The SEC acted swiftly yesterday in the wake of news stories reporting unusual trading activity in the securities of Dow Jones in advance of the May 1, 2007 announcement by News Corp of its $60 per share take over bid.  (see blog post 5/4/07)  Immediately after the announcement of that bid, the shares of Dow Jones increased in value by about 58%, from about $37 to over $57 per share.  In advance of the announcement there was heavy trading in Dow Jones’ options.  According to a report in the New York Times on Tuesday, Dow Jones officials knew about the impending bid prior to May 1 but chose not to announce what is clearly one of the leading business stories of the year.  Eric Dash and Andrew Ross Sorkin, “Scrutiny Seen of Trading in Dow Jones,” NYT, May 9, 2007.  That same article suggested that many people knew about the proposed bid prior to its announcement in addition to the usual cadre of business executives, lawyers, accountants, bankers and other professionals involved with the deal. 

According to the SEC, two individuals who had advance knowledge of the deal are Kan Ling Wong and Charlotte Ka On Wong Leung, a husband and wife residing in Hong Kong.  http://sec.gov/litigation/litreleases/2007/lr20106.htm  The SEC’s complaint claims that the couple is the part owner of a Merrill Lynch account in Hong Kong that purchased 415,000 shares of Dow Jones stock in the two weeks prior to the announcement.  The cost of the shares was just over $15 million, paid for in part from funds in the account and with money wired to the Merrill Lynch account by the wife’s father, other funds the couple wired in from a their JP Morgan account in Brussels, Belgium and margin loans.  Three days after the announcement when the couple directed that the shares be sold, their value had increased by over  $8 million.  The court imposed a temporary freeze over the defendants’ assets and directed them to show cause why their assets should not remain frozen until the conclusion of the litigation. 

The SEC moved extraordinarily quickly in this case.  In the days to come there will no doubt be more developments in this case.  Those developments may explain why this case lacks some of the hallmarks of typical insider trading cases.  For example, the trades were in stock, not options where must larger profits can be realized for a much small investment – particularly here, where there was significant activity in Dow Jones options.  There may also be an explanation for the lack of deception in this case, such as the frequently used technique of using multiple accounts to conceal the size of the trades and keep them off the radar screen of brokerage house compliance departments and other market monitors.  Although the defendants apparently had multiple accounts – the complaint references accounts at Merrill Lynch and JPMorgan – all shares were purchased in one account. 

Further developments may also reveal what we do not know about this case.  What we do not know is who else has an interest in the frozen Merrill Lynch account, although presumably the SEC knows from the account opening records.  What we cannot know yet is what information the defendants had about the potential New Corp deal – the complaint simply uses the stylized legalese “material non-public information.”  Also, what we are not yet privy to is how the defendants supposedly received inside information – the complaint simply says that they had inside information.  The SEC offers no basis for its claim defendants had such information, other than its “belief.”  The initial crux of any insider trading case is, however, whether or not defendants have information that is material and non-public. 

Suspicion abounds when trading picks up in advance of an announcement, particularly if it turns out to be a significant one.  Sometimes the market-monitoring computers of the regulators signal possible anomalies, triggering an initial inquiry into “suspicious” trading to determine if there was illegal activity, such as, insider trading.  Sometimes a flurry of trading generates a lot of finger pointing and head nodding coupled with suggestions that “it must have been” illegal insider trading.  Sometimes it might be a sign of illegal activity.  Other times it might just be the sign of a healthy market. 

Bloomberg.com reported on “suspicious” trading activity in advance of the announcement by Rupert Murdoch’s News Corp. of an unsolicited $5 billion bid to buy Dow Jones & Co. for $60 per share.  http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aukny7sOH5d0 The announcement sent the stock of Dow Jones zooming up about 55% to $57.77, its biggest gain in months.  What was more interesting than the post-announcement trading, however, was the activity in the options markets prior to Mr. Murdoch’s blockbuster bid.  There, trading in options to buy shares of Dow Jones reached an 18-month high suggesting, according to the article, that “word of the . . .bid for the company may have leaked in advance” of the announcement.  The article continues quoting various sources who suggest that something untoward must have happened. 

Indeed, it might have.  As the Bloomberg article notes, just a few months ago the SEC brought an enforcement action and obtained an asset freeze following an investigation which begin with a similar trading pattern in TXU options.  That trading was in advance of a major announcement and the investigation turned up what the SEC says was insider trading. 

We have yet to see what happened prior to the announcement by News Corp.  But before everyone suggests that those option traders were doing something wrong, it is good to remember that the trading may well have resulted from good old fashioned work.  Every proposed deal like this one is worked on by dozens of people.  Those include executives at the company, outside lawyers, accountants, investment bankers, public relations specialists and a host of other people.  All of those people are brought “over-the-wall” and know about the proposed bid as it is put together in the days and weeks prior to its announcement.  It is not untypical for those people to participate in numerous meetings, phone calls, write documents and take other necessary steps.  Frequently they are working long hours.  Those around them including family, friends and others frequently see this increased activity.  Market professionals who watch companies and high profile executives such as Mr. Murdoch for clues to future activity often note the increase in activity – but do not know for certain what is being done.  

The bits and pieces of information gleaned from such observations are hardly material information – they do not tell the observer about the proposed bid.  Together with other public information, however, those bits and pieces can help traders make decisions about whether to buy and sell.  This activity, called “leakage” by economists, helps make the markets more efficient.  The more efficient the markets are the better the price – something that benefits everyone.  When the increased trading results from this type of activity, not only is it not “suspicious” or illegal, but rather it is beneficial to the markets and all traders. 

This theory is hardly new.  (see blog post 8/29/06)  In the late 1980s, then SEC Chief Economist Gregg Jarrell studied data on trading in advance of announcements based on information accumulated by the agency.  In his paper on this study now Professor Jerrell (University of Rochester) concluded that one cannot draw conclusions about insider trading from surges in trading activity prior to the announcement of a significant event.  While the trading might represent something suspicious, it may also be something beneficial to the markets. See Gregg A. Jarrell & Annette B. Poulsen, Stock Trading before the Announcement of Tender Offers: Insider Trading or Market Anticipation?, Journal of Law, Economics and Organization, vol. 5(2), at 225-48 (1989); Gregg A. Jarrell & John Pound, Hostile Takeovers and the Regulatory Dilemma: Twenty-Five Years of Debate, The Midland Corporate Finance Journal, 5 (2) (Summer 1987). Other economists have confirmed this work. 

All of this is to say that before we point the finger at those who trade just before an announcement by Mr. Murdoch we should take care to examine all of the facts.  Those traders may just have worked a little harder than the rest of us.  Those traders may also be doing us all a service by contributing to the efficiency of our capital markets.