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Martha Stewart went to jail for insider trading in stocks. She should have been trading credit default swaps, where it’s pretty close to legal. Last May, the SEC filed a civil insider trading case based on trades in credit default swaps (for a refresher, see below). The amazing thing is that the defendants may have a good defense that there isn’t any law allowing the SEC to enforce securities laws against them. That is just another consequence of the Gramm-Leach-Bliley Act, the law that got rid of Glass-Steagall. It also barred the SEC from gathering information about CDSs. They trade in the shadows, which is exactly what the banksters wanted.
There is one tiny hole for regulation: the Securities and Exchange Commission can enforce the antifraud provisions of the Securities Exchange Act of 1934 with respect to “security-based swap agreements”. The most important antifraud provision is Rule 10b-5, which establishes a broad and open-ended prohibition on all kinds of securities fraud, including insider trading.
In this case, the CDSs protected the debt of VNU, a Dutch company that went private in May 2006, and announced a restructuring of its debt in July. The idea was to issue new bonds from the subsidiaries of VNU. There were CDSs on the VNU bonds, but they would not cover the debt of the subs. An investment banking subsidiary of Deutsche Bank was handling the restructuring, and was concerned about this issue. One solution was for VNU to issue a new layer of bonds which would be covered by the existing CDSs.
One factor affecting the price of CDSs referencing the VNU bonds in July 2006 was the limited supply of bonds covered by (or, “deliverable into”) those CDSs. An increase in the supply of VNU bonds deliverable into CDSs would result in an increase in exposure and demand for CDSs covering the default of such bonds and, therefore, an increase in the market price for CDSs referencing those bonds.
Complaint, para. 14. Deutsche Bank’s employee Rorech tipped off a hedge fund guy named Negrin about the new idea. Armed with that confidential information, Negrin bought a bunch of the VNU CDSs. When the new structure was announced, Negrin sold the CDSs and made $1.2mm.
It’s hard to care about this case. The only people who trade CDSs are huge banks, brokers, hedge funds and other giants. Insider trading in CDSs only hurts the financial elites. If a rattlesnake is fighting a skunk, who cares who wins or loses? Maybe they’ll kill each other, and there will be two fewer varmints.
Studies show evidence of insider trading. From the abstract of one:
Using news reflected in the stock market as a benchmark for public information, we report evidence of significant incremental information revelation in the credit default swap (CDS) market under circumstances consistent with the use of non-public information by informed banks. Specifically, the information revelation occurs only for negative credit news and for entities that subsequently experience adverse shocks. Moreover the degree of advance information revelation increases with the number of banks that have lending/monitoring relations with a given firm, and this effect is robust to controls for non-informational trade.
It’s circumstantial evidence, but what other kind is available if regulators can’t gather information about trading in CDSs? And if you can’t detect insider trading, how is that different from making it legal?
To establish its right to sue, the SEC has to show that the VNU CDSs are “security-based swap agreements.” The defendants moved to dismiss on the ground that the CDSs aren’t security-based. VNU is a Dutch company, so the question is whether the foreign securities are securities subject to SEC authority. There are also questions about US jurisdiction because of the international aspects of the trades. The trial court denied the motion to dismiss on these and related grounds, but allows the defendants to put on evidence at trial to prove that the SEC has no jurisdiction.
The bond availability issue demonstrates a strange interaction created by the existence of CDSs. Deutsche Bank thought that the proper structure was bonds of subsidiaries, but because of CDSs, it had to move to a different structure, instead. That may or may not be a good thing, but it shows the impact of CDSs on the real productive world.
One thing the case makes clear is that trading in “non-security-based swaps” is the free market, with no regulation or liability. That probably includes interest rate and commodity swaps. There, insider trading is perfectly legal.
May the best rattlesnake win.
___________________
To review, a CDS is insurance on bonds or other debt. One party, the protection seller, agrees to pay the other, the protection buyer, the amount of any loss that occurs if the debt doesn’t get paid. The buyer agrees to pay a fee with the contract, and regular payments. For those interested, Wikipedia has a good description. The CDS is a contract, almost always on standard terms established by the International Swaps and Derivatives Association.
Northern Black Tailed Rattlesnake detail by GustavoG
16 Comments
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Martha Stewart did not to jail for insider trading. She went to jail for trying to cover up what she did.
It would be good for the psyche if not the soul if some of these folks had to forfeit or forego their millions due to be caught out in breaking laws/regulations.
Some criminal prosecutions wouldn’t hurt matters either but that’s probably hoping for too much.
Massacio,
You have some guts, calling them what they really are. Snakes. It must be my influence on this web site.
There’s are real difference?
http://www.zeitgeistmovie.com/
We gave the banks a ton of cash do they really want to piss us off when they might need another bailout?
The trade, while ethically questionable, was not illegal.
If she didn’t say anything about it to the press, she wouldn’t have gone to jail.
I think that is a big difference.
Do you think we will have a say?
I think I should clear something up. I don’t know if it was said as shorthand or not, but credit default swaps are not insurance as the Wikipedia link explains. What Geithner is taking heat over relates to CDS and it’s precisely because he paid 100% that he’s getting slammed. If CDSes were insurance, it would be unquestionable that the parties due were owed 100%. I fully support re-implimenting Glass Steagall, but even with Glass Steagall there can still be CDSes and since virtually anyone can sell a CDS, I think it’s hard to press insider trading. What do think is that CDSes have been undervalued and the result will be that CDSes will cost more in the future and also buyers of CDSes wont always get their expected paydays because CDSes don’t have to be secured, which I hope for the same reason that Geithner is fired with how he handled CDS payoffs.
How could this NOT be insider trading?
How could anyone know that the sub-debt was not covered **unless someone tipped them to that fact?**
‘Not insider trading,’ my arse.
Sheesh!
What a pack of crybabies.
Masaccio, RawStory has linked to your post.
Sounds like it is more than high time to put a stake through the hearts of hedge funds and CDSs in the US and enforce it abroad by treaty otherwise the international system can still be brought down. Meanwhile, the little people must divest themselves of all smelly investments they have left. What is a simple worksheet for helping the average folk sort this out? Ae mutual funds (which ones if this is the case) compromised?
The law was changed not long before she was charged with lying to federal investigators despite the fact she was not under oath.
In the end the charge of insider trading was thrown out by the court.
So, she was charged with lying about something which didn’t happen.
I always wondered if it was a political prosecution (like the gov. of Alabama). Did Martha contribute to Dem causes?
The pattern of Republicans using gov’t to punish it’s political opponents is very bad for the political system.
The banks stopped lending and pulled down the economy because the housing market had tanked and their mortgage paper was worth so much less they had to start putting more cash into the reserves.
At least that’s their story and they’re sticking to it.
After we’ve loaned them beaucoup $$$$ they still haven’t been lending much, though it’s hard to get accurate numbers on that (wonder why?).
Credit Default Swaps were revealed during the untangling of all this as a problem, but not necessarily the cause of the collapse. Where they contributed to the disaster is that they serve LIKE INSURANCE, but without the reserves to back them up. They are as close to a simple insurance fraud case as you can get. But, they got politicians to relabel them and protect them from insurance law. Go figure. Anyway, the linkages between firms because of the swaps helped ensure that when one firm, like Lehmann, went down others were endangered big time. That kind of domino effect should be avoided.
Any financial trade based on insider knowledge and having significant effect on a firm’s outlook for it’s investors has to be regulated (to protect the investor’s interests).
Just because CDSs haven’t been traded on an exchange doesn’t mean they aren’t financially significant. Insider trading Law seems entirely relevant.
One easy way of eliminating the inherent risk associated with any transcation is to forbid the use of debt as collateral. It stands to reason that debt as such is not an asset but instead a liablity and can not be be taken for a tangible asset on which to base any transaction.
It is maintained that the whole notion behind CDSs is that they serve to mitigate and manage the systemic risk associated with the sort of speculative transactions that are unavoidable and necessary for the proper working of finances. I would maintain that it is the very use of debt as collateral and the further insurance of transactions based of those debts that cause the risk in these sorts of speculative transactions.
These transaction do not serve to enhance the productive economy. They operate for the sake generating profits only. If institutions wish to enter into such speculative transactions based on debt then that debt should be carried exclusively by the parties involved in that transaction and no other tangible assets can be put at risk.
Do you forsee any problems with this approach?
this is news to me, would you give more details please? i thought it was the cftc that had regulatory responsibility for cds until congress prevented it (permanently in the cfma of 2000).
if i’m missing a big part of the regulation story, i’d like to correct that deficiency. thanks.