The surge in H.J. Heinz Co. options before Berkshire Hathaway Inc. (BRK/A)'s $23 billion takeover bid shows that even the world's most successful investor isn't immune to leaks.
Federal authorities began a criminal probe after almost 2,600 Heinz June $65 call options changed hands on Feb. 13, compared with 14 the day before, according to data compiled by Bloomberg. It was the second instance in two years of well-timed trading before billionaire Warren Buffett's company announced an acquisition. In March 2011, call volume in Lubrizol Corp. climbed to 12 times more than puts days before Berkshire offered to buy the world's largest producer of lubricant additives.
While Buffett is under no suspicion, the government suit shows it's getting harder to keep secrets in mergers and acquisitions, according to Robert Pavlik, chief market strategist at Banyan Partners LLC, which oversees $1.4 billion. Regulators have probed at least a dozen cases of options trading before events such as takeover announcements since 2007, including AstraZeneca Plc (NYSE:AZN)'s purchase of MedImmune Inc. and BHP Billiton Ltd. (NYSE:BHP)'s bid for Potash Corp. of Saskatchewan Inc., data compiled by Bloomberg show.
"People are looking for whatever edge they can get, which includes trying to game the system," Pavlik said in a Feb. 22 phone interview from New York. "With these kinds of big deals there are a lot of participants, and anyone with access to information has friends and family who may engage in nefarious activity simply based on an off-the-cuff remark."
Buffett didn't return an e-mailed request for comment sent to an assistant. Neither he nor his company has been linked to the Heinz trades. U.S. Securities and Exchange Commission spokesman John Nester didn't respond to an e-mailed list of questions.
The SEC filed 58 new actions related to insider trading in 2012, up from 37 in 2009, and the second-highest number since at least 2003, according to the agency's data.
"It's almost uncommon to not see irregular option trading just before a takeover," Ophir Gottlieb, managing director at San Francisco-based Livevol Inc., a provider of options-market analytics, said Feb. 19. "I am at the point now where I am surprised if I don't see what seems to be an improprietous use of insider information."
A U.S. judge last week froze a Swiss account that the SEC said was used to carry out the Heinz trades after its holders failed to appear at a hearing in Manhattan. The defendants, using a Goldman Sachs Group Inc. (NYSE:GS) account, bought almost $90,000 of options the day before Buffett and 3G Capital Inc. announced the takeover, the SEC said. The holdings increased to more than $1.8 million, or almost 2,000 percent.
The timing and size of the trades drew attention because the accounts through which they were bought had no history with Heinz securities in the last six months, according to the SEC. The Federal Bureau of Investigation is working with the commission on a criminal probe of trading "anomalies" before the announcement, Peter Donald, a spokesman for the agency's New York office, said last week.
Call trading in Lubrizol surged to the highest level in a year on March 9, 2011, five days before Berkshire said it would buy the lubricant maker. Less than three months before the deal, Berkshire executive David Sokol bought about $10 million of Lubrizol stock while representing Berkshire in takeover discussions. Sokol resigned in 2011 after Omaha, Nebraska-based Berkshire said he broke company regulations.
No investigation of the options transactions was disclosed publicly by the SEC. Sokol, considered by Buffett biographer Andrew Kilpatrick as the top candidate to succeed him as chief executive officer, won't face enforcement actions from the SEC, his lawyer said last month as regulators concluded their investigation. Barry Levine, a lawyer for Sokol, didn't return a phone message and e-mail seeking comment.
In Berkshire's 2011 annual report, Buffett, 82, promised "complete confidentiality" to sellers of businesses who interact with his firm.
Buffett has emphasized integrity at Berkshire, telling top managers in periodic letters that it's more important to guard the company's reputation than to make money. The billionaire's acquisitions have built Berkshire into a company valued at almost $250 billion with more than 70 operating units that insure against natural disasters, haul freight, generate electricity, make chemicals and sell products from running shoes to chocolate.
Six Chinese citizens and Prestige Trade Investments Ltd., one of Zhongpin's biggest shareholders, made more than $9.2 million in profits on "eerily well-timed" purchases of calls and stock in Zhongpin before the company's chairman proposed taking the Nasdaq-listed company private, according to a court filing by the SEC in April. U.S. regulators are still investigating the case.
Volume in bullish Nexen options reached the highest level since 2008 in July, days before Cnooc Ltd. (883) offered to buy the Calgary-based energy company. The SEC won a $14 million settlement from Hong Kong-based Well Advantage Ltd. after an investigation into $7 million of profit made from stock trades ahead of Cnooc's proposal.
Bullish MedImmune options volume jumped to the highest in at least 11 1/2 years during the two days in April 2007 before the pharmaceutical company hired advisers to explore a possible sale. The SEC brought charges against Stephen Goldfield, a hedge fund manager, and James Self Jr., an executive at another drug company. They agreed to settle the case in 2010, paying penalties while not admitting or denying wrongdoing.
In 2010, the SEC accused Juan Jose Fernandez Garcia of Banco Santander SA and Luis Sanchez for illegally reaping almost $1.1 million through the use of more than $61,000 in Potash stock options before BHP Billiton's takeover bid for the fertilizer producer. A federal judge later dismissed the claim against Sanchez, a Madrid-based investor. Fernandez Garcia, who settled the case by paying more than $625,000, headed the European equity-derivatives division at Santander, which advised BHP Billiton. He neither admitted nor denied wrongdoing.
Options trading often surges for legitimate reasons, such as when a trader speculates on an event, according to David Kass, a professor at the University of Maryland's Robert H. Smith School of Business.
"It's highly leveraged, so a small amount of money can give you a very high percentage rate of return," Kass said in a Feb. 19 phone interview from College Park, Maryland. "Volume activity in options can pick up on rumors and speculation. Sometimes those rumors turn out to be true and sometimes not."
The Chicago Board Options Exchange Volatility Index, known as the VIX (VIX), slipped 0.1 percent to 14.72 at 12:01 p.m. in New York today. Europe's VStoxx Index, a measure of Euro Stoxx 50 Index option prices, fell 4.5 percent to 21.
In the Heinz case, unusual positioning was visible in November, said Gareth Ryan, the managing director of London- based IUR Capital Ltd., which specializes in options strategies.
Investors probably bought January 2014 $60 calls and January 2014 $65 calls, while selling January 2014 $75 calls, establishing a spread strategy for a total cost of $1.35 to $5, according to Ryan. Between 13,000 and 15,000 options were traded, he estimated.
In a hypothetical case of a trader buying an equal number of the $60 and $65 calls while selling the same number of $75 options, the value of the holdings would have jumped to $20.10 at the close on Feb. 14, or four times more than the maximum $5 spent in November. With 5,000 contracts for each leg, the trade would have surged to almost $10.1 million from $2.5 million, or a $7.6 million profit.
A spread allows investors to reduce costs. At the same time, such positioning may go unnoticed, and using options expiring in January 2014 enabled a trade that would profit any time through next year, according to Ryan.
"If you want to be a little more subtle about it and reduce your risk, then that's when you do a spread," Ryan said in a Feb. 22 phone interview. "He may have known something may have been happening, but he didn't know when. That's someone who really knows how to hide his objectives."
The Heinz case is U.S. Securities and Exchange Commission v. Certain Unknown Traders in Securities of H.J. Heinz Co., 1:13-cv-01080-JSR, U.S. District Court, Southern District of New York (Manhattan).