The Outer Limits of Insider Trading

Potash Corporation investors gained when a buyout bid  failed. David Stobbe/ReutersPotash Corporation investors gained when a buyout bid  failed.

Most insider trading cases start out with suspicions about well-timed transactions that prove to be lucrative once information becomes public about a company. Bringing a successful enforcement action requires more than just suspicious trading, however, because the government must have evidence that a trader acted on material nonpublic information and not just that the person made a particularly prescient investment.

A recent decision in the United States District Court in Chicago dismissing civil insider trading charges filed by the Securities and Exchange Commission highlights how difficult it can be to bridge the gap between suspicious trades and securities fraud.

Judge Marvin E. Aspen found that the S.E.C. could not establish that Luis Martin Caro Sanchez, an investor living in Madrid, received confidential information about a takeover offer for the Potash Corporation of Saskatchewan in 2010. A few days before the company disclosed the offer from BHP Billiton, which sent its shares up nearly $30, Mr. Sanchez bought out-of-the-money call options in August 2010 that provided him with a 1,000 percent return on his investment after the announcement.

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The trades were certainly suspicious, fitting a common pattern in insider trading cases. Mr. Sanchez had not purchased call options in his account before, nor had he ever invested in Potash securities. The options would expire in about five weeks, and the company’s underlying stock price was trading about 10 percent to nearly 15 percent below the call options’ “strike price,” which is the price at which the option holder can buy 100 shares.

This type of trading is highly speculative because the options become worthless if the stock price does not increase in a short time frame – except when an investor knows about an impending development that will affect the value of the shares.

Mr. Sanchez pressured his broker to quickly approve his application to trade options in his account. Within minutes of receiving that approval, he began buying the Potash options, investing a little less than $50,000. Just four days later, those options were worth more than $500,000, and he quickly realized his profits by selling them.

Adding to the questionable nature of Mr. Sanchez’s trades was the action of another Spanish investor, Juan Jose Fernandez Garcia, who bought even more speculative Potash call options right before the announcement, generating a profit of approximately $576,000. Mr. Garcia is also a resident of Madrid and happened to be head the European equity derivatives division at Banco Santander, the Spanish bank advising BHP Billiton on its offer for the Potash Corporation.

It all seemed to add up to a classic case of insider trading: highly lucrative trades in speculative securities just days before of an announcement that had a major impact on a company. Add to that an obvious source inside a firm advising on the deal who had a fiduciary duty not to trade on the information. So the S.E.C. filed its lawsuit only three days after Potash’s announcement of the BHP Billiton offer, and froze the accounts of Mr. Sanchez and Mr. Garcia to keep the money from leaving the country, which would likely place it beyond the authority of American courts to order its return.

While Mr. Garcia settled with the S.E.C. in April 2011, Mr. Sanchez did something not often seen in this type of case: he came to the United States to fight. First in an interview with investigators, and then in a formal deposition, he maintained that he bought the call options based on his own research that led to an “intuition” about the Potash Corporation as a good investment opportunity.

He denied knowing Mr. Garcia or anyone else connected to the transaction, and the S.E.C. was unable to determine who might have been a source of inside information for Mr. Sanchez’s trades. A crucial element in proving securities fraud is showing a breach of fiduciary duty through the disclosure of confidential information or trading on it, so without a link to an insider, there is no securities fraud.

The S.E.C. sought to bolster its case by pointing out that Mr. Sanchez had gotten rid of a laptop computer that might have been used in connection with the trading, and that his desktop computer had software on it to remove files. Once again, although these are potentially suspicious actions, they are not enough to prove insider trading.

In dismissing the complaint, Judge Aspen found that “the S.E.C. theorizes that Sanchez was informed of some unidentified information related to the proposed acquisition, at an unidentified time, by an unidentified insider, and traded on this unidentified information.” While insider trading can be established through circumstantial evidence, there needs to be more than just suspicious transactions, even when it results in a profit of 10 times the initial investment in less than a week.

The S.E.C. was certainly hamstrung in its investigation because Mr. Sanchez resides in Spain, so it could not as easily gather evidence of possible connections with Banco Santander or other sources of inside information as it would if the transaction involved American companies and United States residents.

Insider trading cases sometimes involve finding one thread tying a trader to a source that can be pulled to unravel securities fraud. A recent S.E.C. insider trading case highlights how discovering that initial connection can lead to a web of insider trading.

In S.E.C. v. Easom, the insider trading began when a corporate executive sent a text message to his cousin’s husband, who was a stockbroker, about the impending acquisition of his company. The broker in turn tipped five others, one of whom then tipped a friend, and eight defendants were charged with making approximately $450,000 in profits; seven agreed to settle the case.

Absent that kind of evidence against Mr. Sanchez to tie his trading to a participant in BHP Billiton’s offer for Potash, the S.E.C. was left with suspicious trades and a questionable explanation that may, or may not, be the truth. When the evidence is at best only 50-50, the S.E.C. loses because it bears the burden of proving securities fraud by a preponderance of the evidence.


Judge’s Ruling in S.E.C.’s Insider Trading Case

Correction: January 3, 2012
An earlier version of this article misstated the relationship between Potash's stock price and the "strike price" for call options on the company's stock. The underlying stock was trading below the strike price, not the other way around.