Activist Investors Cloud Insider Trading Cases
The ongoing federal investigation into potential insider trading by billionaire investor Carl Icahn, professional golfer Phil Mickelson, and Las Vegas bettor William Walters will be a difficult case to prove. And not just because of the involvement of three highly public figures from seemingly unrelated walks of life.
It underscores the difficulties of enforcing and interpreting insider trading rules when activist investing, given its often public nature, is involved.
The federal case, led by the FBI, is looking at whether Icahn—portfolio manager of hedge fund Icahn Enterprises—tipped off Walters regarding Clorox Co. three years ago, which Icahn’s firm at the time was considering purchasing.
Walters, a prominent Las Vegas sports bettor, is a friend of Icahn’s. Federal authorities are also looking into whether Walters then passed such nonpublic information off to Mickelson. Icahn disclosed that he does not know Mickelson.
The Wall Street Journal, which broke the story late last Friday, reports that there’s no indication that the government would bring a case in the ongoing investigation, and the increasing publicity surrounding the probe makes the necessary covert information gathering efforts difficult.
Activist or event-driven investing, once considered a fringe investing strategy, rose to prominence in the public’s eye recently due to increased coverage of its strategies by the financial press.
Two of the most famous activist investors are Icahn and William Ackman, founder and CEO of Pershing Square Capital Management LP. The two frequently appear on CNBC and other financial media to discuss their strategies and potential targets.
In the past, activist investors were viewed as short-term profiteers and corporate raiders—a label put on Icahn in the 1980s, which helped inspire the character Gordon Gekko in the 1987 motion picture “Wall Street.”
They have since rebranded themselves as proponents of shareholder value on behalf of existing investors. In their view, their proxy fights and corporate demands increase shareholder value for all investors.
Activist investors take equity positions in companies, amassing enough votes (or enough to influence the votes of other shareholders) to influence its board of directors to take certain actions. Such actions involve pressuring company management to spin off unprofitable or non-core businesses, engage in share buyback, increase dividends, acquire or merge with other firms, among other tactics.
Corporate actions usually increase share price of the target companies, allowing the activist investor’s firm to profit. In some cases, the activist proposals need not succeed as the mere public disclosure of an imminent boardroom fight could boost underlying share prices.
In the ongoing case, the Feds are looking at a six-month window in 2011 involving trading of shares of Clorox.
On Feb. 11, 2011, Icahn disclosed a 9 percent stake in the company. There were suspicious trading patterns of Clorox equity options in early July, a few days before Icahn’s July 15 public hostile takeover bid. After a few months of fighting, Icahn ultimately gave up the bid and dropped the proxy battle in late September.
The U.S. Securities and Exchange Commission (SEC) bars anyone trading on material, nonpublic information. The spirit of the law is to protect shareholders and potential investors from losses, arguing that holders of insider information such as officers or directors of public companies owe such fiduciary duties to investors.
But the nature of activist investing—and the publicity of its biggest players—make enforcing insider trading regulations increasingly difficult.
In this case, Icahn isn’t a director or officer of Clorox, and he arguably doesn’t owe fiduciary duties to its investors. Were he elected as a director to the company he would have been under such restrictions. To indict Walters and Icahn, the FBI would need to furnish proof that Icahn told Walters that he was preparing an unsolicited bid for Clorox, and Walters would have knowingly traded on such information for profit.
Adding another wrinkle to the insider trading debate is the publicity of such activist investors. Icahn and other prominent investors, due to their trading clout, can move price of shares simply by airing their views (publicly or privately) on certain companies. They do not need to engage in any real investor activism, nor do they need need to possess any nonpublic information about the companies, to move share price.
The SEC rules also require any investor with more than 5 percent of a public company’s shares to disclose their holdings, within 10 days of amassing their investments. The rule was enacted as part of the 1968 Williams Act. Its opponents today argue that 10 days is too long, and due to the ability of activist investors to move markets, it allows for too many opportunities for insider trading or public leak of such information. “In an era of high-frequency trading, the 10-day reporting window simply makes no sense,” corporate law firm Wachtell, Lipton, Rosen & Katz told Andrew Ross Sorkin of the New York Times.
The CFA Institute reports that assets under management at activist and event-driven funds have tripled in the last five years, allowing them to take bigger risks and target larger firms. Even Apple Inc., with its $550 billion of market capitalization, was targeted by activist investors David Einhorn last year and Icahn this year.
It helps the cause that performance from such funds has outperformed broader hedge funds in 2014. In the first four months of 2014, even-driven strategies returned 3.89 percent, according to data from Preqin, an alternative asset management industry data provider. Those gains outpace overall hedge fund returns of 1.13 percent, long/short strategy returns of 0.77 percent, and relative value fund returns of 1.85 percent.
Some of the biggest event-driven and activist funds include the aforementioned Icahn Enterprises and Pershing Square Capital Management, David Einhorn’s Greenlight Capital, Seth Klarman’s Baupost Group, Daniel Loeb’s Third Point Capital, and Nelson Peltz’s Trian Partners.