News reports over the past day or indicate we may be in the early days of what could prove a widespread regulatory crackdown on insider trading. The FBI has raided the offices of several hedge funds, a number linked with SAC Capital. A west coast independent technology analyst has publicized a failed attempt by the federal police agency to trade more lenient treatment for alleged offenses in return for recording (presumably incriminating) conversations with a client, hedge fund SAC Capital. “If felt like a street mugging,” he’s quoted as saying. The analyst reported this encounter by email to his customers, instead. They, in true Wall Street fashion, immediately ceased doing business with him.
All this prompts me to write about four loosely linked topics: insider trading, expert networks, hedge fund information gathering and issues that the fuzzy nature of what constitutes insider trading create for professional securities analysts.
Two posts, today and tomorrow.
First, a pedantic point. Insiders, like the top managements of publicly traded companies, can trade legally. There are, however, clear restrictions on what they can do and when.
But that’s not what people usually mean when they talk about insider trading. They’re referring to illegal insider trading. There’s actually a good, if a bit dated, survey of insider trading regulations and their purpose on the SEC website.
Here’s my take on what insider trading is. Remember, though, that despite the fact I’ve sat through 25 years+ of mandatory compliance training that included a heavy dose of insider trading information, I’m not a lawyer. As you’ll see below, this can be a pretty fuzzy concept, with lots of gray area, border line cases.
The standard definition of insider trading is that it is based on material, non-public information. Doing so is illegal for two reasons:
1. It’s like stealing. It’s taking information that is supposed to be used only for a corporate purpose and using it for personal benefit instead. For the corporate employee who has such information, trading on it is a violation of the duty of trust and care he is expected to have for his employer.
2. It’s like fraud. That’s because the inside information trader is taking advantage of the fact he knows the person on the other side of the trade can’t possibly be aware of the material information he is acting on.
That’s straightforward enough. But inside information also has a viral or fungal quality to it. Today’s rules maintain that anyone, whether employee of the company involved or not, becomes a “temporary” or “constructive” insider the minute he reads/hears the information. This means he has the same fiduciary obligation that a company employee would have. He can’t trade on the information, even if he had figured out 95% of it on his own already.
It also means that the last thing any securities analyst worth his salt wants is inside information. It’s like a runner getting a knee injury. It puts him out of the game and on the sidelines.
Another modification to the rules concerns selective disclosure, which under Regulation FD (Fair Disclosure) is no longer allowed. At one time, companies routinely disclosed information to sell side analysts but not to shareholders or their representatives. Or they gave extra information to favored institutional shareholders in private meetings. I remember vividly once being asked to leave a briefing by Sony about its video game strategy, even though I was representing owners of the company’s stock, because I didn’t work for an investment bank. That’s crazy, to tell company secrets to strangers but not the owners, but it happened. (I refused, by the way, and wasn’t thrown out.)
Analysts and expert networks are different.
Most sell side analysts specialize in a single industry. Their buy side counterparts usually cover several industries, sometimes closely related, sometimes not. Both kinds read industry literature, attend trade shows, go to company analyst days (where top management explains how the company in question makes its money and where it stands among its competitors), read company SEC filings, listen to earnings conference calls. They also produce detailed spreadsheets modeling company operations, hoping to project future earnings with a high degree of accuracy. Gradually, even if they have no prior industry background, they become extremely knowledgeable about the areas they cover.
Expert networks, in contrast, are collections of industry consultants who are assembled by a middleman and whose services–usually a one- or two-hour meeting–are offered to professional investors for a fee, most often paid in soft dollars.
Say a company wants to find out about communication networking equipment and doesn’t have an experienced analyst who covers the area. Or maybe the company does but a portfolio manager wants an especially detailed or technical question answered. Then he calls the expert network organizer to say what he needs. What he probably gets is a middle-level manager or technical employee from, say, Cisco, who is willing to talk for two hours for $1,000 (the payment to the network organizer may be $2.000-$3,000).
The legal issue is that the guy from Cisco may have no idea how much of what he knows is inside information. So the result of the meeting may be that inside information is passed from the expert network consultant to the investor. If so, it’s the functional equivalent of whacking every investor at the meeting in the knee with a crowbar. What the SEC is investigating is whether obtaining inside information is the intent of the meeting and, in particular, if some hedge funds use these networks as conduits to get illegal information that they can trade on.
Back to analysts, for a minute. I don’t John Kinnucan, the analyst the FBI tried to wire, and I’ve never seen his work. The Wall Street Journal description of his business suggests he operates in a gray area. According to the article, his specialty is “channel checks.” That is, he schmoozes with tech company salesmen and with distributors, to see what’s selling and what isn’t. He then synthesizes the information he gets and passes it on to clients. It’s also possible that clients ask for specific items of information–I don’t know whether they do or not, but I think it’s a reasonable supposition that they do.
The big question is whether Mr. Kinnucan’s sources of information tell him very specific things that they have an obligation not to reveal to people outside the company. In other words, is this activity like #1 above, a use of confidential company information for personal benefit. If so, Mr. Kinnucan and any of his clients who receive his reports are infected. They’re insiders and can’t trade on the information. The FBI appear to have waned Mr. Kinnucan’s taped conversations with SAC Capital to build/buttress an insider trading case against SEC. So they must either think, or hope, that the information in the reports do contain inside information.
That’s it for today. Tomorrow: why I think hedge funds use expert networks and highly specialized analysts like Mr. Kinnucan; and practical issues for any securities analyst.