Buybacks + Options + Hedge Funds + Inside Information = Crime?

Stock buyback programs are a legalized form of market manipulation, sanctioned under SEC Rule 10b-18 and that serve to drive up the price of a company’s stock and to give false value to executive stock options — something that the SEC considers a “legitimate business reason” for rigging the market.

Virgil shows Dante the Greedy in Hell
Virgil shows Dante the Greedy in Hell

Companies disclose the board approval and the intended scope of a buyback operation, but not information regarding the specific timing of trades or the brokers involved.

In 2003, an attempt to improve disclosure of buyback operations, including the names of brokers, failed. Stock brokers protested and the SEC caved in to market insiders.

No Safe Harbor From Insider Trading Sanctions

As Rule 10b-18 now stands:

  • The issuer announces that it has authorized the repurchase of a certain number of shares, without setting the price or timing, or committing to a certain volume of transactions. Details of the buyback program and the broker involved are secret from the public.

  • If the price of the company stock should rise after the announcement of a buyback, an investor has no way of knowing whether the price increase is the result of the market manipulation, or in anticipation of the manipulation, or a legitimate reflection of increased intrinsic value of the stock.

  • Contemporaneous information on the buyback operation is material and secret. This is “inside information”, privy to executives of the issuer and to brokers involved in the buyback program. Disclosure of inside information is a crime, subject to prison.

  • Once a buyback operation is completed or abandoned, buying pressure on the issuers’ stock ceases and the stock often falls in value. Until publicly announced, information as to the completion or abandonment of a buyback program is also inside information, subject to criminal sanctions on improper disclosure.

To Whom Is Inside Information on Buybacks Valuable?

Obviously, an executive who wants to time the sale of his or her stock options to meet the peak price during the buyback program, needs to know the timing and details of the transactions. This gives the executive an advantage over ordinary investors, but the SEC does not seem concerned with this. There seem to be no special procedures to keep buyback transaction information secret from executives who might hold options and benefit from the program.

The manager of an investment fund can benefit greatly from inside information as to the timing a buyback program. With these details , the fund manager can buy the stock cheaply, before buybacks begin. After holding the stock until the final flurry of purchases by the issuer, the fund manager can sell at a nice profit at the top of the market as the program ends.

Hedge Fund Managers Are Prime Customers for Inside Information

Hedge fund managers benefit even more from inside information because they engage in short selling and margin trading, leveraging the value of secret information, both as the market rises and as it falls after buybacks are completed.

Of course, the broker who manages the buyback program and is aware of each trade and the intentions of management, can pass on this information to fund managers in exchange for their brokerage business.

Knowing which hedge fund managers have this secret advantage, the broker can recommend this hedge fund to his high net worth clients, building up a private banking portfolio. And finally, the broker can use the inside information in trading the firm’s own proprietary portfolio.

The advantage of inside information can be multiplied by employing derivative transactions in trading strategy.

For a practical example of a buyback program (without a discussion of insider trading), see: “The Boeing Buyback“.

How Hard Is It To Pass On Inside Information?

Many company executives have no difficulty in getting inside information about buyback trades, because they are insiders.

The stockbroker that executes the buyback program, also is privy to inside information.

The central player in the illegal use of buyback information is the stock broker:

The stockbroker can tip off the investment and hedge fund managers by simply saying something like,

Do you remember the XYZ Company Buyback?” (The existence of a buyback program is public information).

I think you might want to consider buying (or selling) that stock now.” (Wink! Wink!)

To tip off a high net worth client, all that the broker need do is to say,

I think that ABC hedge fund does a good job and I recommend it to you.” (Note, the high net worth individual often is a company executive, who can use the device of the hedge fund to shield himself from accusations of improper trading.)

Hedge funds are secretive that their clients are effectively shielded from insider trading by hedge fund manager secrecy.

The key elements in using buyback inside information without going to jail are:

  1. The market manipulation exemption of Rule 10b-18 shields the issuer from prosecution;

  2. Brokers can disclose the existence of a buyback program, since this is already public knowledge; and

  3. A broker can pass on critical secret information regarding the buyback program to sophisticated professionals without actually verbalizing the information that should not be disclosed. This makes it difficult to trip up the broker, especially when the SEC is not aware of, nor investigating this type of fraud.

How Pervasive Is This Crime?

From Federal Reserve flow of funds accounts F213 (Corporate Equities), we can see that net stock buybacks by non-financial corporations totaled $765.5 billion during the period 2000-2005.

If these buybacks were simply taking stocks off the market, without encouraging collateral short-selling, we would expect the net stock sales by individuals over this period to be about the same as total buybacks.

We note, in the above explanation, that illicit profits from insider trading come from selling on the way up, and then short-selling on the way down. In other words, if something funny is going on, we would expect a excess of sales by individuals, compared to buybacks by issuers.

Indeed, we do have some funny numbers here. Net stock sales by individuals during the years 2000 to 2005 totaled $2 trillion!

This was $1.2 trillion more than the net volume of buybacks. Obviously something was going on that encouraged people to sell almost double the amount of stocks that were being repurchased.

A possible (but unlikely) explanation, might be that excess sales reflected the first wave of Baby Boomers adjusting portfolios for their coming retirement.

However, what we need is an indication of some big player that would have motivation to be into this market on this scale.

Data published in the Wall Street Journal on July 1, 2020, showed that assets managed by hedge funds almost doubled to $1.2 trillion between 2000 and 2006 and that hedge funds now account for about 20% of stock traded in any given day, a large part of which is short selling.

It seems that hedge funds have the resources and motivation to sell equities in the volumes observed in the flow of funds accounts for households. However, it is not clear how hedge funds are reported in the Federal Reserve flow of funds accounts.

We note, however, that the household figure in the flow of funds accounts is not derived from reported data, but is calculated as a residual from other reported data.

It is plausible that hedge funds are short selling equities on a gigantic scale (which could account for the massive volume of net equity sales by individuals, calculated as residuals of other reporting sectors) and that hedge funds would have both the motivation and opportunity to take advantage of inside information with respect to stock buyback programs that dominate the U.S. equity markets.

Will Justice Prevail?

The SEC has little stomach or political support to proceed against leading stock brokers, hedge fund managers, and their famous academic backers. Without an investigation, the most likely suspects for this large scale insider trading may never be discovered.

The July 1, 2020 edition of the Wall Street Journal devoted the lead editorial and two articles to a vigorous defense of hedge funds and short-selling, quoting economist Owen Lamont of Yale School of Management as citing the “salutary effects of short-selling on the markets … tend[ing] to ferret out frauds and … a force that helps prices in the marketplace reach more efficient levels more quickly.”

Yeah, Sure! Especially with the benefit of inside information.

The likely insider trading practice will continue, to the detriment of modest investors, saving for retirement in 401k plans and IRAs.

Big brokers, fund managers, hedge fund operators, and academics that support these so-called ’sophisticated’ trading operations and buybacks are well-connected at high levels of government, with power to shape opinion in the financial press.

Things may begin to unravel as the Baby Boomers retire and as the funds needed to support this massive pump and dump scheme begin to dry up, or even, as people eventually wise up.

In the meantime, if you are unscrupulous and are sure that a particular hedge fund has access to inside information on buyback programs, investing in such a fund would be a way to cash in on the buyback craze with relatively little risk.

In any event, before committing to such a scheme, you might want to look at the engraving of Virgil pointing out to Dante the torments of the greedy in hell.

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