also shared information about his personal life.

This is a well-recognized way for insider trading to be illegal: If you get the information from an insider, and you have a "relationship of trust and confidence" with that insider,  then trading on it feels pretty corrupt, and is illegal. If the FDA official told Johnston about the drug approval process as part of their confidential personal relationship, and then Johnston went off to trade on it (or sell it to Valvani to trade on it), then that would be a crime.

But it's just obviously not what happened here! Johnston didn't call the FDA official just to chat about their personal lives and gossip about the drug-approval process. He called the official to ask questions, on behalf of his clients, about prescription drug approval. From the SEC complaint:

In 2009 and 2010, Johnston frequently called, and met in person with, the FDA Official in his capacity as a representative of the Generic Drug Trade Association or of the drug companies for which he consulted. Johnston had reason to call the FDA Official on behalf of the Generic Drug Trade Association, because of, among other things, policy issues that concerned both OGD and the Generic Drug Trade Association.

For example, Johnston discussed with the FDA Official and others legislation that would make it easier to approve "biologics" legislation. Enoxaparin, although classified as a drug (which contains only synthetic components), was similar to a "biologic"(which contains naturally occurring components). OGD's review of the enoxaparin ANDAs was important to the Generic Drug Trade Association because OGD's approval of such an ANDA would show that the FDA was capable of approving "biologic" drugs, and that provided a pretext for Johnston to glean information from the FDA Official for Valvani's benefit.

That is: The official knew that Johnston's clients -- the drug companies who were members of the generic drug trade group -- were interested in the FDA's review of the Abbreviated New Drug Applications for enoxaparin, a generic drug that was also of interest to Valvani.  The FDA official and Johnston may have had a long history of confidential heart-to-heart conversations, but their talks about generic drug approval weren't part of that history. No one has confidential heart-to-heart conversations about generic drug approvals, not even former FDA officials. They talked about generic drug approvals in their business conversations, which presumably the FDA official knew that Johnston would share with his clients. It's just that he misunderstood who the clients were. He thought Johnston was a lobbyist (which he was) and not a hedge-fund consultant (which he also was). And sharing that information with lobbyists was just fine!

Of course Johnston encouraged that misunderstanding. He did that using the oldest trick in the book: banter.

Regardless on whose behalf Johnston said he was calling, during calls and meetings with the FDA Official and other OGD personnel, Johnston engaged in banter about issues of concern to Valvani, such as the enoxaparin ANDAs, in order to glean nonpublic information. Such banter was possible because of Johnston's personal friendship with the FDA Official and other OGD personnel. Johnston mixed this banter with professional discussions and gossip about mutual friends and colleagues to hide his efforts to obtain nonpublic information.

Additionally, Johnston concealed from the FDA Official that he was seeking information on behalf of Valvani or Investment Adviser, and he was in fact careful not to ask questions that would reveal he was calling on their behalf or on behalf of any investor. Further, Johnston never told the FDA Official that he was providing, or had ever provided, consulting services to any investor. And the FDA Official did not otherwise know that Johnston provided consulting services for Investment Adviser or any investor. In addition, Johnston was careful not to bring up the enoxaparin ANDAs too often with the FDA Official so as not to raise any suspicion in the FDA Official as to Johnston's true objective—to provide information to Valvani.

I love this description. I have talked before about my fascination with the bribery industry, because of its similarities to the sales industry. The insider trading industry -- and, for that matter, the lobbying industry -- is apparently also a lot like sales. You don't just call someone up and say "Hey, are you approving these drugs or what?" (Just like you don't just call someone up and say "Hey, buy this car I'm selling.") You banter. You gossip. You triangulate:

In his calls and meetings with the FDA Official, Johnston asked "indirect" and "triangulating" questions designed to obtain information not publicly available. Through such questions and by using his friendship with the FDA Official and his role as the Generic Drug Trade Association's representative to the FDA as a pretext, Johnston was able to trick the FDA Official into providing specific information that confirmed that an enoxaparin ANDA was still being considered and informed him of its progress through the review process.

Johnston's essential crime here, according to the Securities and Exchange Commission, is that he was too good at asking questions. His questions weren't just blunt, direct, contextless questions. (Which: would be legal!) They were indirect, leavened with banter, mixed with gossip, preceded by decades of friendship. The FDA official was powerless to resist them. And so he shared with Johnston information that he shouldn't have, and that Johnston knew he shouldn't have, but got out of him by trickery.

Does the banter make it a crime? Who knows. The SEC and the Justice Department say that the FDA official told Johnston this stuff in confidence, and Johnston knew it, making it a crime for Johnston to trade on it, or to sell it to Valvani to trade on it. I think that the FDA official pretty obviously didn't tell Johnston this stuff in confidence, making their theory suspect. Of course Johnston has already pleaded guilty. But to convict Valvani, the government needs to prove both that Johnston had a relationship of trust and confidence with the FDA official, and that Valvani knew it. That seems challenging.

The SEC also says that Johnston had a duty to the Generic Drug Trade Association to keep the information confidential: When he called up the FDA, on this theory, he was getting information on behalf of the GDTA, his full-time employer, and the GDTA did not authorize him to trade on it or to share it with anyone else.  This theory makes some more sense to me; Johnston was calling up the FDA on behalf of the GDTA, so any information he got on those phone calls belonged to the GDTA, and he couldn't just go sell it to the highest bidder. (Arguably this also undermines the SEC's other theory, that any information he got on the phone calls was given to him in confidence and not to be shared with anyone.) It's a less compelling reason to charge Valvani, who presumably didn't know the details of Johnston's employment agreement with the GDTA. Valvani allegedly hired Johnston to get information out of the FDA, not the GDTA, and the information that Johnston brought him came from the FDA, not the GDTA; it's hard to see how he'd know that Johnston was breaching his duty to the GDTA. In any case, the Justice Department does not rely on this theory in the criminal case against Valvani or Johnston: It just argues that Johnston breached his duty of confidence to the FDA official.

The Justice Department charged Johnston and Valvani, not just with insider trading, but also with theft of government property and defrauding the U.S., which again I find pretty weird. Johnston called up a government official and asked him questions, and the official answered the questions. He asked the questions skillfully, and he was perhaps less than honest about whom he was asking the questions for. But there's no real claim that he lied to the government official, or bribed him. It's hard to see how he stole from or defrauded the government. It can't really be a theft from the government just to ask a government official questions?

By the way, in addition to the insider trading case against Valvani and Johnston, prosecutors and the SEC also brought charges against two other Visium employees, Christoper Plaford and Stefan Lumiere, for mis-marking distressed securities in the firm's credit fund. This was fairly run-of-the-mill mis-marking: Allegedly, Plaford and Lumiere would call up friendly brokers, get "sham quotes" for illiquid securities they owned, and then mark those securities based on those sham quotes rather than on more objective pricing sources. "During the Relevant Period,the Credit Fund's month-end valuations for the securities Lumiere and Plaford mis-marked were inflated, on average, between approximately 5 and 35 percent." Oops! Plaford was also accused of doing some trades based on inside information that he got from Valvani, making a profit of about $300,000; Plaford has pled guilty. One possible moral of the story is, if you are mis-marking your book, don't also do a little bit of insider trading on the side. When the SEC comes for the insider trading, they'll also get you for the mis-marking!

The core problem in U.S. insider trading law is distinguishing information that insiders share corruptly from information that they share in the ordinary course of business. Information that is shared as part of an official business conversation is, for good or ill, mostly fair game to trade on : If a corporate investor-relations department gives a portfolio manager some guidance, or a senator drops hints on upcoming legislation during an exchange of policy ideas with the portfolio manager, people may complain about the favoritism, but he probably won't go to jail for trading on it. But if the portfolio manager bribes the investor-relations person, or if she gives him guidance not because he is a big shareholder but because he is her brother-in-law, then our complaining about favoritism crosses over into charges of insider trading. But the hard cases are where the insider has both a business relationship and a personal relationship with the portfolio manager, where the information might be shared legitimately as part of their respective jobs or taken corruptly as part of their personal relationship. And every good business relationship is a bit of both; no one gets very far in any business relationship without occasionally asking about the other person's family and interests. Business -- the hedge-fund business, the investor-relations business, the drug-approval business, the lobbying business, any business -- is an essentially human activity; it relies on people developing personal relationships. A law that relies on distinguishing personal relationships from business relationships is doomed to be murky.

  1. This is neither legal advice nor a complete statement of the rule. 

  2. Probably for lots of reasons, not just insider trading ones! But also insider trading. This is the basic rule of U.S. v. Newman, the big insider trading case that we've talked about a lot over the past few years: If the insider gets a "personal benefit," a quid pro quo, for giving you the information, then it's illegal to trade on it.

  3. Rule 10b5-2, covering "duties of trust or confidence," is relevant here.

  4. In the case of corporate executives, the relevant rule is Regulation FD. Various government agencies presumably have their own rules about how their employees are allowed to communicate with the public.

  5. Though who knows. Not legal advice! By the way, this relies on me calling him up out of the blue; if instead I am his brother, and he gives me the information out of his gratuitous love for me, we might get in trouble. The main case is U.S. v. Salman, currently on appeal to the Supreme Court.

  6. By the way, if I ever ran, like, a cocaine business, "Generic Drug Trade Association" would be a great name for it. (And no one seems to be using it; the GDTA has become the "Generic Pharmaceutical Association"?)

  7. As the Valvani indictment helpfully explains:

    The FDA's decision to approve a generic drug ANDA typically has a positive impact on the stock price of the company receiving approval, and a negative impact on the stock price of the company producing the brand name drug.

    An ANDA is an "Abbreviated New Drug Application," to sell a generic version of a brand name drug.

  8. The full quote:

    “Sanjay Valvani is an innocent man whose investment decisions were always based on rigorous and entirely appropriate research and analysis, consistent with his high integrity,” his lawyer, Barry Berke, said in a statement. “It will be shown that the prosecution of Mr. Valvani is yet another example of this United States Attorney’s office stretching the facts and law to try to transform entirely innocent trading decisions into a crime.”

  9. Similarly, in the criminal complaint against Johnston:

    GORDON JOHNSTON, the defendant, understood that Individual-1 expected that JOHNSTON would maintain the confidentiality of the information Individual-1 shared, by virtue of their relationship of trust and confidence.

    The relevant SEC rule is, again, Rule 10b5-2, which says "trust or confidence," though there is some question of how enforceable the rule is in criminal cases. In any case, courts have generally endorsed the idea that breaching a relationship of trust and confidence can make insider trading illegal.

  10. It's the generic version of Lovenox, a Sanofi-branded drug for deep vein thrombosis. Several generics companies filed Abbreviated New Drug Applications for enoxaparin, and in 2010 the FDA approved Momenta's application:

    In reaction to the Momenta Announcement, Momenta's stock price jumped from $11.93 (as of July 22, 2010) to $21.70. The announcement also negatively impacted Sanofi, the brand-name manufacturer, and the other two enoxaparin ANDA filers. Sanofi's stock price, for example, dropped from $61.27 to $58.75 and the price of its ADRs dropped from $30.64 to $29.35.

    Visium was long Momenta and short Sanofi at the time of the announcement, allegedly based on information that Johnston passed to Valvani.

  11. From the SEC:

    At the outset of his calls and meetings with the FDA Official, Johnston would generally say whether he was calling on behalf of the Generic Drug Trade Association or the drug companies for which he consulted. If Johnston did not say who he was calling for, the FDA Official understood that Johnston was calling on behalf of the Generic Drug Trade Association.

    He was never calling just to reminisce confidentially about the good old days in the Office of Generic Drugs. He was always calling on business!

  12. I mean, wait, no, it wasn't. The SEC and the Justice Department both fulminate about how illegal it was to share this information. From the SEC complaint:

    OGD's evaluation and investigation of an ANDA is nonpublic and strictly confidential. Prior to an official announcement, OGD does not publicly disclose the existence of any particular ANDA and whether or when it will be approved.

    From Valvani's criminal indictment:

    At all times relevant to this Indictment, FDA employees were prohibited from disclosing non-public information that they learned in the course of their employment to individuals outside the FDA, unless such disclosure was authorized by law. That prohibition recognized that the disclosure of such information could affect bond and stock markets. 

    And yet no one seems the least bit perturbed that the FDA official would share this information with Johnston as part of Johnston's job as a lobbyist for drug manufacturers. Of course he could keep them up to date!

  13. From the SEC complaint:

    Johnston also concealed his role as a hedge fund consultant from the Generic Drug Trade Association. The Generic Drug Trade Association was unaware that Johnston conveyed information he learned from his conversations with the FDA Official and other OGD personnel to Valvani or any investor. Indeed, the Generic Drug Trade Association did not know that Johnston consulted for Valvani, Investment Adviser, or any investor. In relaying to Valvani the nonpublic information he received from the FDA Official and other former OGD colleagues concerning the enoxaparin ANDAs described herein, Johnston violated a duty he owed to the Generic Drug Trade Association to keep such information confidential and refrain from using his role as its representative to the FDA for personal gain. In obtaining the material non-public information from the FDA Official for the benefit of Valvani, Johnston breached his duty to the Generic Drug Trade Association to devote all his time during business hours to the affairs of the Generic Drug Trade Association.

  14. Or, I suppose, vice versa. I don't know which bit of naughtiness was their downfall, though my money is on the insider trading. Incidentally there were other ways that they could have been caught:

    On or about April 14, 2013, Lumiere told a former Investment Adviser employee that he would disclose the "f***ing bullshit marking of the book" if Investment Adviser ever fired him.

    You know I never give legal advice, but this is not how to do whistle-blowing.

  15. Unless the conversation is subject to a confidentiality agreement. Or there are other exceptions. This is all very much not legal advice!

  16. Either, as in the allegations in Salman and Newman, because the insider is corruptly doing a favor for the outsider by tipping him, or, as in the allegations here, because the outsider is corruptly betraying the insider by misusing his confidences.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net