New York, NY – Last week, an article in the Wall Street Journal called Investors Bullish on Fed Tips raised the issue of institutional investors getting advanced notice of important policy developments from central bankers. This article is quite timely as a number of buy-side firms have recently asked us whether they could be at risk of receiving material nonpublic information and being charged with insider trading as a result of the information provided by macro-economic and policy research firms. Despite what many believe, the answer is yes.
Investors Bullish on Fed Tips
Last week’s WSJ article discussed how this past August, a number of analysts and other market participants, after meeting with members of the Federal Reserve, advised their clients that the US central bank was planning to embark on a program to lower interest rates and spur the economy called Operation Twist.
This advice was quite profitable for fixed-income investors as the price of 10-year Treasury bonds surged over the next month or so. By September 21st, when the Fed officially announced that it would implement Operation Twist by selling $400 billion in medium term notes and using these funds to purchase longer term treasuries, gains for 10-year treasuries had come to an end.
The WSJ article pointed out that such talks between Fed officials and investors are legal so long as the policymakers limit their discussions to matters that are already public. Traditionally Fed officials have encouraged these meetings to gauge how investors might respond to monetary policy changes and to obtain feedback from market participants on how these plans might impact the economy.
In fact, due to a request for clarity from policymakers, the Federal Reserve approved a new set of guidelines about how US central bankers should communicate policy changes to the public in June, 2011. These new guidelines state that Fed members should avoid meeting privately with anyone who could profit financially from information received from the Fed unless those views have already been expressed publically.
Insider Trading Not Limited to Stocks
Historically, most investors have concluded that you can only be found guilty of illegal insider trading if you obtain material nonpublic information about a public company and trade in its equity or debt securities as a result. However, a recent SEC case clearly reveals that this is not the case.
In June 2009, a jury in the United States District Court for the District of Massachusetts returned a guilty verdict against defendant Steven Nothern, a former Senior Vice President and manager of seven fixed income mutual funds for Massachusetts Financial, finding that he traded in 30 year US Treasury bonds on inside information (SEC v. Nothern, Civil Action No. 05-CV-10983).
The SEC claimed that Nothern was provided with confidential information by a consultant Peter Davis, who obtained the information at a special Treasury Department briefing. Those who attended the briefing agreed not to release the information for 35 minutes – until 10:00 a.m. The information concerned the Department’s plans to suspend issuance of the 30 year bond. Despite the agreement to embargo the information, Mr. Davis phoned Northern, who knowingly traded on the confidential information, yielding $3.1 million in illegal profits.
To settle the action, Mr. Nothern consented to a permanent injunction prohibiting future violations of Section 10(b) of the Exchange Act and Rule 10b-5. Mr. Nothern also agreed to pay a civil penalty of $460,000. Mr. Nothern was not charged criminally as a result of the case.
Eddie Murphy’s Impact on Insider Trading
Until last summer, investors could legally trade on material nonpublic information in the commodities and futures markets. However, CFTC Chairman Gary Gensler pushed the addition of language to the Dodd Frank Act expanding traditional insider trading laws to the futures markets – making it illegal to trade on non-public information from agencies like the U.S. Treasury, Federal Reserve and Department of Agriculture.
Gensler explained this move by citing the 1983 Eddie Murphy movie “Trading Places” where the two protagonists of the movie intercepted a confidential Department of Agriculture report on orange crop forecasts and used it to successfully corner the orange juice futures market before the report was publicly announced. Gensler said that in real life, the trading highlighted in the movie based on “misappropriated government information is actually not illegal under our statute,” but should be in the CFTC’s view.
The “Eddie Murphy Rule” as the language is called, was included in the Dodd Frank Act when it was signed on July 21, 2010 and can be found in Section 746 of the Wall Street Reform and Consumer Protection Act.
Impact for Macro / Policy Research
So, what do the new Federal Reserve guidelines on communicating policy changes to the public, the SEC v. Nothern case, and the Eddie Murphy Rule mean for macro-economic and policy research services?
In our view, each of these three developments suggest that certain confidential or nonpublic information obtained from government officials, policy makers, or other connected individuals by macro-economic or policy research providers about policy changes or upcoming government releases could be considered material nonpublic information. Consequently, clients that receive and trade on this information – whether in the equities, Treasury bond, or futures markets – could be seen to be guilty of insider trading by US regulators.
This means that macro and policy research firms need to evaluate where they collect the information used in their research process, if this information is nonpublic or confidential in nature, and whether this information could be material to investors in the equities, Treasury bond, or futures markets. These firms then need to develop and implement relevant compliance policies and procedures to control this information from either entering their firms in the first place or from being passed on to clients if they do inadvertently obtain MNPI.
Given legal developments over the past two years, and the increasingly aggressive stance that the SEC has taken with its insider trading investigations and actions, we think it is unwise for macro-economic and policy research firms or their customers to rely on outdated views of what comprises MNPI and insider trading.