Companies in sunset industries sometimes have a history of reinventing themselves. For Eastman Kodak, the potential transition from onetime photo industry giant to future drug producer is being facilitated by the government. The U.S. International Development Finance Corporation (DFC) signed a letter of interest to provide a $765 million loan to Kodak on July 28 to support the company’s new plan to produce drugs for the U.S. domestic market. Thereafter, a series of ensuing events raised concerns about potentially illegal insider trading, and of an uneven level playing field for investors in U.S. stock markets. The immediate response by U.S. Congress was to call for an investigation.
Whether the suspicious trading activity is a case of illegal insider trading activity is difficult to judge without further scrutiny by prosecutors. However, these new types of substantial loans from the government to private companies — the Kodak loan was the first of its kind — give rise to a new type of private information. While traditional corporate events, such as earnings announcements or corporate takeovers, are subject to strict rules about the disclosure of information and reporting requirements, it appears that the disbursement of government subsidies and grants falls into a grey area not covered by existing rules. Thus, it is necessary to consider more transparent and consistent protocols on information disclosure to avoid providing unfair advantages to a select group of company insiders.
Just one day before the official announcement of the loan, on July 27, Kodak’s stock price jumped by about 25 percent on a trading volume of 1,645,719 shares, over five times the average daily trading volume in prior months. These unusual trading activities were likely attributable to the premature release of the news by several media outlets.
Unusual trading activity also occurred in Kodak’s stock options, even prior to the news leakage. The trading volume was especially strong in out-of-the-money (OTM) call options, which are set to profit especially from a positive jump in stock prices, with daily trading volumes of all OTM call options on July 17, 20 and 27 that was more than 10 times larger than average volumes since the beginning of 2020.
Kodak’s executives and board members are also linked to controversial transactions. About one month before the announcement, on June 23, the company’s executive chair and a director purchased over 50,000 shares of the company’s stock a day during the time when the company was negotiating loans with the government. In addition, four executives were granted stock options right on July 27, just one day before the stock price skyrocketed. Prior to another major stock price drop, due to a freezing of the Kodak loan associated with the congressional investigation, a board member donated $116 million in company shares, entitling the donors to a substantial tax deduction.
These events have alerted legislators and raised concerns that trades of investors may explain the suspicious activity with access to material non-public information. On August 3, Sen. Elizabeth Warren (D-Mass.) formally requested the Securities and Exchange Commission (SEC) to investigate the possibility of insider trading and violation of regulatory compliance rules. Two House committee chairs also launched their own inquiries, requesting detailed records from the loan provider, DFC.
Besides these valid outcries due to concerns about the potential for illegal insider trading, this turn of events raises a question of broad public interest. Why was the usual protocol for the enforcement of news disclosure and insider trading regulations around corporate events not followed in this case? The announcement of the government-sponsored Kodak loan is no different from traditional corporate events, such as earnings disclosures, announcements of mergers and acquisitions, spinoffs, or new product announcements. It also involves secret negotiations in executive offices that give rise to the potential for trading on privileged information.
In the Kodak case, the private information was indeed material. The $765 million government loan it received amounts to 54 percent of the company’s total assets, 78 percent of its annual revenue and is 64 times larger than its annual operating cash flows, according to its most recent 10-K filing. It is not surprising that such news boosted the stock price from about $2 to $60 in a matter of days. Another related issue is that the DFC and Kodak did not release the news at the same time. This lack of consistency in information disclosure makes it difficult to pinpoint when the information was publicly available.
The Kodak experience is unlikely to be unique. The massive monetary and fiscal interventions that have been announced in the U.S., Europe and elsewhere are likely to lead to similar types of sensitive news releases. The difference with respect to more traditional corporate announcements is that the government has a seat at the table. U.S. officials and their counterparts elsewhere are picking winners and losers in the disbursal of grants, loans and contracts. Thus, a new source of privileged information has emerged that raises the possibility that insiders may well profit from possession of such information before it is released to the market.
Given the massive stimulus packages that are in force today and expected to be implemented going forward, regulators need to set clear guidelines for how and when such privileged information can be disclosed, and impose rigorous trading restrictions for investors with access to private information. Failure to do so would give unfair advantage to some and damage the level playing field in financial markets.
To avoid providing such unfair advantage to selected executives, the SEC and the Department of Justice need to develop new procedures to incorporate potential illegal transactions derived from information about government intervention through diverse channels. We advocate for a more transparent and consistent protocol on information disclosure regarding government’s loan programs to prevent similar events from recurring. For example, the government could channel the release of news about COVID-19-related stimulus interventions through a common platform to prevent leakage from diverse sources and reduce information asymmetry among investors.
The DFC loan to Kodak is the first of its kind under the Defense Production Act, and so it is not surprising that it raised a number of new issues. Since we are in unprecedented times, government agencies and regulators need to make changes to adapt to the current situation and fulfill their mission to ensure a level playing field for investors even during this difficult period.
Patrick Augustin is associate professor of finance at the Desautels Faculty of Management at McGill University. Francis Cong is a researcher at the Desautels Faculty of Management at McGill University. Marti G. Subrahmanyam is Charles E. Merrill Professor of Finance and Economics at the Stern School of Business at New York University.