Einhorn judgement could lead to greater scrutiny of CDS trading
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Einhorn judgement could lead to greater scrutiny of CDS trading

David Einhorn’s £7.2 million ($11.3 million) fine by the UK’s Financial Services Authority for insider trading in Punch Taverns stock should make some hedge fund managers and investment bankers very afraid.

It might signal a renewed regulatory focus on the murky flow of information at the nexus of the credit and equity markets.

A global push to crack down on insider trading initially focused on obvious skullduggery at the fringes of the capital markets. US investigations into abuses of expert networks of consultants had no more impact on Wall Street than exposure of mob-linked boiler-room scams, and most of the 11 insider-trading convictions secured by the FSA by the start of this year punished unsophisticated dealing on confidential information conducted via personal broking accounts.

The SEC case against Galleon hedge fund founder Raj Rajaratnam brought the regulatory drive closer to the heart of Wall Street. Goldman Sachs’s chief executive, Lloyd Blankfein, was forced to testify about delivery of confidential information to former board member Rajat Gupta, which the one-time McKinsey consultancy head was accused of immediately passing on to Rajaratnam. Blankfein is likely to be back in court soon for Gupta’s trial.

Rajaratnam’s conviction and 11-year jail sentence was for demonstrable pursuit of insider information for profit.

Einhorn’s case was less clear-cut but has more serious implications for market practitioners. The core facts are not in dispute. Einhorn’s hedge fund, Greenlight Capital, was a big shareholder in struggling UK pub firm Punch Taverns when the company decided to explore a stock offering early in June 2009.

Punch’s corporate broker, Bank of America Merrill Lynch, approached shareholders asking them to become wall-crossed, or privy to insider information, to discuss potential issuance with Punch. Einhorn declined to cross the wall but agreed to a conference call with Punch executives and the broker during which he was given clear indications that a deal was in its advanced planning stages.

Einhorn then immediately started selling Punch stock and avoided about £5.8 million of losses that would have been incurred had his trades been made when a share sale of £375 million and a convertible bond buyback offer was announced by Punch at the start of the following week.

The divergence in opinion between Einhorn and the FSA starts at this point. Einhorn maintained that because he had declined to receive formal details of the planned offering he was within his rights to trade Punch stock – even if it was to bail out of his exposure as fast as possible: he placed sale instructions within two minutes of concluding his conference call and without any in-house compliance discussion. The FSA ruled that he had effectively received inside information and clearly acted upon it.

The FSA ruling prompted squawks of outrage when it was announced in late January, not just from Einhorn, who is based in New York, but also from other US investors, bankers and lawyers.

An unwelcome intrusion into the murky world of information flow

Einhorn complained on another conference call – this time with investors in his fund – that his action was "as much like insider trading as [American] football is like soccer", and gained some sympathy for his stance that the FSA’s definition of insider trading was vague by US standards. But Einhorn was effectively playing soccer, to pursue his analogy, by trading a UK stock in the UK. And the FSA’s approach to the totality of the evidence it gathered on Einhorn’s trading is strongly reminiscent of a famous US Supreme Court ruling from 1964, when Justice Potter Stewart described the difficulty in defining hard-core pornography, before adding "but I know it when I see it".

The FSA’s hard line in the Einhorn case signals an apparent resolve to tackle insider trading even when there are hurdles to obtaining enough evidence for a conviction. This might lead to a renewed focus on information flows in the credit markets, where there is less disclosure than in listed equity.

In the final years of the credit rally that led to the bust of 2008 there were clear signs of leakage of insider information in trading of derivatives, for example, as credit default swaps frequently made substantial moves ahead of announcements of debt issues. An attempt to crack down on CDS abuses seemed to have been stopped in its tracks in 2010 when a US judge threw out a case by the SEC against a former Deutsche Bank salesman who was accused of leaking information about a debt issue by Dutch publisher VNU to a hedge fund.

The SEC case against the salesman, Jon-Paul Rorech, rested on allegations that were strikingly similar to those involved in the more recent FSA ruling over Einhorn’s trading. Rorech was accused of giving signals to his hedge fund client that made it clear that a VNU debt deal was coming, and with it a likely sharp increase in the cost of its default swaps. Einhorn was accused of being in receipt of similarly clear signals about Punch’s equity plans.

The US case against Rorech was dismissed over jurisdictional issues surrounding the regulation of default swaps but the FSA seems determined to press ahead with comparable cases involving important capital markets players.

The fine for Einhorn and his hedge fund shone a light on the idiosyncratic role that corporate brokers play in the UK markets, and the extent to which these brokers – which are now owned by big banking groups – effectively make up their own compliance standards as they go along.

The transcript the FSA provided of comments made on the Punch conference call by the BAML broker offered inadvertently comic detail on the telephonic version of nods and winks provided by a very English broker to a very American hedge fund manager.

"Really it’s fair to say like, consulting with all of the – the major shareholders in terms of taking, you know, taking into account their views... a number of people have sort of signed NDAs (non-disclosure agreements) because we had a bit more open conversations... I think it’s fair to say that, you know, broadly, mostly all the shareholders are supportive," the broker said.

Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks

Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks

That might seem confusing as a transcript, but the FSA decided that it was perfectly clear to Einhorn that a deal was going ahead and he was also told by the broker that it would be "something like 350 sterling", which Einhorn took the trouble to confirm meant £350 million as a minimum issue size. A case alleging insider trading involving credit default swaps could shine a similarly unwelcome light on the channels of information about debt issues within banks and between dealers and their hedge fund clients.

There is every chance that future regulatory regimes will expose lax standards in the flow of credit information between dealers and their clients.

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