Thursday, November 20, 2008

The Mark Cuban charges – and the economic purpose of insider trading laws

Warning: this post contains observations on American law written by a non-lawyer Australian. Technicalities might be wrong but (I think) the general theme is right.

Mark Cuban is loud and opinionated. I like his opinions sometimes. He also gave me one nice big-cap stock idea once – but he didn’t even mean to give it to me. Indeed he probably didn’t even trade it himself. It is just that something he said about high definition TV changed my views on DirecTV and I purchased it about $13 as a result. It was a very quick profit. Thank you Mark.

That said Mark Cuban has famously been charged with insider trading regarding his trades in mamma.com – a stock I would never have touched. On the information given his actions look unethical – but whether they are illegal is another thing.


The purpose of insider trading rules

The purpose of this post is really to explore the economics of insider trading in light of the Cuban charges.

There is a daft argument that pops up every now and again about why insider trading should be legal. Here is one reference to it. It takes some doing to explain why this is daft. Here goes:

The total returns to stockholders from a business over a very long period should equal the return from the business less transactional costs. The stock market doesn’t actually “make profits”. Businesses make profits – and hopefully those profits get distributed to shareholders via buybacks and dividends. Of course some clever people buy low and sell high – but to the extent that some smarty (hopefully me) makes a return above the business return some sucker out there (hopefully someone who does not read this blog) makes a return below the business return.


If the market were perfect we would all know what the returns to each sort of business were and we would allocate capital accordingly. There would be no misallocation.

But the market is not perfect – and the returns to a business can only be estimated. Most shareholders solve the problem by owning a bundle of stocks (its called diversification) and the returns to the bundle of stocks should in some sense be reflective of the returns to business per-se. Of course this is only true if you hold the stocks over a very long period of time – but it should prima-facie be true on average if the market approximates efficiency.

Of course all this breaks down if management steal from shareholders. Indeed if management always stole all the returns to shareholders there would be no shareholders – and there would be massively sub-optimal investment in business. If management steals a little the returns to investors would be slightly lower than the returns to business and the investment level would thus be sub-optimal.

Now back to insider trading. Insider trading cannot change the end returns over very long periods to shareholders. The returns to shareholders are ultimately determined by the returns of the business. The stock market does not make economic returns – the businesses do that. But insider trading increases the returns of insiders and hence must reduce the returns of non-inside shareholders. It is economically the equivalent of theft as it allocates returns from capital providers to insiders.

It is facile to say that insider trading is good because it brings stocks closer to fair value. That would only be desirable if it brought shareholder returns closer to business returns… and it does not do that.

Now having stated this, it is clear what insider trading rules are meant to do. They are meant to stop theft by people who are in a position of trust with respect to a company and thus deny insiders and advantage over external shareholders.

Fine – but that is not what the Australian laws do (though it is closer to what the American laws do).

The Australian law is an ass. There was a case of a guy who found gold on a mining lease he personally owned. The only problem was that the ore body was open-ended and clearly extended far onto the neighbours lease. He did what a sensible sort of fellow would try to do – he tried to buy the neighbours lease without telling him about the ore body. Of course he was trying to get maximum return from his prospecting effort (and I still have not worked out what is wrong with that from a microeconomist’s point of view…)

But the problem was that the neighbour’s lease was owned by a small public company controlled by Joe Gutnick. [Regular readers will know that Diamond Joe has made a few appearances on this blog…]

So he started buying stock in Joe’s company.

This was deemed by the Australian authorities (and later the courts) to be insider trading. He was trading on non-public information (that there was gold in them there hills). The only problem is that he found that non-public information by informed and legal sleuthing on his own and not by being an insider. This would seem to make stock research (at least if involves digging in the dirt) look like insider trading. I hope the authorities don’t want to stop me doing research. But the key here is our hapless gold prospector was not an insider, did not have a position of trust and hence did not abuse that position of trust. I cannot see the justification for the insider trading rules – but being an Australian I have to live with them.

Anyway the American rules are much more clearly about position of trust. When the CEO of Imclone sold shares (or sold his daughter’s shares) when he knew the FDA was going to reject his drug that was insider trading. If he hinted or told another person (Martha Stewart) to sell her shares that was also a breach of the position of trust. But Martha Stewart selling her shares – that was legal. Martha Stewart is not an insider. What Martha Stewart did would have been illegal in Australia – but it was not in the US. For those that do not know she went to the big house for lying to investigators and not for insider trading.

I think the American rule is right from the economic perspective – but it is awful hard to prove.


Enter the Mark Cuban case.

Mark Cuban owned a large stake in mamma.com. He received a call from the CEO asking if he wanted to participate in a secondary offering (a pipe). He sold his shares.

There is no criminality in that because Mark Cuban is not an insider. If it were Australia the case would be easy to prove because he does not need to be an insider – he only needs to be in possession of non-public knowledge – and that is clearly the case.

To make him an insider he needs to have agreed to be an insider. He needs to have agreed with the CEO that he will take information confidentially. In other words the case hinges almost entirely on the contents of a phone call between the CEO of a failing dot.com and Mark Cuban – and the call is meant to have taken place in 2004. Nobody is going to credibly remember it. If it came to a criminal charge (which required absence of reasonable doubt) then you would have to acquit Cuban because at best this case will be two people saying “he said” and the other saying “no I did not” about a conversation years ago. As far as I know there is nothing in writing in which Mark Cuban agrees to be an insider (though something in writing is what is required). It is telling that there was no criminal charge filed with the civil charge. The criminal charge wouldn’t fly.

Now the fact that I don’t think (at least beyond reasonable doubt) that Mark Cuban is guilty of insider trading doesn’t mean I condone what he did. It was unethical – in that with information given to Mark at least because of his position (as a rich guy) he acted in a way that increased his returns vis other shareholders. It is not nice behaviour and it would be illegal in Australia.

And that makes the only case I can think of for the Australian laws. As the Aussie laws do not require evidence that Mark Cuban agreed to treat information as confidential he would be guilty here. It would be a slam dunk to use the American phrase. The case for the Aussie law is that the case is easier to prove.

For the record I am fairly sure no criminal charge will be filed (in the absence of the bit of paper or email in which Cuban agrees to treat information as confidential the case would not fly). On the civil charges on the evidence given I would acquit however there may be considerably more evidence than is given. I am not sure that is economically the right outcome – but I think it is where the law is as I understand it.

In full disclosure I have to say that I still feel favourably to Mark Cuban (I made money on DirecTV). I wish him luck even though the most charitable interpretation of his behaviour is that it stinks.

As for lessons: it doesn’t pay to hit the ball close to the line. Even if Cuban’s behaviour was legal (as I suspect) it invites criticism and it looks bad. Mark is paying dearly for it now – and that payment might be deserved.

John Hempton

7 comments:

Jestyn said...

Hi John

Isn't there still a distinction that could be drawn between Cuban and your gold digger? Cuban received information that he knew, or ought to have known, came from an insider and he traded on it. That seems like "insider trading" whether he agreed to act on it or not. (Put another way, even if the dotcom guy DIDN'T ask him to become an insider he must have known that a breach of Reg FD had occurred, and the way the law ought to work you shouldn't trade on that?).

The gold digger on the other hand just found out something, completely independent of any insider, and used it to trade. That's no different from an analyst who digs around a company - talks to the waiters coming off shift, or reads an airline pilots blog - and discovers something that makes him take a different view on a stock. No way that should be insider trading.

John Haskell said...

John- Ugh.

The key phrase in the US law is "in receipt of material non public information."

A farmer goes out a huntin for some food, and up came a bubblin' crude. He then starts buying shares in the neighboring mining company. Is he "in receipt of" material non public information? No, he found the oil (or gold) himself. This cannot be insider trading in the US because there was no insider, or person in a position of trust, who abused that position of trust to tip off the farmer. How your Austrialian law works there is pretty bizarre and maybe someone will fix it eventually.

Martha Stewart- Martha is flying to Cabo for vacation. Sam Waksal's broker, Peter Bacevic, calls her up, and in an unethical effort to curry favor, says, "I think you should know that Waksal is blowing out all of his family's stock."

Now this is important. Bacevic didn't add "because he knows the FDA isn't going to approve their drug." And Waksal didn't say squat to either Bacevic or Martha. The only information that either Bacevid or Martha had at the point of decision was that Waksal was selling.

You might argue that this was somehow inside information (usually insider sales are disclosed on a Form 4) and I don't know what discussions the US Attorney's office had on this point. Certainly it would have been a hell of a stretch. In any case they didn't have to try it, because under oath Martha made up a BS story about why she sold. With everyone and his brother also having to give testimony her BS story quickly folded and she was convicted of perjury.

Now back to Cuban. Out of a clear blue sky he decides to dump all of his stock in Mamma.com. It turns out that Mamma was also in the middle of fundraising and that the CEO says he talked to Mark Cuban. Now whom are you going to believe, Mark Cuban or your lying eyes?

So there was a phone conversation a long time ago. So what? If you were on a jury, and someone told you that the CEO of this co. called Mark Cuban, and Cuban immediately thereafter dumped all of his shares, would you believe that the CEO and Cuban were talking about whom the Mavs were going to pick in the next round of the draft?!

Cuban's BS story will get him about as far as Martha's BS story, and if his lawyer is worth a damn he will not let Cuban testify to any of this under oath. (which may have already happened, I haven't been following it that closely.)

Nadav Manham said...

John,

Suppose Cuban was not investing his own money but was a fiduciary for others' capital, and received the identical call from the CEO. Assuming he did not agree to become an insider, and the call caused him to question the company's future, would he not then have been obligated to sell the shares?

John Hempton said...

As for legal questions - I know the Aussie law well. It is on a day-to-day basis what I have been obliged to deal with.

But taking the extreme - suppose he found out - as one of the comments suggests - that there was a material seconday offer in the wind and he owned the stock not for himself but for clients.

It looks awful like he had a fiduciary obligation to act for those clients.

==========

I confess to being so nervous of all this stuff that I don't ever want to play. When I get information in my email (which I do every now and again) I reply saying if this is genuine inside information I do not want to receive it. If it is widespread rumour please mark it as widespread rumour as it is interesting to know what people are talking about.

J

# 56 said...

"If it came to a criminal charge (which required absence of reasonable doubt) then you would have to acquit Cuban because at best this case will be two people saying “he said” and the other saying “no I did not” about a conversation years ago."

Tell it to Scooter Libbey, that is exactly how Patrick Fitzgerald convicted him of a felony in federal court.

Blank Xavier said...

> There was a case of a guy who
> found gold on a mining lease he
> personally owned. The only
> problem was that the ore body
> was open-ended and clearly
> extended far onto the neighbours
> lease. He did what a sensible
> sort of fellow would try to do –
> he tried to buy the neighbours
> lease without telling him about
> the ore body.

Unethical.

All contracts must be voluntary and well-informed. He deliberately withheld knowledge from the other party. How that knowledge came about is irrelevant.

USLaw.com said...

For more background on the SEC's claim Cuban traded on insider info:

http://www.uslaw.com/pop/mark-cuban-may-need-to-hide-behind-his-mamma/?p=158

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.