Justin Lane/European Pressphoto Agency
The Financial Times reports that the Securities and Exchange Commission has started a preliminary inquiry into whether Standard & Poor’s employees selectively leaked information about the impending downgrade of the United States’ debt rating to AA+ from AAA, a decision that roiled the financial markets. This appears to be a prelude to investigating whether any investors used that information to profit before S.&P. officially disclosed the debt downgrade on Aug. 5.
Even if the S.E.C. finds that the information was improperly disclosed, proving insider trading will be difficult. And while S.&P. and other credit rating agencies are required to adopt policies to prevent such disclosure, it is questionable whether just leaking information violates any federal regulations, even if it breaches a corporate confidentiality policy.
Representative Maxine Waters, Democrat of California, sent a letter to Mary L. Schapiro, the S.E.C.’s chairwoman, stating that “it is appropriate for the commission to conduct an investigation into whether S.&P. selectively disclosed information related to the U.S. government debt downgrade to any financial institutions, and whether any institutions that had that nonpublic information traded on that information prior to the official announcement.”
Insider trading requires proof that material nonpublic information was used in trading securities in advance of its public disclosure. The first step is showing that information about the downgrade was not already available in the financial markets.
S.&P. announced on July 14 [link below] that it had placed America’s sovereign debt on credit watch with “negative implications,” indicating that a downgrade was potentially in the offing because of the political wrangling over raising the debt ceiling. And the Egan-Jones Credit Ratings Company, a much smaller credit rating agency, had downgraded American debt three weeks before S.&P. did.
It is arguable whether S.&P.’s announcement on Aug. 5 of the rating change was all that confidential, given the speculation about it. Investors profiting from the debt downgrade can claim there was sufficient information in the market about the likelihood of S.&P.’s decision, much like the “mosaic theory” offered in the trial of Raj Rajaratnam, the head of the Galleon Group hedge fund, on insider trading charges.
Assuming information about the downgrade was confidential, it must also be material, which means a reasonable investor would consider it important. This seems to be an easy element to establish because the wild gyrations in the market on the first trading day after the downgrade shows how investors viewed it.
The problem with proving materiality is that the information must be material to a particular security, so the question is, “Material as to what?” In the typical insider trading case, the information impacts a specific company, or at least a particular industry. That does not appear to be the case with the debt downgrade, whose impact was felt across almost every market, from stocks and bonds to commodities and derivatives.
In Dura Pharmaceuticals v. Broudo, the Supreme Court held that in private securities fraud cases, one element of proving a violation is “loss causation,” which requires showing “a causal connection between the material misrepresentation and the loss.” While that element does not apply in S.E.C. insider trading cases, it still must be shown that the disclosure of confidential information caused the value of the securities to rise or fall, and that a defendant profited from the change in value.
While the S.&P. downgrade certainly affected the markets, there were a number of other factors that likely contributed to the wide swings seen in the equity markets, like concerns over possible European sovereign debt defaults and a possible double-dip recession. In the Dura Pharmaceuticals case, the Supreme Court noted that “changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events, which taken separately or together account for some or all of “the fluctuation in the price of a security.”
If it can be shown that S.&P. employees disclosed material nonpublic information, the next step is identifying who used the information in trading. The company warned the government about the downgrade, and Washington is not known for its ability to keep secrets.
The typical insider trading case involves tracing backward from a profitable trade to identify the source of the information, like when a trader makes an outsize gain by buying stock or options immediately before a takeover announcement. With the debt downgrade, it is not clear where the S.E.C. would start to look for improper trading.
The securities directly affected by S.&P.’s announcement were United States Treasury bonds, but they rose in value rather than declined, the opposite of what one would expect on a downgrade.
On Aug. 5, the stock market closed down before the announcement and then suffered a precipitous decline the following Monday. That would seem to put the focus on those who shorted stocks, but the fact that it seemed like almost every stock declined that day would make it hard to show any particular company was specifically impacted by the downgrade rather than just caught up in the market’s downward momentum.
The mere disclosure of confidential information is not a securities law violation, which only occurs when the information is used to trade. The fact that a S.&P. employee might have selectively disclosed the debt downgrade before its official announcement would not violate Section 10(b) of the Securities Exchange Act and Rule 10b-5 unless the person gave the information with the understanding that the recipient would trade on it, i.e. “tipping.” Without a link to a particular trader, there is no case for the S.E.C. to pursue against the company.
The credit rating agencies are required to take steps to keep their information confidential because it can have such a great effect on the markets. S.E.C. Rule 17g-4 requires the credit rating firms to adopt written policies and procedures prohibiting “[t]he inappropriate dissemination within and outside the nationally recognized statistical rating organization of a pending credit rating action before issuing the credit rating on the Internet or through another readily accessible means.”
To meet that requirement, S.&P.’s “confidential and sensitive information” policy provides:
“Employees must not disclose — even to other employees of ratings services or to personnel from Standard & Poor’s or the McGraw-Hill Companies, Inc. — pending rating actions, the specific deliberations of a rating committee, or any other confidential information with respect to a credit rating unless the other employee needs to know the information in order to appropriately perform his or her credit rating activities or related oversight responsibilities.”
Leaking information to banks and other investors about the impending debt downgrade would clearly violate the company’s policy, but it is not clear whether that disclosure would also violate Rule 17g-4. That provision only requires S.&P. to have in place “policies and procedures reasonably designed to prevent” such disclosure, but does not provide for any punishment of the firm by the S.E.C. if there is a violation of its internal policy.
The Credit Rating Agency Reform Act, 15 U.S.C. § 778o-7, authorizes the S.E.C. to suspend or even revoke the registration of a credit rating agency that violates the federal securities laws. Insider trading would certainly constitute such a violation, but it does not look like that case could be proven based only on disclosure of information about the debt downgrade without showing it was given to someone to actually profit on it.