the “mosaic” theory

When I became a securities analyst in 1978, the mosaic theory was what was commonly understood as being an adequate defense for an analyst accused of trading on inside (that is, material, non-public) information.

An example:  I’m interviewing the CFO of a large company I know is in negotiations over a very lucrative project in China.  This firm has a smaller, publicly traded partner, for whom this project could, say, triple its earning power.  After a series of questions, I tell the CFO that I’m estimating the company’s interest expense for next year will be $200 million.  I ask if this sounds right.  He responds that it will more likely be $250 million.

I know the company’s cost of debt is about 5%, so the added interest expense means new borrowing of $1 billion.  The only reason to do so would be to fund the China project, which seems innocuous enough but which has enormous implications for the smaller partner.   So I buy the stock of the partner for my clients’ portfolios.

Let’s add one more thing.  I’ve spent a half hour on the phone with the CFO, asking a lot of questions.  My main purpose has been to create an atmosphere in which he’d answer the interest expense question.

Am I trading on inside information?  At the start of my career, the answer would have been no.  Ten years ago, I might have gone to a compliance officer before acting–and most likely would have been told not to trade.

Another example:  Same companies, but this time I’m in Narita Airport in Tokyo and see the CFO boarding a plane for Beijing.  He doesn’t appear to be on vacation.  He hates business travel.  The only work reason he would have for a trip to Beijing would be to sign the joint venture project agreement with the Chinese government.  Do I have inside information or have I just made an astute conclusion based on my professional background and experience?

Same answer.  I’d worry and would again seek assurance that my firm would defend me in a lawsuit.  I’d probably be told not to trade.

To be clear, I’m not at all a fan of so-called “expert networks,” which are many times thinly veiled centers for bribery of corporate officials and theft of proprietary information.  At the same time, it seems to me that over my career the focus of SEC prosecution of traders on inside information has gradually shifted from a focus on the illegal character of the information collection to whether the information itself is widely known, with no regard to if its possession is the result of professional skill and knowledge or simply theft.

A recent appeals court decision (I read about it in the New York Times) overturning the insider trading conviction of two hedge fund managers may signal that the scales are starting to move in the other direction.

The court ruled that the SEC must prove that the receiver of an “inside” tip who acts on it must know both:

–that the information is not for public release, and

–that the provider has received an “exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature” in return.

The ruling seems to me to have wider implications than just protecting securities analysts from arbitrary prosecution.  It also appears to open the door widely to old-boy network activity, which I don’t regard as a good thing.  Still, if I were still a working analyst it would give me heart to do my job more aggressively.