If you’ve ever wondered why stocks seem to rise inexplicably hours or even days before big positive news and start to weaken before big negative news, an insider mole and his minions may be at work.
This phenomenon has been observed recently with the drugmaker Viatris Inc. (TRV, Financial), whose chief information officer was recently charged by the Justice Department with insider trading.
As the FBI and the Securities and Exchange Commission pursue the case, court documents show that insider Ramkumar Rayapureddy, who is the CIO of Viatris, conspired with his former colleague, Dayakar Mallu, to trade Mylan and Viatris securities based on inside information the latter obtained through his position at Mylan and before corporate announcements that move the market for their own financial gain. Mallu, the former head of global IT operations at Mylan (the predecessor company to Viatris), left the company in 2017 and was a close personal friend of Rayapureddy.
A relatively new company, Viatris was born from the merger of Mylan and the Upjohn division of Pfizer Inc. (DFP, financial) in November 2020.
From 2017 to 2019, Rayapureddy allegedly tipped Mallu on multiple occasions with nonpublic insider information about Mylan relating to, among other things, Food and Drug Administration drug approvals, financial earnings, and a merger with Pfizer’s UpJohn division. Mallu then used the inside information to execute stock and option trades in the company’s securities. According to the FBI, Mallu made about $7.2 million from these transactions. In exchange for the tips, Rayapureddy then received cash payments in Indian rupees from Mallu through intermediaries in India.
Rayapureddy is charged with conspiracy to commit securities fraud and three counts of securities fraud. If convicted, he faces a maximum sentence of 20 years in prison.
Previously, in September 2021, Mallu pleaded guilty to conspiracy to commit securities fraud and assisting in the preparation of a false tax return and is awaiting sentencing in February. He also pleaded guilty to tax evasion by filing false tax returns and laundering money through an LLC controlled by him using false expenses to launder profits.
Once they caught Mallu, the FBI obviously used the information obtained from him to charge Rayapureddy. It remains to be seen whether Mallu will testify against his friend to reduce his sentence, but it seems likely.
Viatris issued the following statement following the indictment of its former CIO:
“Since the charges against Dayakar Mallu were made public over a year ago, the company has thoroughly and independently assessed all relevant information available to it. We take the government’s allegations made today very seriously. against Ramkumar Rayapureddy today and we will continue to review the matter in the same manner. The Company is committed to the highest standards of integrity and respect for the law. Ramkumar Rayapureddy is on leave from the Company. We have and will continue to cooperate fully with the authorities, and expect no further comment on this matter.”
What is insider trading?
The SEC, the government agency responsible for enforcing the law against market manipulation, has adopted rules regarding insider trading that define it as any securities transaction made when a person involved in the trade has material non-public information and uses such information to violate its obligation to maintain the confidentiality of such knowledge by using it for profit.
Inside information is “material” if its disclosure affects a company’s stock price. For example, the announcement of a takeover bid, a pending merger, a positive or negative earnings report, the pending approval or rejection of a new drug by the FDA, accounting restatements, etc. .
A person is defined as an “insider” if they have a relationship with a company that gives them access to information that has not yet been made public. Insiders, especially those in management or board positions, have a fiduciary relationship with their companies and their shareholders. Therefore, trying to profit from insider information places the interests of the insider above those of the entities to which they owe this duty. It’s like a lawyer or a doctor who uses the vulnerability of a client or patient to gain an advantage.
However, not all insider trading is illegal. It is perfectly legal for insiders to trade as long as all material information is public and the trades are disclosed and public. Indeed, insider trading is avidly followed by investors and analysts in an attempt to determine positive and negative insider beliefs.
The illegal variety of insider trading occurs when a securities transaction (i.e. the purchase or sale of stocks, bonds or derivatives) is influenced by the knowledge that only a small group of people inside the company (insiders) whose shares are traded would know about. This obviously gives the insider an unfair advantage that allows them to take advantage of information about a potential fluctuation in a company’s trading value before others are aware of it. This allows the insider to “run ahead” of the market.
As in the case of Viatris, insiders sometimes use someone outside the company to carry out the trades. In these situations, there is a “tipper” and a “tippee”. The spiller is the person who breached their fiduciary duty by intentionally disclosing confidential information to third parties. The tippee is the person who knowingly uses this confidential information to complete a transaction with the intention of making a profit or avoiding financial loss.
Obviously, the reason insider trading is illegal is that it gives the insider an unfair advantage in the market, puts the interests of the insider above those of shareholders, and allows an insider to artificially influence the value of a company’s shares. It also undermines the confidence of the investing public in the proper functioning of the markets.
Valuation and finance
While Viatris is an unfortunate victim of this betrayal of faith by its high profile employee, overall I think the stock is very undervalued. Insider trading does not appear to be significant enough to have affected its value.
About half of its revenue comes from off-patent brand name drugs (i.e. Lipitor, Xanax and Viagra), with the rest coming from generics and non-prescription products. The company is using its strong cash flow to grow its pipeline and pay out a good dividend (current yield of 4.06%).
GuruFocus’ exclusive FCF value is $25.61, more than double the current stock price. GuruFocus developed Projected Free Cash Flow to address situations where earnings are erratic or masked by non-cash charges as in this case. Essentially, the metric takes 80% of book value and adds it to the present value of free cash flow averaged over six years.
In terms of valuation, it is one of the cheapest stocks in the market as it trades at a forward price-to-earnings ratio of just 3.5. Recent results have been encouraging and the stock is bouncing off its low. At the current price, investors should be very well rewarded in the years to come.
Insider trading is common and lucrative, but notoriously difficult to prove and prevent. A 2020 study estimated that only about 15% of insider trading in the United States is detected and prosecuted. Insider trading is even more prevalent outside the United States, where markets and regulators are not as advanced.
Investors should be aware that insider trading is a possible contributor to stock volatility, which may be more common than they realize. This is all the more reason why they should demand a margin of safety in buying stocks, so even if there are shenanigans like this (and you never know) they will always turn out well.