The Mark Cuban-backed Sharesleuth.com, discussed in detail here, has found the previously unexploited Achilles' Heel of the insider trading laws and fired an arrow deep into it.  The result is that for the first time, a legal form of what most people would consider "insider trading" exists and can be replicated by anyone with (a) the resources to hire a skilled investigative journalist, (b) the ability to generate a readership on the Internet.

To recap, Sharesleuth.com is a new web publication--basically a blog--backed by businessman Mark Cuban.  Cuban has hired a business reporter named Chris Carey, formerly of the St. Louis Post-Dispatch, to run the publication and conduct investigations to "identify suspect companies."    Once identified, Sharesleuth.com says it will "shine a spotlight on questionable companies," and will "name names and show our evidence, by linking to documents, photographs and other information."  What makes Sharesleuth.com unique and controversial, however, is the fact that it discloses right up front that Cuban is going to make personal investments based upon the information discovered, and do so prior to the publication of this information on the website.

In short, the business model for Sharesleuth.com is that Cuban takes short positions in advance of the publication of the stories published on Sharesleuth.com with the hope and expectation that the negative stories will be read by other investors.  These investors will then presumably sell the stock, drive down the stock price and enrich Cuban.  And repeat.

For those who believe that there is a flat prohibition on insider trading based on material, nonpublic information, the fact that such a business model could be legal may be surprising.  As I have written before, however, there is no such prohibition:

The root of the problem with the "insider trading laws" is that there really aren't any. The offense of insider trading stems from Section 10(b) of the Securities Exchange Act of 1934, a vague statute that prohibits the employment of "any manipulative or deceptive device" in connection with the purchase or sale of securities. Although insider trading is sometimes loosely defined as any trading based on "material, nonpublic information," the legal definition flowing from case law is much more complicated and relies heavily on concepts such as fiduciary duty and the "familial duty of trust and confidence."

For instance, in the 1980s, football coach Barry Switzer attracted the attention of the SEC when, after overhearing a corporate executive discuss the imminent "liquidation" of a public company merger, he profitably traded on that information in advance of the liquidation. The SEC brought an enforcement action against Switzer alleging insider trading.

Although Switzer's conduct would seem to meet any commonsense definition of insider trading, he nonetheless defeated the SEC's case against him. The court ruled that the necessary "duty" had not been breached--because the corporate executive was unaware that Switzer had overheard his discussion of the liquidation, the executive had not breached his fiduciary duty to the company. Accordingly, because Switzer's potential liability as a "tippee" under Section 10(b) would have been derivative of his "tipper's" liability, the court's finding that the executive did not breach his fiduciary duty meant that Switzer's trading based on nonpublic information was actually legal.

In numerous ways, Sharesleuth.com's model is identical to the illegal trading scheme carried out by R. Foster Winans, the WSJ reporter who traded in advance of the WSJ's Heard on the Street column and ultimately went to prison over it.  The difference is that the WSJ had a confidentiality policy in place protecting its information, and Winans breached his duty to the WSJ by trading on that information.  Similarly, as I have written about extensively, many people have been sued by the SEC or face criminal charges for learning/stealing the information to be published in Business Week's Inside Wall Street Column, and trading in advance of its publication.  Again, a fundamental part of the cases against them was Business Week's confidentiality policy regarding its data. 

Sharesleuth.com has no such policy--to the contrary, it flat-out promises to trade based on its information.   As a result, most people who have analyzed the legality of the Sharesleuth.com business model seem to agree that it does not constitute insider trading and is legal.  This no doubt includes Sharesleuth.com/Cuban's own lawyers.  (The ethics of this plan are another issue altogether and have been the subject of some heated debate).

All of which leads me back to where this post started--the Achilles' Heel of the insider trading laws.  That Achilles' Heel, in my opinion, is that the law does not flatly prohibit insider trading based on material, nonpublic information.  Rather, as discussed above, it prohibits some such trading, but excuses other trading if there is no legal "duty" under the circumstances not to trade.  Such arbitrariness has not been a systemic problem to date because the "excused" insider trading has always been a one-off, non-repeatable type of situation, e.g., the trader who overhears inside information on a plane and profits from it.  Prior to Sharesleuth.com, there has not been, to my knowledge, a "replicable-on-demand" model that avoids the insider trading laws while permitting an investor to trade on nonpublic information.

This is not to say that the Sharesleuth.com business model is necessarily a lay-up.  For the model to be profitable, the investigative reporter involved will need to be able to find compelling evidence of fraudulent or questionable public companies that has not yet been discovered.  In addition, the publication must generate an audience of critical mass that finds it credible and trades based upon its findings.  Assuming all of this can be accomplished, however, the first company that makes its money from legal insider trading will have been created—with a business model that can be duplicated by anyone with similar resources and abilities.  If this occurs, Congress and the SEC may need to give serious thought to whether it is time to refine the insider trading laws.

August 9, 2006

Comverse Execs Face Criminal Charges

The Criminal Complaint filed today by federal prosecutors against three former executives of Comverse Technology (the former CEO, CFO and General Counsel) for options backdating is available here, courtesy of the WSJ Law Blog. 

Before your eyes glaze over and you hit the "Back" key to go read about something less arcane than strike dates, compensation accounting rules, etc., just know that the stuff in the Criminal Complaint is pretty fascinating.  The FBI agent providing the statement in the Criminal Complaint gets deep into the details of the alleged scheme at Comverse, including the creation of a secret slush fund account called Phantom in which options to fictitious employees were stashed and later awarded to favored employees for recruitment and retention.

The Criminal Complaint also details the alleged cover-up of the scheme when the WSJ started asking questions about options grants in March 2006, which according to the complaint included evidence tampering and numerous misstatements and half-truths to company lawyers, the company's auditors, the WSJ, and the Special Committee hired to investigate the matter. 

One of the more interesting statements in the Criminal Complaint is that according to the defendants, the backdating practice was shut down in April 2002 because of "the advent of Sarbanes-Oxley and a more stringent enforcement 'environment.'"

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August 8, 2006

Xethanol Watch!

Xethanol Corp., the first "skeweree" of the Mark Cuban-backed Sharesleuth.com, appears to have begun tanking today following the negative investigative piece posted yesterday by Sharesleuth.com.  The stock was down over 13% on far greater-than-normal volume. 

Will the Sharesleuth.com money machine actually work?  Stay tuned!

XETHANOL CORPORATION (AMEX:XNL) Delayed quote data

Last Trade: 5.95 Trade Time: 4:00PM ET Change: 0.96 (13.89%) Prev Close: 6.91 Open: 6.47 Bid: N/A Ask: N/A 1y Target Est: N/A

Day's Range: 5.70 - 6.50 52wk Range: 2.30 - 16.18 Volume: 894,600 Avg Vol (3m): 387,425 Market Cap: 156.61M P/E (ttm): N/A EPS (ttm): -0.74 Div & Yield: N/A (N/A)

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August 7, 2006

Always the Maverick, Part II

As previewed here, the Mark Cuban-backed Sharesleuth.com issued its first investigative piece today, absolutely skewering a company called Xethanol Corp.  You may recall the Sharesleuth.com concept discussed in the earlier post:  Cuban backs the Sharesleuth.com investigations/journalism, and tells the world right up front that he is going to be trading and/or shorting the stocks discussed in the Sharesleuth.com articles in advance of the articles' publication.  Indeed, today's article discloses that Cuban has already shorted 10,000 shares of Xethanol Corp. 

So everything seems to be clicking along according to plan for Cuban and Sharesleuth.com (find a company to skewer--check; write the article--check; short the stock pre-publication--check; publish the article--check) except for one thing:  despite the publication of the negative article at 10:05 am, the stock price has remained virtually unchanged (it closed at $6.95/share on Friday according to the article and closed today just 4 cents lower at$6.91/share, on below average volume). 

What's the problem here with this sure-fire money machine?  Why isn't the stock going down?  Does the market not find the Sharesleuth.com analysis persuasive?  Is nobody reading Sharesleuth.com yet? 

Come on, people!  Don't you realize that journalism paid for by short-sale profits can't sustain itself if the stock doesn't go down post-publication?

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Guest Post: Third Circuit Reconsiders the "Presumption of Reasonableness"

SLW guest-poster Wayne Schneider, General Counsel of the New York State Teachers' Retirement System, is back with another excellent piece on what appears to be an under-examined aspect of the Third Circuit's recent opinion in In re: AT&T Corp. Securities Litigation: is the Third Circuit backing away from the "presumption of reasonableness" it announced in the Cendant case for a fee negotiated between a lead plaintiff and class counsel?

Mr. Schneider writes:

Several years ago, the Third Circuit opined in the landmark Cendant case that a fee request of class counsel based upon counsel’s retainer agreement with the lead plaintiffs appointed pursuant to the 1995 Reform Act should enjoy a “presumption of reasonableness”.  The federal securities class action plaintiffs’ bar have trotted this notion out ever since in support of their fee requests, no matter how excessive.

Mr. Schneider observes that in the cases in which his retirement system has objected to fee requests which it believed to be excessive,

class counsel has invariably trotted out the "presumption of reasonableness" as their argument of choice.  Indeed, class action lawyers love the presumption because they see it as inviting a court to determine not whether they have carried their burden under the Reform Act of proving their requested fee is reasonable, and not excessive, but to determine only whether the precise objections raised by objecting parties “clearly” establish their requested fee is unreasonable.  As they would have it, their requested fee must be determined to be reasonable under the “presumption” unless proven otherwise.

In the recent AT&T decision, however, Mr. Schneider sees some language that suggests to him that "perhaps securities investors can look forward to the day real soon" when the "presumption of reasonableness" notion disappears entirely.

You can read Mr. Schneider's entire post on the AT&T opinion here.

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August 3, 2006

What Are We Going to Do? Yacht Trip!

Interesting article in the New York Observer about a lavish yacht trip last Friday night aboard the 160-foot-long Duchess, which cast off from a dock along the Hudson River at 41st Street in New York.  The passengers aboard this yacht?  None other than the lawyers of recently-indicted law firm Milberg Weiss Bershad & Schulman.  Read the whole article for a good account of where things stand now for the Milberg Weiss firm and its steadily declining number of lawyers.   

And I must ask--does this unlikely yacht trip and its surrounding circumstances remind anyone else A LOT of a certain scene from a movie?  How about this one?

HOOVER:  Ladies and gentlemen, l'll be brief.   The issue here is not whether we broke a few rules or took a few liberties with our female party guests.  We did.   
                  
But you can't hold a whole fraternity responsible for the behaviour of a few sick, perverted individuals.  If you do shouldn't we blame the whole fraternity system?  And if the whole fraternity system is guilty, then isn't this an indictment of our educational institutions in general?

I put it to you, Greg.  Isn't this an indictment of our entire American society?    
                  
Well, you can do what you want to us.  But we won't sit here and listen to you badmouth the United States of America!  Gentlemen!

WORMER: You're not walking out on this one, mister.  You're finished.  No more Delta! You've bought it this time, buster!  I''m calling your national office!  I'm going to revoke your charter!  If you wise guys try one more thing, one more, l'll kick you out of this college!  No more fun of any kind!

***

BOON: Jesus. What's going on?

BLUTARSKY:  They confiscated everything, even the stuff we didn't steal.  They took the bar!  The whole @#&$# bar! 
                  
BOON: This is ridiculous.  What are we going to do? 
                  
BLUTARSKY: Yacht Trip!  Road trip!

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August 2, 2006

Options Backdating Securities Class Actions: The List--Update

Our options backdating securities class action list has been updated to add Safenet, Inc. and remove Analog Devices.   Despite this article that suggested the Analog Devices case was a securities class action, SCAS has no confirmation of that to date. 

With one case added and one removed, the number of companies on the list remains at 11.

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August 1, 2006

'Bout Time!

The SEC announced today that on July 28, a federal court in Georgia ordered Arnold E. Johns, Jr. to pay $372,578 of disgorgement, plus prejudgment interest of $399,209, for insider trading.   To which all we can say is... it's about time!!!

Suffice it to say that the insider trading at issue occurred many, many moons ago.  How long ago?  Without looking at the release, see if you can guess.  Here are your clues:

1.  As noted above, the prejudgment interest now actually exceeds the amount of the disgorgement.
2.  ER was the top-rated TV show.
3.  The #1 song on the pop charts that month was "One Sweet Day" by Mariah Carey and Boyz 2 Men.
4.  Dallas beat Pittsburgh to win the SuperBowl.
5.  At least where I worked at that time (the SEC), you needed to go to a special room and terminal to use the Internet.

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