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Legendary hedge fund manager Michael Steinhardt has been sanctioned by a Delaware judge for improper trading in a ruling that says Steinhardt wrongfully traded after receiving non-public information while serving as a plaintiff in a securities lawsuit.
Vice Chancellor J. Travis Laster of the Delaware Court of Chancery issued an opinion on Friday that directed Steinhardt to self-report his insider trading to the Securities & Exchange Commission and disgorge profits of $534,071 related to his shorting of shares of Calix., a Petaluma, Calif., provider of broadband communications access systems, after it had agreed to purchase Occam Networks in 2010.
“By serving as representative plaintiffs, Steinhardt and the Funds gained access to real-time insights informed by Confidential Discovery Material and counsel’s litigation assessments,” Vice Chancellor Laster wrote in his 29-page opinion issued January 6. “Based in part on this information, Steinhardt and the Funds decided to abandon their challenge to the Merger and exit their Occam position in a manner designed to capture the arbitrage spread between Occam and Calix.”
Steinhardt, chairman of WisdomTree, is a hedge fund pioneer who liquidated his hedge fund in 1995 and has been managing his own money through Steinhardt Overseas Management and Ilex Partners. He did not quickly respond to a request for comment, but in legal papers his lawyers have argued that none of the information he received while acting as a plaintiff was material, non-public information. Steinhardt in a legal filing denied any wrongdoing and said he received no information that would matter in trading Calix or Occam stock.
Steinhardt orginally got into this mess because of one of his former hedge fund partners, Herbert Chen, who has been running another fund firm, Lattanzio Chen Partners, since 2005 with John Lattanzio, another Steinhardt alumnus. Chen’s links to Steinhardt have remained strong—he has worked out of Steinhardt’s offices free of charge in an office that is roughly 20 feet away from Steinhardt’s office.
It was Chen who got Steinhardt interested in Occam. Chen had purchased 2.9% of Occam’s stock and was a big advocate of the company. His championing of Occam’s shares made sense since they represented at one point some 20% of his net worth, the Laster opinion says, but Chen used unorthodox ways to promote the company. Using pseudonyms, Chen frequently posted about Occam on Yahoo message boards and he also wrote research articles about Occam for SeekingAlpha.com under the alias “Mr. Bert.”
But by January 2009, the Lattanzio-Chen fund needed cash to meet a margin call, the legal opinion says, and Chen turned to Steinhardt, offering a block of Occam shares at a distressed price. Steinhardt ended up buying 2.8 million shares of Occam, or 13.5% of its shares outstanding. In September 2010, Calix announced that it had a deal to purchase Occam for $170 million of cash and stock.
Steinhardt and Chen did not like the deal, which implied a value of $7.75 per Occam share, because it represented little premium to the price range where Occam’s stock had been trading. In October 2010, Steinhardt and Chen filed a class action complaint in Delaware Chancery Court, alleging Occam’s directors breached their fiduciary duties in approving the deal at an unfair price. They later pursued an injunction against the merger. One month later, in November 2010, Vice Chancellor Laster approved a confidentiality order. It stated that information exchanged by the parties of the case could only be used for the purposes of the litigation and it restricted any trading in the securities of Occam and Calix. Occam’s investment banker, Jefferies & Company, in December 2010 started document production and Chen reviewed some 3,000 pages, many of which were designated confidential.
According to Laster’s opinion, Steinhardt began short selling Calix common stock on December 28, 2010 and sold short 589,097 Calix shares through the closing of the merger in February 2011, which was approved by shareholders representing 64% of the company’s shares. The short selling was a way for Steinhardt to exit his position in Occam and according to Occam, take advantage of the arbitrage spread that existed between Calix and Occam. When the deal closed, Steinhardt used the shares of Calix he received for his Occam stock to cover his short sales. Steinhardt testified that “based upon everything that [he] knew, there was a very high probability of that merger occurring,” the Laster opinion says.
“[I]f you made three times your money in a relatively short period, and much of that money is being made in a merger that has aspects to it that are viewed as uncomfortable and even unsavory, then the idea of sticking around isn’t all that attractive,” Steinhardt explained in testimony. “Particularly if you are sticking around in a company whose management gooses the stock from the public offering, and gooses the stock again in anticipation of the merger.” Steinhardt testified that in light of the stock run-up the risk reward was not so great and he was “happy to go home.”
The problem for Steinhardt, however, is that he had been receiving weekly written and oral updates about the class action litigation from Chen, who acted as a kind of conduit between Steinhardt and his lawyers by telling Steinhardt what he learned in conversations with the lawyers and from the documents and depositions in the case. For his part, Chen did not like the fact that Steinhardt was selling Calix stock short and Chen believes that he warned Steinhardt about the problem of trading Occam shares in light of his status as a representative plaintiff.
Still, Chen also sold Occam shares, 2,500 of them, in January 2011, because of a margin call. But Chen claimed that he mistakenly sold those Occam shares while trying to sell shares of Cisco, even though Cisco’s ticker symbol in no way resembles Occam’s ticker symbol. Chen dismissed the trade as a fat-finger error. He testified that he trades by clicking a mouse on small symbols and not by typing in ticker symbols—and that he probably clicked the wrong spot. Occam got wise to all of the Steinhardt and Chen trading by collecting information through discovery requests. When Chen moved with another investor for class certification in the lawsuit, Steinhardt did not join him in asking to be certified as a class representative. Chen did not quickly respond to request for comment and he has not been found to have committed any wrongdoing.
Delaware Chancery judges have ruled in the past from the bench that any trading based on non-public information gleaned from class action proceedings is a no-no, but actual written opinions on this issue have been rare. “Steinhardt sold Calix short with the benefit of knowledge received from Chen, whose insights in turn were based on discussion with counsel and the discovery of record,” Laster says in his opinion. Laster adds that Steinhardt’s knowledge from the litigation helped him conclude that the merger would be consummated with no change in price and that Steinhardt could not segregate the knowledge he received from Chen and exclude it from his trading decisions.
In his opinion, Laster orders Steinhardt to self-report to the SEC’s enforcement division, which “will then be able to determine whether any further remedial action is warranted.”
