March 4, 2014

Debunking the “SEC as Insider Traders” Study: SEC Staffers Ain’t Driving Ferraris

Last week, a new study by an accounting professor and a doctoral student became a minor media darling as it shows that stock trades by SEC Staffers produce abnormal returns. Here are the study’s two findings, which I’ll quote from the bottom of page 1: “We find that at least some of these SEC employee trading profits are information based, as they tend to divest (i) in the run – up to SEC enforcement actions; and (ii) in the interim period between a corporate insider’s paper-based filing of the sale of restricted stock with the SEC and the appearance of the electronic record of such sale online on EDGAR.” [Here’s my 4-minute video on “5 Reasons Why ‘SEC Staff as Insider Traders’ Study Is Bogus.”]

The Mass Media Blindly Eats It Up

Even though there are a kabillion studies every year, this one was reported by one media outlet – and a few others followed like lemmings. Some were really out of hand such as this one entitled “The SEC Should Really Start a Hedge Fund.” That articles notes there were 4k trades in individual stocks – over a period of 2.25 years – made by 4k staffers and claims it was excessive trading! Really? An average of one trade per Staffer over two years is excessive? Journalism today! If I report it, it must be true.

How the Study Was Conducted

Anyways, let’s go ahead and analyze the study. The authors were able to obtain data of the trades made by all Staffers over this 2-year period – but not the identity of the traders. This means they couldn’t tell if an individual trader made or lost money in a transaction – nor whether those trading worked in jobs where they might have advance knowledge of actions that could move a stock price.

Those are pretty big limitations – but yet this professor is telling reporters: “It does suggest it is likely, or probable, that something is going on.” Pretty damaging thing to say. Hopefully, it’s based on some knowledge of how the SEC’s ethical rules work – and how SEC Staffers are (and aren’t) permitted to trade? Yeah, right. At the bottom of page 3 of the study, the authors say “Insiders file open market transaction records with the SEC every month.” Um, the Section 16 rules were revised over a decade ago requiring Form 4s to be filed within 2 business days of the trade. Clearly, this accounting professor & student don’t know much about the SEC’s rules. Anyways, let’s forget that we’re not dealing with securities law gurus and get to the meat…

The SEC Staff’s “Form 144” Informational Advantage? A Real Laugher!

I’m gonna deal with the study’s second finding first because it’s so ridiculous. The authors completely don’t understand Form 144s – which are still required to be filed on paper – and the timing of when they are filed. As noted on page 24-25 of the study, they think that the Staff gets access to the information on them before the same data is filed on Form 4s on EDGAR. They think Staffers are running down to the Public Reference Room in the SEC’s basement to look at the lone filing cabinet containing the paper filings of Form 144s (I recently visited that filing cabinet and no one ever visits it; a separate blog on that is forthcoming).

In fact, the real world is that the complete opposite happens! That’s one of the reasons we submitted this rulemaking petition to the SEC a few months ago asking that the agency require electronic filing of Form 144 (and thus we would have joint Form 4/144 filings). In our petition, we argue that the Form 144s for insiders are currently useless because the information they contain typically has already been filed on Form 4s!

5 Reasons Why SEC Staffers Aren’t Routinely Trading on Enforcement Action Developments

Let’s get to the heart of the other part of the study – trading in the “run up” to Enforcement actions. Here are five explanations that could debunk the theory that SEC Staffers are insider trading – there probably are more, but five should be enough to give someone pause before saying something that would needlessly damage the agency’s reputation:

1. SEC Staffers Forced to Sell Financial Services Stocks After Join the Staff – SEC Staffers are not allowed to hold financial-related stocks – but those restrictions only kick in after they join the agency. That means that there is a steady stream of sales of financial stocks as new employees join. The study shows just that: SEC employees sell financial stocks much more than they buy them, and more than other types of stocks. If over the period in the study, financial stocks underperform the broader market (as they did, returning -5% while the market grew by +24%), a virtual portfolio that net sells financials would outperform a baseline portfolio. [I got this one from a comment on a news article.]

In other words, there is a sell-side bias in the SEC’s trading due to forced divestment – so comparing the percentage of sell transactions by the SEC Staff to the 50% figure for the market as a whole (a pretty trivial figure, because the market as a whole has to balance buys and sells or else the market wouldn’t clear) is not very meaningful.

2. “Need to Know” Culture Severely Limits Opportunities – Having worked at the SEC twice – and in a role dealing with a lot of Enforcement actions – I can tell you that very few Staffers have access to how a particular investigation is going. All employees have access to a database showing all of the investigations – but the ratio of investigations that appear in that database compared to ones that ultimately go anywhere probably is in the 50-to-1 range. On page 10 of the study, the authors note that the SEC has 4000 open investigations at a time.

If an Enforcement Staffer comes across anything suspicious, they will open a “Matter Under Investigation” (known as a “MUI”) – but in most cases, these MUI’s don’t go anywhere. Sort of like a sales lead. Over the course of a month, a salesperson might have hundreds of leads, but maybe pursue only a few dozen – and close only two sales. So having knowledge that a MUI exists is fairly meaningless. Which means that this statement on page 5 of the study is without a basis: “While many bureaucratic government positions provide opportunities for access to privileged information on which the bureaucrat can trade profitably, few agencies provide such opportunities with the regularity of the SEC.”

The SEC has rules to safeguard confidential information – so knowledge about the details of specific matters and facts are limited to those working on the matter. So only those 2-3 persons in Enforcement actively working an investigation will be the ones who know whether a particular case might be going anywhere. And there are all sorts of investigations that wouldn’t move a stock price even they became publicly known (eg. garden variety insider trading case). The real market movers are the financial fraud cases – and there are not that many of those cases brought by the SEC. A handful each year.

3. Enforcement Staff Knows They Are Under Surveillance – When you join the SEC and you see how the Market Surveillance Unit in Enforcement can so easily catch folks who conduct trades based on illegal material nonpublic information, you become amazed that anyone would be so stupid to try to insider trade. This Unit investigates all trades with abnormal returns – that is, all trades just before a major announcement. While not everyone on the Staff is a genius, there are very few who would be dumb enough to engage in one of those abnormal trades when they are so aware how closely other SEC Staffers are looking at them.

4. If SEC Staffers Really Wanted to Profit, They Wouldn’t Sell – They Would Buy – Generally, stock prices go up once settlements with the SEC are announced since that ends the uncertainty which the market detests. If a SEC Staffer has inside knowledge about a pending settlement, why would they sell? Yet, the study is mostly about Staffers profiting from selling.

5. SEC Staffers Should Know The Market Better – This one is from King & Spalding’s Russ Ryan: It should not be surprising that people who are so interested in the securities markets – and who devote their entire careers to the subject matter – are likely to be better educated, sophisticated, and able to understand risks, disclosures, and financial records than the average bear. By analogy, I suspect that on average, high school varsity athletes do better at fantasy sports than the student body at large, and no rational person would suspect cheating based on that correlation.

The Bottom Line: Irresponsible Academics & Journalists

I’m not saying it’s not possible that a few rogue Staffers somehow work the halls and find out information that allow them to trade favorably. This would involve breaking the SEC’s ethics rules, which happens occasionally rarely. If more than a handful of SEC Staffers truly were doing this, news would have leaked well before this.

The bottom line is that the notion that there is more than a tiny fraction of the SEC staff that would risk their jobs and reputations like this is absurd. The SEC Staff typically come in two types (with many hybrids): Those who hope to work there for a long time – and those who hope some day to parlay their experience into a higher paying job in the private sector. Getting caught at insider trading would be so obviously fatal to either path that it is virtually inconceivable that someone would take that risk, especially knowing what a unique media feeding frenzy would accompany any discovery of insider trading by a Staffer of the very agency that polices it.

So let’s take this study means with a lot of salt please. It’s mind-boggling to me that a professor would take the time to slug through all this data and draw up some conclusions without doing any research into the subject matter and considering a variety of possible explanations. I’m not as surprised about the mass media not bothering to ask anyone with real knowledge to verify the study – as I gave up on most journalists a long time ago…

More on the Bogus Study: A Possible Sixth Reason

And here’s another possible explanation for the study results that is more subtle that I received from a member:

This possible explanation would require a bit of research. With respect to the six companies that are featured in Table 3 (Bank of America, General Electric, Citi, Johnson & Johnson, JP Morgan, and General Electric), measuring sales 30, 45, 60, and 90 days before the announcement of the SEC’s enforcement action may tell you little or nothing about an SEC Staff “informational advantage” if those companies had already publicly disclosed the SEC investigation during one of those time periods, or even before them, as many companies do these days.

If a company has already disclosed the investigation, and particularly if it has disclosed a Wells notice or an agreement in principle to settle the SEC matter, then the SEC enforcement case would already be reflected in the market price of the stock by the time the SEC got around to publicly announcing the case, negating an “informational advantage” for the SEC Staff.

In that situation, you also would be particularly likely to see the “uncertainty-ending” upward bounce that you suggest below. Needless to say I have no idea what you would see if you looked at SEC Staff transactions 30-90 days before the company’s disclosure of the SEC matter, but the data wouldn’t be the same as the data the authors present, and also would be measured by an event that the Staff couldn’t control, which also would blunt the “informational advantage” that the authors seem so confident about.

Finally, unless I missed it, the study doesn’t say what happened to the six companies stock prices post-enforcement action. It wouldn’t shock me if some – or most – of them went up once the SEC case was behind them. If that were the case, the SEC Staffers missed out on some gains.

Webcast: “M&A Litigation: The View from Both Sides”

Tune in today for the webcast – “M&A Litigation: The View from Both Sides” – to hear Robbins Geller’s Randy Baron, Wilson Sonsini’s David Berger, Grant & Eisenhofer’s Stuart Grant and Morris Nichols’ Bill Lafferty analyze the latest wave of M&A litigation that has permeated nearly all deals. This program features two lawyers from the plaintiff’s side – and two from the defense perspective.

– Broc Romanek