A New Round of Insider Trading Cases: Where to Draw the Line

Virtually every day there seems to be another round of disclosures about a company reviewing its stock option issuance practices or the resignation of an executive mired in the growing scandal. Backdated stock options seem to be everywhere. Yet, surely the SEC is investigating other matters.

One area that the SEC may be focusing on for a new round of investigations is insider trading. A long-time key program area for the SEC’s enforcement division, it may be that new actions are coming that could challenge backdated stock options as the “flavor of the month” scandal. Not long ago the New York Times ran an article based on a study it commissioned showing increased trading activity before the public announcement of mergers. The article suggested that such activity may be insider trading (see Blog entry of Aug. 29, 2006). Following that article, Congress began hearings on insider trading.

Now the New York Times reports on what may be another series of insider trading investigations. In an article published on October 16, 2006, the NYT reported on possible insider trading arising from the relationships between lenders and companies. Specifically, bond and debt holder of companies typically have covenants in their lending agreements that require they receive periodic financial reports from companies. Some lenders have periodic conference calls with their borrower companies in which they receive non-public information. Many of these lenders are not the traditional bank lender but are hedge funds, entities the SEC has been trying, with little success, to regulate for sometime.

As a result of their bond contracts and lending agreements hedge funds and other lenders may be receiving the material non-public information about their borrower companies. To the extent this information is material, trading by the recipients prior to its disclosure would be prohibited by insider trading rules. The information receive under the bond and lending agreements may, however, not be material. The information may be non-public but in and of itself may not be material. When that information is added to other bits of information it may become knowledge which investors seek – material information.

Piecing together bits and pieces of non-material information is the type of practice that analysts and shrewd investors are suppose to do. In fact, that type of activity contributes to the overall efficiency of the securities markets. The efficient market theory is of course the basis for much of the SEC’s regulation of corporate information. At the same time, just where the line is between what is material and what is not material and between what has become material because non-material information has been carefully compiled and totals material information can be a difficult task. The NYT article reports that the SEC is looking at these issues. It should be interesting to watch where the SEC draws the line in these cases. If the SEC is to aggressive it can deter the market efficiency that is key to much of its regulation. If it is not aggressive enough it could permit hedge funds and other lenders to have an insider trading advantage in the securities markets that can undermine investor integrity.