One of the best pieces of advice inexperienced writers can get is “find your own voice.” Another thing people say, though, is “good artists copy; great artists steal.” In the latter spirit, here are my thoughts about an insider trading enforcement action that just hit the news. Matt Levine is on vacation this week, so I can safely avoid an unflattering direct comparison for a few days.
The Case
The story here is largely straightforward for an insider trading case. Some guys allegedly got information about a merger before it was public and loaded up on call options on the company being acquired. From the article (Bloomberg, via Yahoo! Finance):
Four current and former minor league baseball players illegally traded on Jack in the Box Inc.’s $575 million purchase of Del Taco Restaurants Inc., according to the US Securities and Exchange Commission. … According to the SEC, Qsar was told about the upcoming purchase by a former teammate from Pepperdine University’s baseball team who was working on the due diligence of the acquisition for Jack in the Box. The SEC said Qsar learned about the deal when he was out drinking with his former teammate in San Diego in October 2021. Qsar went on to tell Bernard, Witherspoon and Lambert, who had played baseball together, about the potential acquisition. Each then purchased out-of-the-money call options on Del Taco stock, which was then trading on the Nasdaq with the symbol TACO, according to the SEC.
Insider trading stories aren’t that rare, so why is this one noteworthy enough for me to write about? The main reason this story caught my eye is because I saw the headline listed as sports news on Bloomberg. Lots of white collar crime stories are just worth talking about because the people and places involved conjure funny mental images. Sharing sensitive corporate information during a drunk squash outing is a recent favorite of mine. In this case we have “Qsar and Witherspoon allegedly made trades in Del Taco options from the locker room of a baseball training camp they were both attending.” Yeah, man, just whip out Robinhood after batting practice and illegally buy some TACO options with the boys. I also love when I can make news stories about me, and I’m a Washington Nationals fan, so I enjoyed learning that Jordan Qsar was briefly part of the organization. Go Nats!
About the actual story though, I want to mention some things these gentlemen did right and some things they did wrong. There are two parts to being caught insider trading: the “insider” part and the “trading” part. If you want to get away with it (you shouldn’t, it’s illegal, I extremely do not recommend insider trading, if you do it talk to a lawyer but also don’t do it) you need to hide both. In this case they did a good job with the former but not the latter.
The Jack in the Box employee who spilled the beans on the merger appears not to have made any trades on the information, and presumably there’s no evidence that he intended Qsar to trade on it or that he expected any sort of reward for sharing the info, or else the DOJ would be going after him too. Assuming that’s the case, then Qsar did a good job identifying an opportunity to (allegedly) insider trade where the path leading back to the insider is decently weak. If it doesn’t look like the insider himself is planning to trade and you don’t have any incriminating electronic communication with him, then what are the chances the authorities can make any connection? You played baseball with the guy at Pepperdine like six years ago. Probably half of that team are working in M&A now and most of them are regularly gambling on fast food call options for fun, so there’s nothing special about you.
Additionally:
Despite knowing of a potential deal, the SEC said that Qsar and Witherspoon texted each other pretending that Del Taco was a great investment opportunity. They tried to come up with alternative explanations for their trades, the regulator said. In one example cited by the SEC, Witherspoon texted Qsar: “[c]heck out this stock guys Del taco, this chart is looking bullish to me. Might try to gamble on some options or something, I love to eat at del taco,” according to the SEC.
This is really good. A lot of these cases involve defendants texting in extremely stupid code about their insider tips and how much money they’re making. In this case, the plausible deniability is cheekier, which is fun, and maybe also more plausible. “Look, your honor, you can clearly see that I’m just a degenerate gambler” might be better than “your honor we were genuinely texting at length about our pet chickens named Jack and Taco” or whatever someone less clever might have come up with.
They did get caught, though, and it’s mostly because they didn’t do enough to hide the trading. Matt Levine’s second law of insider trading is “don’t buy short-dated out-of-the-money call options on merger targets.” Basically every time a merger is announced the SEC looks to see if there was any unusual activity in the options markets leading up to the announcement date, and if they catch even a whiff of suspicion they’ll investigate and find you. Unfortunately for the defendants, this completely ruins everything I praised them for above. It’s like if Ocean’s Eleven planned their casino heist and then decided to rob a liquor store in front of police headquarters at noon instead.
An Explanation
If you’re not familiar with some of these concepts, like what short-dated out-of-the-money call options are and what they have to do with insider trading, here’s a primer. Feel free to skip it if you know what I’m talking about and you just want to read my further takeaways from this story. None of this should be taken as any sort of advice and it might also be factually wrong! I am simplifying things, don’t believe what you read on the internet, etc.
If you have so-called “material nonpublic information” (MNPI) about a publicly traded company (such as Jack in the Box Inc., which trades under the ticker JACK, or Del Taco Restaurants Inc., which formerly traded as TACO), it is illegal for you to trade that company’s stock. The “material” part effectively means that it’s information that could be reasonably expected to affect the price were it to become public. When a company is acquired, the acquiring company typically buys all of the outstanding shares of the target company for some price greater than its current price. So, when a merger is announced, the price of the target’s stock usually jumps up quickly to the price that the acquirer has declared they intend to pay for each share. This means that information about a merger before it becomes public is extremely material to the target stock’s price.
Let’s say you hear that JACK is proposing to acquire TACO at a price of $12.51 per share. First of all you’d say that $12.51 is a mighty steep price for a single taco and tell Jack that home cooking is a little easier on the budget. Bad jokes aside, if you were hell-bent on making money off of your MNPI (again, illegal, don’t do it) you might look at the current price of TACO, see that it’s been trading around $9, and realize that you can just buy as many shares as you can to lock in a surefire 40% return. You probably expect the announcement to come out within a few months, if not sooner, so it’s a pretty quick profit too.
The other key piece is that the alleged insider traders purchased “out-of-the-money call options.” A call option is a contract that allows the buyer to purchase 100 shares of a certain stock for a pre-determined price before some specific date in the future. The relevant terms here are “expiry” and “strike price.” If you purchase a call option on TACO expiring on December 17, 2021, with a strike price of $12 (you can say “struck at 12”), that means that on or before December 17 you can buy TACO from the person on the other side of the contract for $12 per share, no matter what the current market price is. If it’s trading at $12.51, we would say the option is “in the money,” since the price of TACO is higher than the strike price. You can lock in 51 cents of profit per share, for $51 total. If TACO isn’t trading above $12, the option is said to be “out of the money.” If the option expires out of the money, you don’t have to do anything; you’ve spent whatever you paid for the option in the first place, but you have no obligation to overpay for TACO.
So how much would you expect to pay for this option? If an option is in the money, then the price should be roughly equal to the amount by which it is in the money: a call struck at $12 when TACO is trading at $15 ought to be worth at least $3 per share, so you should have to pay at least $300 to buy this option. (In fact the quoting convention is to divide that by 100, so the price would look something like 3.00 in this case). If an option is out of the money, then the price roughly reflects the seller’s expectation that they might have to sell you some TACO at a loss if it goes up past the strike price (if they think there’s a 10% chance they have to eat a 50 cent loss, they will want to quote you at least 0.05). Notice how cheap 0.05 is: If the market doesn’t expect the option to ever be in the money, but you know for sure it will be, you can spend $5 to make $51. Much better than 40%. I’m far from an expert on options pricing, and I don’t know where to find comprehensive data from the market for TACO options in October–December of 2021. But from looking at the price history of the stock (it traded between $7.50 and $9.30 in the months leading up to the December 6 merger announcement and its price rarely moved more than a few percent per day) and current options prices for similar fast food companies, I think 0.05 for December calls with a $12 strike is very roughly the right ballpark. There may or may not have been $12 calls available at the time; maybe the highest strike available was $10 or something, in which case you’d stand to make $2.51 per share; you’d expect these to be more expensive than a $12 call but they were probably still something like 0.25. Either way a roughly 10x return is a reasonable order of magnitude.
The point of all this is that, if you know what you’re doing and your MNPI is solid, it is extremely straightforward to make a lot of money by buying out-of-the-money call options on merger targets. It can be as good as knowing exactly what number a roulette wheel will spin next (although nowhere near as good as knowing exactly what the Mega Millions numbers will be). It’s so straightforward, of course, that the SEC knows to look for it and punishes it eagerly, which is why people don’t try it. Saying “it’s easy to make money by insider trading on mergers” is like saying “it’s easy to save money by shoplifting.”
The Big Picture
So, sure, the SEC knows what patterns of trading to look for if they want to detect insider trading. But are they actually checking for this kind of activity on every merger? From the same article:
The case originated from the SEC’s data analysis center, which analyzes market data to detect suspicious trades. Unusual purchases of options ahead of merger announcements can trigger an investigation. “It baffles me that folks still think that they could buy way-out-of-the-money call options before some announcement, and not think that they’ll trigger some sort of alert or some sort of tool that we have out there looking at this information and get caught,” Gurbir Grewal, the SEC’s enforcement chief, said earlier this month. He didn’t reference any particular case or investigation.
Yes, yes they are. But I want to focus on Grewal’s confusion here. How do people not know they’re going to get caught by the federal government. Are they stupid?
I think this is an interesting angle on the modern discourse surrounding surveillance, privacy, and “data.” So much of the 21st Century has been spent discussing which corporations and governments we’re worried might be recording, retaining, and sharing our data. In many of those conversations the specifics are vague, and I think most people don’t know what they should be imagining when thinking about data retention. For instance, you may understand that a social networking app simply has to retain some amount of data in order to execute its most basic functions, or to improve user experience, or for its own completely reasonable internal purposes. But you might also have some vague idea that they’re selling some subset of that data (to whom?) in order to generate revenue, and, taking it one step further, maybe they’re also coming up with some other kinds of things to record about you that they wouldn’t have needed otherwise but that they know they can sell. The lines get blurry. Maybe you have some general understanding that your electronic communications and records can be subpoenaed, but do you know under what conditions that would happen, or what that process looks like? If your texts with your friend get investigated because he’s implicated in an insider trading scheme, do you have to hand over your phone, or can Apple just send over a transcript they have archived from their servers without your permission or knowledge? What types of data do law enforcement agencies need warrants for?
Many of those questions have definite answers, while some of them are kind of unknowable. I (and I would guess most people) don’t act as though I know the answers most of the time. I think a lot of people operationalize all of the above as something like “if I google the wrong thing, I might end up on a list” without thinking about who would know to put them on what list and why.
Here’s the thing about the stock market though: every single thing you do is definitely recorded. Securities regulation may have some nuances, but the question of what transactions are being surveilled is not one of them. The public markets are public! Every financial institution involved in securities trading is required by some combination of federal and industry regulations to precisely document every purchase or sale of a security they’re involved with. Every time you buy a share of a stock, half a dozen different institutions write it down in triplicate. And if a regulator wants the information, they just have to ask. This isn’t a secret, either; here’s a webpage explaining the process for responding to a request for data. This other page explains the format of the reports (these specifically are called “Blue Sheets”). If you look at that page, you can see what gets sent to Finra if they ask for a Blue Sheet: attached to each trade is the account holder’s full name, address, social security number, and employer name. Investigating these sheets doesn’t involve crawling through some complicated web of connections to figure out who traded what when. I’m making up the specifics here, but for instance the SEC can just ask the Options Clearing Corporation for every TACO options trade in some time period, find out which broker-dealer was buying out-of-the-money calls, ask that broker-dealer for their Blue Sheets, and see exactly who made what trades. They need to do more work to build an enforcement case, but they have no trouble catching you in the first place.
Broker-dealers that fail to comply properly with this policy are held accountable (to the extent that a $6 million penalty counts as holding Goldman Sachs accountable), and you agree to be part of this system when you open a new account at a registered broker-dealer. In some sense it’s obvious. I give my broker my SSN, and I don’t give it to Facebook. I know for a fact the broker sends my data to the federal government for tax purposes. For whatever reason, though, people who understand that insider trading is illegal seem to think they can get away with the most flagrant version of it right under the nose of a financial institution that knows all of their identifying information. Maybe it’s hard to feel like your activity is worth hiding. When you picture the NSA storing a billion text messages per day, you can easily convince yourself that you don’t stand out among the crowd.
But in the case of insider trading, you really can stand out. Even in the 2020s, when it feels like irrational options trading has become impossibly popular, the market for high-strike-price call options on random small companies is pretty quiet. Not very many people want to buy these options unless they’re trying to insider trade, so it really isn’t hard to spot suspicious trading patterns. It’s possible the defendants in this case were the only ones buying TACO calls for weeks. You can imagine why Grewal feels it’s too easy.