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.

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The current SEC and DOJ investigations into the backdating of stock options may have, in part, been prodded by news articles, primarily those in the Wall Street Journal. In this regard, these investigations would not differ markedly from those into the so-called “market timing” and “late trading” practices at mutual funds, which were spurred in part by wide spread press coverage. In fact, both scandals share common threads. Backdating stock options is not in and of itself illegal as SEC Commissioner Paul Atkins noted in a July 2, 2006 speech. Similarly, market timing is not in and of itself a violation of the federal securities laws and late trading is, at best, only arguably a violation of those statutes. All of these practices may, however, violate the federal securities laws when combined with other activity such as non-disclosure or improper accounting in the case of backdating options or violation of specific representations in a prospectus or other disclosure documents in the case of market timing and late trading.

Now consider stock option spring-loading and bullet dodging. The former refers to timing the issuance of an option just before a company announces good news, while the latter is the opposite, timing the grant to avoid a downward movement in the stock price from bad news. Neither practice is considered a best practice in corporate governance. Rather, these practices may be forms of insider trading that differ from backdating. Insider trading is based on the theory that insiders should not use company information for their personal benefit. If, however, the company uses the information is there an abuse? Many would say no because the company is permitted to use its information as it sees fit. These points are discussed in a recent New York Times article. Despite recognition of the at best dubious legal theory on which spring-loading and bullet dodging may be based, the article ends by suggesting it would be regrettable if government prosecutors chose not to prosecute these cases.

Why? If these practices are not insider trading or if the basis of the legal theory is dubious at best, what would be regrettable is for the government to try and prosecute those cases. Government enforcement actions, whether civil when brought by the SEC, or criminal when brought by the DOJ, carry terrible consequences for those accused. That accusation can cause significant harm to a company and severely damage, if not end, the a career of an executive or professional. In many ways the power to charge is the authority to convict because the accusation whether proven or not never goes away – it lingers for years to sully what may have otherwise been a good reputation built over the years. So here is hoping that in this case publicity may not spur more action by government prosecutors and that great care is taken in bringing option enforcement actions.

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