Thursday, March 13, 2014

Always Leave your Options Open, (especially suspicious ones)

I am very interested to know who knew about Herbalife's CID before the rest of us knew. Reading Dan McCrum's blog, I was immediately struck by the first line of the post, which was italicized and naturally drew my attention.
After we got in touch with the company to tell them we were writing this story, they halted trading and put out a statement confirming the investigation.
We all remember the fiasco that ensued after it was uncovered Scott London was illegally trading insider information. Mr. London's actions are not the slightest bit defensible, however he was covert about breaking the law. Yesterday, someone decided that overt was a better strategy. 

According to a DealBook post from Alexandra Stevenson and Peter Eavis, Herbalife's lawyers received notification on Tuesday afternoon that they would be receiving a letter from the FTC on Wednesday. Later on Wednesday, Herbalife was halted at 13:18:19 and didn't resume until 13:50:36. I don't know when Mr. McCrum received his tip, but he certainly had to have contacted Herbalife before because they halted the stock in response to his inquiry.

Before the Wednesday halt, while the stock was up roughly 5%, there was a flurry of activity in Herbalife's April options, specifically in near money puts. The trades weren't subtle either. Somebody was hunting puts with an elephant gun. 

With the exception of the 52.50 strikes (which had zero volume) you can walk down the strikes starting at 62.50 and easily see that someone had insider info and was making a play between 11:30-12:30(while shares were trading lightly) on the impending news of the CID. If you think that's a stretch, simply look at all of the other options traded in Herbalife. You could virtually pick any other put with high volume for comparing trading patterns to the April options, but for simplicity, below is a comparison between the March and April 55 strike puts, in which the April puts stick out like a middle finger to the SEC. 

Note that trading in the March puts was virtually non-existent until after the halt and trading resumed. That pattern is the same for practically all non-April expirations.

HLF March 55 Puts
Now, notice the large block trades in the April puts before the halt, and the subsequent churn following the resumption of trading. This pattern is the same for all of the large volume April options listed above.
HLF April 55 Puts

That's a lightning strike of preemptive April put buying right before the halt.

To put these numbers in context, collectively these blocks represent almost all of the put volume prior to the halt and about 60% of all volume for those options for the entire day. If you were to ignore trades after Herbalife resumed, these block trades alone would have increased the open interest by 350%.

This begs the question: if Mr. McCrum knew about the CID, who else knew? 

Based on the Stevenson/Eavis article, it appears that the FTC notified Herbalife council to expect a letter on Wednesday and that Herbalife did not know what kind of letter, or the contents of that letter until they received it yesterday. I contacted the FTC, but they could not offer any additional information beyond the following:
"...since an FTC investigation has been disclosed by Herbalife we can acknowledge the existence of the investigation, but we have no further comment."
That leaves a rather short window of time between when Herbalife would have received the letter, and when they were contacted by Mr. McCrum. I'm sure the FT provided the company an opportunity to respond, but based on lack of additional information I can only assume that there was a short window of time from when they were contacted by Mr. McCrum and when they halted their stock.

I would never expect a journalist to give up their sources, but I'm dying to know where Mr. McCrum poached his information from. I can only think of four places he'd have gotten that information.

  1. Herbalife itself 
  2. FTC source directly leaked it to Mr. McCrum 
  3. The FT illegally obtained the information a la Rupert Murdoch's News of the World 
  4. Indirectly leaked through to a lobbying organization with ties to a government official that had knowledge of the CID, such as a Representative, Senator or State Attorney General.
They could all be wrong, but I think the first three are all extremely unlikely. The fourth option though, particularly a source like an AG's office, seems like the most reasonable explanation and there are nine to choose from. Your guess is as good as mine. 

There is little doubt that dissemination of the CID news was not limited to a single third party (Mr. McCrum) before the news broke; based on the trading activity yesterday it certainly appears that he was not the only person with the information. I think we could all agree that there is no way in hell Dan (or his colleagues at FT) bought over 11,000 put options before the news hit so we'll have to keep hunting.

Whoever knew about the CID is obviously someone that likes to make money, even if they don't get to keep it.

No bueno.

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