Here’s a story for you. Warren Buffett was thinking about investing a few billion dollars in a deal. But he worried that the deal might be negatively affected by some possible legislation. To assess the odds of that legislation happening, and being bad for his deal, he did what anyone else would do if they could: He called Senator Orrin Hatch to say “you’ve got to do something about” the legislative discussions.
And then Hatch gave Buffett some non-public information about the possible legislative action. “I think he wanted to know where we were going and he knows I’ll tell him the truth, which I did,” said Hatch, publicly, with his own mouth.1 So, armed with the information he got from Hatch, Buffett went off and made his investment.
Now this story is true, but my telling of it is pretty stupid and slanted. Buffett’s $3 billion preferred stock investment in the Burger King (BKW)/Tim Hortons (THI) deal probably won’t be affected much by any likely legislative action on tax inversions, so the inside information that he got from Hatch probably had little to do with his investment decision.2 Also my guess is that Orrin Hatch doesn’t particularly know what Congress will do about tax inversions, and that no one else does either, so I doubt the information that Buffett got was all that valuable.
More importantly, though: This is the sort of conversation that legislators are supposed to be having. Why would you want Congress to legislate about complex business questions without first talking to some complex businesspeople? Why would you want Orrin Hatch to make decisions on tax policy by locking himself in a quiet room and looking deep into his own soul? What does his soul know about international corporate tax incidence? Warren Buffett is a very smart businessman with a gift for explaining complex issues using simple, vivid, semi-pornographic images. Congress should talk to him all the time.
Meanwhile, in another part of town, there is this story about congressional insider trading. What we already knew is that the Securities and Exchange Commission is looking into a congressional staffer who apparently told a lobbyist about a pending decision on Medicare reimbursement before it was public. The lobbyist told Height Securities, a research firm; Height told a bunch of its hedge fund clients (via an e-mail citing “very credible sources”); and the clients traded on the information before it was public.
What we learned today is that some of the clients — including Citadel, Viking and of course SAC Capital — also talked to Height on the phone after getting that e-mail but before trading:
There is nothing inherently illegal about investors talking with individuals at Height Securities about its research note. In fact, it would be normal for them to do so before making a large trade based on such a note. But investors could be liable for violating insider-trading rules if they knew the information was obtained illegally — or if they should have known that the information was obtained illegally. As a result, the information relayed in the communications between Height and the hedge funds is critical.
But what does “obtained illegally” mean? Well, illegal insider trading is trading based on material nonpublic information obtained from a tipper who violated a duty of confidence in exchange for some personal benefit. Congressional employees have such a “duty arising from a relationship of trust and confidence to the Congress, the United States Government, and the citizens of the United States with respect to material, nonpublic information.” So basically the question is:
- Did these hedge funds know that this information came, ultimately, from a congressional employee?
- Did they know that he was bribed for the information?3
I mean? We don’t know that he was bribed for the information. He probably wasn’t! He gave the information to a lobbyist, probably because congressional staffers exchange information with lobbyists, that is like their whole job. (Their bosses, of course, exchange information with Warren Buffett, but same basic idea.) Maybe the lobbyist replied, “Thanks! I know people who can trade on this information! Here’s some money!” But that would be an unusually idiotic thing for the lobbyist to do.
Similarly, an idiotic thing for the hedge funds to do would be to call up Height Securities and ask, “Hey are these very credible sources employed by Congress? And did you bribe them?”4 It seems to me very very difficult to argue that SAC or Citadel was insider trading based on an anonymously sourced, widely distributed e-mail from a research firm. Once they checked up on the sourcing, though, they’re at risk.
The basic problem here is that
- legislators should probably talk to people who are not legislators as part of doing their job, but
- those people probably shouldn’t go and trade on what they learn in those talks.
That seems like such a simple thing to say! But it’s not. What if the people talk to other people? Can those people trade? What about people they talk to? Can you really blame SAC or Citadel for trading on fourth-hand information obtained from a congressional staffer?
But corporations have the same issue. Corporate executives should be able to talk to people outside of the corporation: the company’s bankers and lawyers, for one thing, or the executives’ own spouses or psychologists or golf buddies. Or Warren Buffett for that matter: If you’re thinking about selling some preferred stock, a good thing to do would be to call up Warren Buffett and ask him if he might want to buy it. These are all useful sources of information and advice for executives. We just don’t want the lawyers or golf buddies or Warren Buffett to trade based on those conversations.
And so securities law has evolved a rough balancing of those priorities, though imperfections and uncertainties remain. The rule is, sort of:5 Corporate executives can call up anyone they want and tell them secret stuff, as long as those people first agree to keep the stuff confidential and not trade on it. Then the burden shifts to them: If they trade on the information, or disclose it to someone who trades on it (without an agreement to keep it secret!), they get in trouble. If anyone ends up trading on the inside information, it’s (normally) because someone broke the chain of confidentiality. You figure out who that person was, and they get in trouble. So does anyone further down the chain who knew about the violation and passed on, or traded on, the information.
One thing you could do would be to apply the same set of rules to Congress:6
- Go ahead and talk to lobbyists or Warren Buffetts or whoever, but
- Make them sign a confidentiality agreement and promise not to trade first.
Then if they trade, or pass on the information, they know they’ll get in trouble.
But that’s a little undemocratic, no? You can’t really ban private citizens from talking about their conversations with members of Congress. You can ban them from trading on them, sure, but without the confidentiality requirement that doesn’t really work. Congressman talks to A who relays the conversation to B who mentions the substance to C who summarizes it to D who trades on it. Who gets in trouble? D probably doesn’t even know where the information came from. D, here, is Citadel.
So you need some other rule. (Maybe: If you pass on the information in exchange for money, that might be suspect.) But that rule doesn’t seem to exist yet. Right now, Congress can talk to citizens, and those citizens can talk to each other about their conversations with Congress. So why shouldn’t they trade based on those conversations?
1 To the U.S. Chamber of Commerce, which I guess is the one group in the world most likely to be supportive of this sort of thing. Also Buffett’s office seems to have confirmed the story; from the same Bloomberg News article:
The call happened before Burger King “reached final agreement” on the deal and “consequently well before it was announced” on Aug. 26, Debbie Bosanek, Buffett’s assistant at Omaha, Nebraska-based Berkshire, wrote in an e-mail today. “Mr. Buffett tells me that in addition to inversions, they talked about other matters. Senator Hatch made his usual friendly attempt to convert Mr. Buffett to the Republican Party.”
Aren’t they darling.
2 As we’ve discussed, Burger Tim will really be concentrated in Canada, so will meet the loopholes to avoid most of the anti-inversion proposals. Also the deal does not seem to be driven primarily by tax savings. Also of course Buffett’s preferred is a fixed-income claim so he’s not all that concerned about the nuances of Burger Tim’s tax situation, though I guess he’s concerned enough to ask.
3 Here I am perhaps getting ahead of the law. The Stock Act provides that there is a duty of confidence, the main Supreme Court case about the question in the corporate context does require personal gain to prove a breach of a duty, so presumably some personal benefit is required for a conviction under the Stock Act. But that’s pretty untested ground. You could imagine reading the Stock Act to mean that any disclosure, whether or not for a personal benefit, violates that duty. That seems weird, though, right? Like if Orrin Hatch talks to Buffett about legislation because he wants Buffett’s advice, Hatch is breaching his duty of confidence to the American people? So he can’t talk to anyone – investor or not — for advice? Weird.
4 Actually there is some chance that that happened though!?
Katie Spring, a Citadel spokeswoman, said: “Our communication was for the sole purpose of verifying information contained in what we understood to be a broadly disseminated email, and was part of our compliance process specifically undertaken at the behest of our compliance team.”
Did the compliance team tell them, “Hey you gotta see if this is illegal inside information”? Maybe, right? To avoid any sort of “willful blindness” claims? But then, like … what answer did they get?
5 Not legal advice obviously. The basic framework here is a combination of insider trading law and also Regulation FD, which bans companies from making selective disclosure without requiring confidentiality. Among the uncertainties are:
- What relationships create an automatic assumption that you’ll keep the stuff secret? Obviously you can talk about a pending merger with your priest, in confession, without demanding that he sign a confidentiality agreement. But what about your golf buddy?
- How do you get potential investors agree to keep potential deals secret? Like, if you call them and say “I’ve got a secret for you, sign this confidentiality agreement,” they can just say no and try to guess what your material news is. (Hint: It’s pretty much an equity offering.) Mark Cuban had a related problem.
6 Which the Stock Act doesn’t do, because it’s really just an insider-trading provision, and what you need is something like a parallel to Regulation FD for congressional staffers.