Par for the Course

Why Phil Mick­el­son wasn’t charged with in­sider trad­ing

Bloomberg Businessweek (Europe) - - CONTENTS - By Shee­lah Kol­hatkar

Ad­van­tages the ma­jor­ity of in­vestors didn’t—and aren’t sup­posed to—have. Sev­eral per­fectly timed stock trades yield­ing mil­lions in profit. Is that le­gal?

Just ask Phil

On Fri­day, July 27, 2012, Phil Mick­el­son re­ceived a phone call. It wasn’t just any call; it was, ac­cord­ing to the U.S. Se­cu­ri­ties and Ex­change Com­mis­sion, a trans­mis­sion of busi­ness in­tel­li­gence po­ten­tially worth mil­lions of dol­lars. Mick­el­son’s friend, a gam­bler named Wil­liam Wal­ters, was call­ing to urge him to buy shares of Dean Foods. The Dal­las-based dairy con­glom­er­ate was go­ing to an­nounce a spinoff of its or­ganic foods unit the fol­low­ing week, and the com­pany’s board thought it would cause Dean stock to pop. Wal­ters had got­ten the tip from the best pos­si­ble source, a board mem­ber who’d par­tic­i­pated in the con­fer­ence call where the board en­cour­aged the Dean chief ex­ec­u­tive of­fi­cer to move ahead. It was about as close to a sure thing as you could get, and Wal­ters, who un­der­stood odds bet­ter than most peo­ple, had al­ready ac­cu­mu­lated al­most 4 mil­lion shares, an ag­gres­sive bet worth about $50 mil­lion.

The golf great was hardly a high-ve­loc­ity stock trader. Mick­el­son, who’s made al­most $80 mil­lion over his play­ing ca­reer, had never be­fore in­vested in Dean, ac­cord­ing to the gov­ern­ment. Yet that fol­low­ing Mon­day and Tues­day, he al­legedly pur­chased 200,240 shares, partly on mar­gin, for $2.4 mil­lion. A week later, on Aug. 7, Dean an­nounced the spinoff, and as the board had pre­dicted, the stock shot up 40 per­cent. Wal­ters made $17.1 mil­lion and Mick­el­son $931,000.

Three peo­ple, one a celebrity ath­lete, with ac­cess to in­ter­nal in­for­ma­tion about a pub­licly traded com­pany. Ad­van­tages the ma­jor­ity of in­vestors in the mar­ket didn’t—and aren’t sup­posed to—have. Sev­eral per­fectly timed trades yield­ing mil­lions in profit. If one were to de­scribe the trans­ac­tion to a layper­son, it’s likely that it would sound like a crime.

Se­cu­ri­ties in­ves­ti­ga­tions travel at an inch­worm’s pace, and al­most four years later, on May 19, the U.S. at­tor­ney for the South­ern District of New York, Preet Bharara, stood in front of a room full of re­porters to an­nounce se­cu­ri­ties fraud charges against Wal­ters and his source, for­mer Dean board mem­ber Thomas Davis. Davis had co­op­er­ated and pleaded guilty; Wal­ters had been ar­rested the night be­fore. With the snappy lan­guage he’s known for— Bharara called Davis a “se­cret bug in the board­room”—the U.S. at­tor­ney ex­plained that Wal­ters and Davis had used an anonymous pre­paid cell phone and a code, “Dal­las Cow­boys,” to re­fer to the tar­get com­pany. “These bets were no gam­ble at all,” Bharara said of their trades, be­cause Wal­ters “had to­mor­row’s head­lines today.”

“Brazen in­sider trad­ing con­tin­ues to be a blot on our se­cu­ri­ties mar­kets,” Bharara con­tin­ued, “and the in­tegrity of our mar­kets con­tin­ues to be a pri­or­ity of our of­fice.”

So why wasn’t Mick­el­son charged? The an­swer is that cer­tain kinds of be­hav­ior pre­vi­ously un­der­stood to be in­sider trad­ing are now ef­fec­tively le­gal— or at least not pros­e­cutable. More than 20 years af­ter the im­pris­on­ment of Ivan Boesky, the in­fa­mous ar­bi­trageur, it’s be­come vastly harder to con­vict some­one for in­sider trad­ing—the re­sult of sev­eral years of le­gal chal­lenges that handed Wall Street an enor­mous vic­tory. An ap­peals court rul­ing in De­cem­ber 2014 ba­si­cally le­gal­ized the don’t-ask, don’t-tell in­for­ma­tion-gath­er­ing model em­ployed by many hedge funds; it’s now OK to trade on ques­tion­able in­for­ma­tion that one re­ceives se­cond­hand, as long as you don’t know too much about how it was ob­tained.

Of­fer­ing some­one a pile of cash in ex­change for con­fi­den­tial, mar­ket-mov­ing in­tel­li­gence is still clearly over the line. But to cite an ex­am­ple Bharara him­self has used: Say a CEO knows his com­pany is be­ing taken over in a few weeks—he could, po­ten­tially, pass that in­for­ma­tion to a nephew for noth­ing in re­turn, and the nephew and his friends could, in the­ory, trade on it. Al­ter­na­tively, the CEO could share the plans with a bookie in ex­change for for­giv­ing a gam­bling debt. The bookie could then tell his friends to trade, who could then tell their friends to trade. As long as none of those fur­ther down the chain knew the tip­per’s gam­bling debt was for­given, they would be in the clear.

Is it fair for rich, well-con­nected in­di­vid­u­als with ac­cess to valu­able cor­po­rate in­for­ma­tion to freely make money from it? Or is that deeply un­fair? “I don’t know that it gives traders carte blanche to break the law,” Richard Hol­well, a fed­eral judge who’s presided over ma­jor Wall Street tri­als, told Bloomberg News. “But it cer­tainly makes it eas­ier to get away with.”

The events that led to this new le­gal

re­al­ity be­gan in Novem­ber 2010, when a group of dark, un­marked cars pulled up to an of­fice build­ing in Stam­ford, Conn. The SEC, FBI, and pros­e­cu­tors from the Man­hat­tan U.S. At­tor­ney’s Of­fice were in the midst of a ma­jor in­ves­ti­ga­tion into in­sider trad­ing at mul­ti­ple hedge funds. Raj Ra­jarat­nam, the co-founder of the $7 bil­lion-plus Galleon Group, had been ar­rested the pre­vi­ous Oc­to­ber; gov­ern­ment in­ves­ti­ga­tors were chas­ing down Ra­jarat­nam’s con­nec­tions, and their con­nec­tions’ con­nec­tions. One trader on the list was Todd New­man, a port­fo­lio man­ager at the hedge fund Di­a­mond­back Cap­i­tal. The FBI had come to Di­a­mond­back’s Stam­ford of­fice to try to per­suade New­man to co­op­er­ate, or else storm in and search the premises. While that was hap­pen­ing, a sep­a­rate FBI squad was pre­par­ing to raid Level Global, a Man­hat­tan hedge fund co-founded by An­thony Chi­as­son. A third fund, Bos­ton’s Loch Cap­i­tal, was also tar­geted. Soon, FBI agents were cart­ing hard drives and cell phones out of ma­jor in­vest­ment firms in broad day­light.

Chi­as­son and New­man were charged with in­sider trad­ing in Jan­uary 2012. But it wasn’t a typ­i­cal case. Rather, the two were at the outer ex­trem­ity of a ring of six traders and an­a­lysts the gov­ern­ment ac­cused of play­ing a sort of de­mented game of “bro­ken tele­phone”—shar­ing and trad­ing on ma­te­rial non­pub­lic in­for­ma­tion. Bharara called it a “crim­i­nal club.” In one ex­am­ple, an in­vestor re­la­tions em­ployee at Dell shared the com­puter maker’s in­ter­nal fi­nan­cial in­for­ma­tion with a friend at an as­set man­age­ment firm. The friend passed it along to an an­a­lyst at Di­a­mond­back, who passed it along to his boss—New­man—as well as to a friend at Level Global, who passed it to his boss, Chi­as­son. New­man and Chi­as­son traded on the in­for­ma­tion. In all, they made over $70 mil­lion trad­ing tech stocks this way, ac­cord­ing to the gov­ern­ment. It was un­clear what, ex­actly, they knew about the source of the in­for­ma­tion, but it cer­tainly looked sus­pi­cious.

The courts be­gan to con­sider: Was this il­le­gal—or sim­ply what traders in the mod­ern mar­ket do ev­ery day?

Much of the in­sider trad­ing that oc­curred dur­ing the Boesky era was straight­for­ward and trans­ac­tional, some­times in­volv­ing suit­cases of cash de­liv­ered by men in suits in ho­tel lob­bies. By the early 2000s, the gov­ern­ment saw in­sider trad­ing as more amor­phous, an ex­change of fa­vors, ru­mors, and some­times hard num­bers passed along for good­will or ex­pec­ta­tions of ca­reer help. Traders cared less about one-off merg­ers and more about com­pa­nies’ quar­terly earn­ings. But while this new mech­a­nism for mak­ing money was highly prof­itable and un­avail­able to av­er­age in­vestors, prose­cut­ing it was hard.

The mar­ket’s driven by ru­mors at all times, with stock prices yo-yoing in re­sponse to “whis­per num­bers” about earn­ings or word that a big in­vestor is pre­par­ing to buy or sell. There are so many fac­tors and in­for­ma­tion sources af­fect­ing a share price that get­ting “edge”—a

term for valu­able mar­ket in­for­ma­tion that oth­ers don’t have—doesn’t guar­an­tee that a trader will even make money. “You peo­ple in the media, you think we’re all like mon­keys, like we’re just sit­ting around wait­ing for the ba­nanas, and when we get the ba­nanas, we jump up and down and eat them,” a for­mer Galleon trader told me. “But it takes a tremen­dous amount of tal­ent to know what to do with the edge, even if you get it.”

Soon af­ter charges were filed against New­man and Chi­as­son, their de­fense lawyers got to work. They saw a ma­jor hole in the gov­ern­ment’s case, and they in­tended to drive an 18-wheeler right through it.

In­sider trad­ing has never been clearly de­fined by law. Rather, its con­tours have been shaped through a se­ries of court de­ci­sions, as if a ma­jor form of se­cu­ri­ties crime were a piece of beach glass at the mercy of the waves. A ma­jor rul­ing came from the Supreme Court in 1983, in

Dirks v. SEC, which held that for a crime to have been com­mit­ted, an in­sider leak­ing com­pany in­for­ma­tion must have dis­closed the in­for­ma­tion in re­turn for a ben­e­fit. Pro­vid­ing help or fa­vors to a friend could count. It fol­lowed that any­one re­ceiv­ing the in­for­ma­tion se­cond­hand could be found li­able for trad­ing on it only if they knew it was the bad kind of in­for­ma­tion, i.e., that the per­son who first gave it out got some­thing in re­turn.

By the time New­man and Chi­as­son’s cases went to trial, their lawyers, Stephen Fish­bein, of Shear­man & Ster­ling, and Gre­gory Morvillo, of Morvillo Law, re­spec­tively, were fo­cused on the idea of “re­mote tippees”—peo­ple who are sev­eral steps re­moved from the orig­i­nal source of in­side in­for­ma­tion. The in­for­ma­tion had flowed from Dell through two other peo­ple be­fore reach­ing New­man; three for Chi­as­son. The lawyers ar­gued that their clients had to have known that the orig­i­nal leaker had done some­thing wrong—de­fined by hav­ing re­ceived a ben­e­fit—in order to have com­mit­ted a crime them­selves. The Dell source worked in the com­pany’s in­vestor re­la­tions de­part­ment, which made the point harder to prove, since it was part of his job to share in­for­ma­tion with an­a­lysts. (In fact, the gov­ern­ment hadn’t charged the Dell em­ployee, im­ply­ing he didn’t do any­thing il­le­gal.) District Judge Richard Sul­li­van dis­agreed, the jury found New­man and Chi­as­son guilty, and they were sen­tenced to lengthy prison terms.

The men ap­pealed, and two years later, in De­cem­ber 2014, the Sec­ond Cir­cuit Court of Ap­peals is­sued a harsh re­buke to Bharara’s of­fice, rul­ing that the U.S. At­tor­ney had been too ag­gres­sive. New­man and Chi­as­son had their con­vic­tions over­turned. The de­ci­sion went far beyond sim­ply clar­i­fy­ing that in­sider trad­ing re­quires a per­son to know that the orig­i­nal source of a piece of in­for­ma­tion parted with it for a ben­e­fit; the court also ruled that the ben­e­fit had to be sig­nif­i­cant, an “ex­change that is ob­jec­tive, con­se­quen­tial, and rep­re­sents at least a po­ten­tial gain of a pe­cu­niary or sim­i­larly valu­able na­ture.” The hope of fu­ture ca­reer ad­vice or ca­sual friend­ship wasn’t enough. This sweep­ing change to the ben­e­fit re­quire­ment was a dev­as­tat­ing blow to the gov­ern­ment. Bharara was en­raged by the de­ci­sion, pub­licly com­plain­ing that the prece­dent cre­ated an “ob­vi­ous road map for un­scrupu­lous in­vestors.” Phones at the SEC started ring­ing off the hook, as de­fense lawyers called, try­ing to un­ravel or re­tract civil set­tle­ments that now looked weak.

The Supreme Court may clar­ify the sit­u­a­tion when it rules on an­other in­sider trad­ing case it agreed to take up in Jan­uary, USA v. Sal­man. The court will rule on whether dis­clos­ing valu­able in­for­ma­tion to help a rel­a­tive—a brother in this case—qualifies as hav­ing re­ceived a per­sonal ben­e­fit.

In the months af­ter the Dean Foods trade, “Lefty,” as Mick­el­son is known, gave a clue as to the ex­tent of his pre­oc­cu­pa­tion with mat­ters of money when, in Jan­uary 2013, he com­plained about his high Cal­i­for­nia tax rates and threat­ened to move to mil­lion­aire-friendly Florida: “If you add up all the fed­eral and you look at the dis­abil­ity and the un­em­ploy­ment and the Social Se­cu­rity and the state, my tax rate is 62, 63 per­cent,” Mick­el­son said, ac­cord­ing to the As­so­ci­ated Press. “So I’ve got to make some de­ci­sions.” He later apol­o­gized.

Af­ter Wal­ters was charged, Mick­el­son tried to back away from the Wal­ters-Davis train wreck. The SEC named Mick­el­son only as a “re­lief de­fen­dant,” mean­ing that he was seen to have re­ceived ill-got­ten pro­ceeds that he would be com­pelled to re­turn but not as hav­ing en­gaged in un­law­ful be­hav­ior. “The com­plaint does not assert that Phil Mick­el­son vi­o­lated the se­cu­ri­ties laws in any way. On that point, Phil feels vin­di­cated,” Mick­el­son’s lawyer said in a state­ment. “At the same time, how­ever, Phil has no de­sire to ben­e­fit from any trans­ac­tion that the SEC sees as ques­tion­able.”

Ex­perts and pun­dits quickly of­fered their own ex­pla­na­tions for Mick­el­son’s seem­ingly mirac­u­lous es­cape. “The gov­ern­ment can go af­ter the orig­i­nal tippee, which is what they have done here,” says John Cof­fee, a Columbia law pro­fes­sor. But re­quir­ing proof that any­one else who traded on the in­for­ma­tion knew the orig­i­nal tip­per was paid for it is too high a bar and will in­cen­tivize traders to sim­ply not ask ques­tions. “That is ir­rel­e­vant in­for­ma­tion, it’s legally dan­ger­ous, and peo­ple don’t want to com­mu­ni­cate it—and peo­ple don’t want to hear it,” Cof­fee says. “Wall Street runs as a fa­vor bank, where peo­ple know if they get in­for­ma­tion today, they’ll get a fa­vor to­mor­row, and they keep it safe by never dis­clos­ing the source.”

At the May 19 press con­fer­ence an­nounc­ing the case, re­porters in the room re­fused to co­op­er­ate with Bharara’s at­tempt to present the Wal­ters in­dict­ment as a vic­tory for jus­tice and homed in on Mick­el­son’s glar­ing ab­sence from the crim­i­nal charges. Martha Ste­wart, af­ter all, did hard time.

“Why is it that Phil Mick­el­son is not charged in this?” a reporter asked as soon as the Q&A pe­riod be­gan. An­other chimed in: “Are you say­ing he didn’t re­al­ize he was go­ing to be mak­ing money, that he’s an in­no­cent per­son here?”

Bharara and An­drew Ceres­ney, the SEC’s head of en­force­ment, de­flected the ques­tions as best they could, but the sub­text was clear: Mick­el­son wasn’t charged be­cause of the New­man de­ci­sion, the new prece­dent they all hated.

“I’m not go­ing to com­ment,” Bharara said, more than once.

Fi­nally, an­other, es­pe­cially per­sis­tent reporter weighed in: “Doesn’t it un­der­mine con­fi­dence in the mar­kets to not charge the celebrity de­fen­dant and not ex­plain why you are not charg­ing the celebrity?” She added: “What mes­sage do you think that sends to the Amer­i­can pub­lic?”

Preet blinked. <BW>

“It takes a tremen­dous amount of tal­ent to know what to do with the edge, even if you get it”

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