Inside Looking Out: Enforcing the Law Against a Market Designer
On Tuesday, September 22, 2020, the U.S. Securities and Exchange Commission (SEC) charged two men, Yinghang “James” Yang and Yuanbiao Chen, with reaping the economic benefit of an insider trading scheme. The U.S. Attorney for the Eastern District of New York charged the two with criminal securities fraud. Chen, age 29, is a sushi restaurant manager. Yang, age 27, is the index manager of a “popular stock market index” operated by a company that maintained “widely recognized stock market indices.” The SEC enforcement action and the parallel criminal complaint alleged that, from June to October 2019, Yang would disclose to Chen beforehand what stocks would be added or deleted from the index that Yang managed before it happened. Chen then bought or sold options on those stocks and profited from the movement in the market price of those stocks resulting from the changes in the index. All told, the profits exceeded $ 900,000. Neither Yang nor Chen knew anything particular about any of the 14 companies whose stocks were the subject of the options Chen purchased based on Yang’s information.
Enforcing the Law Against a Market Designer
Under Rule 10b-5.1 of the Securities and Exchange Act of 1934, as amended, it is illegal to purchase or sell a security “on the basis of material, non-public information about that security,” IF the person making the purchase or sale was aware of the material nonpublic information at the time of the purchase or sale. Rule 10b-5.1 was adopted by the SEC in 2000 in an effort to create a framework for company insiders to purchase or sell securities of their companies without violating insider trading laws. But it also codified a regulatory view of the behavior that the SEC saw as misuse for the personal profit of information that, once publicly disclosed, would affect market price. Under the facts alleged by the SEC and the U.S. Attorney’s office, there is little doubt that Yang, as manager of the index, knew material “market-moving” information (his indexing decisions), which he “tipped” to Chen for their personal profit. This case is very reminiscent of the 1985 conviction of R. Foster Winans, a reporter for the Wall Street Journal, who from 1982 to 1984 was co-author of the Journal’s “Heard On the Street” column. Winans would “tip” a stockbroker about the contents of his upcoming column so the stockbroker could trade on that information. Winans’ conviction was upheld (despite assertions of First Amendment protections for journalists) on appeal in 1987 in a rare 4 – 4 decision by the U.S. Supreme Court. Winans served 9 months in prison. Yang faces up to 20 years imprisonment for his offenses.
Inside Looking Out
As more and more investment decisions now involve index funds and other data aggregates, not to mention Exchange Traded Funds (featuring interests in stocks and in notes) with their structural risks of retrogressive pricing, the Yang/Chen prosecution underscores the necessity to protect investors and even the most sophisticated of market participants from abuses related to the manipulation of such data for personal profit. This market reality has become particularly acute when “day traders” and algorithm-driven robo-investors cause use data to “move” billions of dollars in seconds (see “Flash Boys” by Michael Lewis, 2014). It may well make sense for businesses like Yang’s employer to enhance both the scrutiny of the conduct of employees able to affect the data and the internal safeguards to keep the data (and its use) secure from intrusion or misuse, even by “insiders.”