William A. Ackman and Valeant Pharmaceuticals’ hostile bid for Allergen is giving the public a close look at how nonpublic information can be used without breaking insider trading rules.
The issue emerged after Mr. Ackman’s Pershing Square Capital Management bought a large block of Allergan shares before disclosing that it was part of a hostile bid for the company. Questions have been raised about how well the rules governing this type of trading protect investors, and whether they should be adjusted to account for new ways of doing business.
Mr. Ackman’s firm formed a partnership with Valeant as part of an unsolicited $45.6 billion takeover bid for Allergan, best known for making Botox. Pershing Square bought up almost 10 percent of Allegan’s stock before disclosing its ownership stake and the offer for the company. Once that information came to light, Allergan’s shares jumped in price, bringing Mr. Ackman a tidy paper profit immediately. He also could make even more if the bid is successful.
What makes this so unusual – at least for now – is the combination of a hostile offer with an activist investor taking a large stake in support of the transaction before its announcement. Pershing Square used confidential information about Valeant’s interest in bidding for Allergan to buy shares in a company that was virtually guaranteed to increase in price once the offer became public.
William D. Cohan asked in a DealBook analysis whether Mr. Ackman’s profit was from “what feels like insider trading.”
Allergan shareholders who sold in the days before the announcement are certainly unhappy because there was trading by someone with a significant informational advantage.
But as Mr. Ackman was quick to point out, knowledge of Valeant’s intentions came to him legally, and indeed for the very purpose of trading on it. He highlighted the legal advice of Robert S. Khuzami, the former director of enforcement at the Securities and Exchange Commission, who gave the strategy a clean bill of health under the securities laws.
And he is right that there was no illegal insider trading, even if confidential information was used to profit on the trade. The real test of determining illegal insider trading lies in establishing a breach of duty of trust and confidence by the trader.
When the source – in this case, Valeant — can’t buy stocks because of legal restrictions but instead shares the information with others, there is nothing improper about it – despite the aura of unfairness.
Adding to the perception that something nefarious occurred was how Mr. Ackman acquired his large stake in Allegan. Mr. Ackman’s fund took advantage of a provision of the securities laws that gives any person or group 10 days to report the acquisition of 5 percent of the shares of a publicly traded company. Pershing Square used that window to buy about 11.5 million more shares of Allegan in advance of the disclosure of Valeant’s bid.
Was Mr. Ackman taking advantage of loopholes in the law? A loophole is usually understood as an unintended consequence of ambiguity or an omission in a provision.
It is hard to say that he bent the law by using the 10-day period to acquire shares based on information properly disclosed to him. The market will always have winners and losers, and just because someone profited by taking advantage of the rules is hardly a reason to change them.
Pershing Square’s push to buy more shares of Allergan during the 10-day window may have even resulted in other traders taking advantage by front-running the firm’s orders. The stock price rose significantly in that period, and as Matt Levine wrote in BloombergView, “Whoever did it – tippees, momentum-seeking tape-reading day traders, or HFT algorithms – someone traded ahead of Ackman here.”
But even if “sauce for the goose is sauce for the gander,” there remains a certain unease about the use of confidential information to such great advantage. One rationale for the insider trading prohibition and the 5 percent ownership disclosure rule is to promote transparency in the market, so that investors can make decisions based on roughly equal information.
If transparency is a reason for punishing trades based on confidential information, then the definition of insider trading could be expanded to cover situations like Pershing Square’s purchases of Allergan shares. One way to do that is by adopting the “possession theory” of insider trading that makes any use of confidential information improper before disclosing to the market.
The S.E.C. took that position when it first began pursuing insider trading in the 1960s. The United States Court of Appeals for the Second Circuit adopted it in 1968 in S.E.C. v. Texas Gulf Sulphur Co. when it held that “anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.”
But the Supreme Court rejected that approach to insider trading in its seminal decision in Chiarella v. United States when it stated that “a duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information.”
Unlike the United States, the European Union has embraced the possession approach to what is called “insider dealings” in the Market Abuse Regulation. It states that “insider dealings arises where a person possesses inside information and uses that information by acquiring or disposing of, for his own account or for the account of a third party, either directly or indirectly, financial instruments to which that information relates.” This provision would encompass the purchases like those by Pershing Square based on confidential information.
Expanding the scope of the insider trading prohibition would make more of Wall Street subject to potential civil and criminal prosecution. But only Congress could make such a change because the law of insider trading is largely created by judges, and the Supreme Court has dictated that a violation requires a breach of duty.
It is an open question whether it’s a good idea to adopt the possession theory as the basis for insider trading cases. The potential for more prosecutions just for having confidential information could inhibit firms from trying to dig out information on companies and then trade profitably.
The 10-day window for disclosing the acquisition of a 5 percent stake in a company has also come in for criticism for giving activist investors too much time to operate secretly to amass a sizable position and then agitate for changes at a company.
The New York law firm Wachtell, Lipton, Rosen & Katz, known for defending corporate management from activist investors, submitted a proposal in 2011 to the S.E.C. to shorten the time frame in which to make the required disclosure. Pershing Square’s trading will increase the debate over whether the rule should be revised.
Greater transparency in the markets does not mean everyone will have the same information, and disparities will always exist. If the type of trading undertaken by Pershing Square is a real concern, and not merely sour grapes from those on the wrong side of its trades, then adjusting the rules on insider trading and ownership disclosure are viable options.
There is the danger of unintended consequences when a rule’s coverage is broadened, especially for conduct that can result in a criminal prosecution. The law of insider trading is hardly a model of clarity, so expanding its scope could result in cases involving conduct that is perhaps only of questionable illegality becoming subject to prosecution.