more insider trading arrests

the arrests

Yesterday, the office of the US Attorney for the Southern District of New York announced the arrest of four more individuals, which is accuses of insider trading.  In the same press release, the Justice Department revealed that a fifth individual had already pled guilty to charges of insider trading and is scheduled to be sentenced in December 2013.

Four of them were (they’ve been fired by their companies) employees of technology firms.  The fourth works for the “expert network” firm, Primary Global Research of Mountain View, California.  PGR recruited the others, organized their contact with hedge funds and other investors and paid them a total of $400,000 for their information.  (See my posts from last month for background on this case and on expert networks.)

The announcement of the conviction and delayed sentencing of the fifth person, a global supply manager for Dell, is important for reasons not spelled out in the release.  It signals that he has agreed to cooperate with authorities in return for more lenient sentencing.  Not only will he testify about his illegal activities.  But he has presumably recorded all his PGR-related conversations since being caught some months ago–and been coached by the Feds on how to steer to telephone calls in ways that make it likely the other person will make self-incriminating statements.

I haven’t read the indictment, but the New York Times has a lot of details, if you’re interested.

not “experts” at all

What jumps out at me is that none of the four tech employees is an any way an “expert” in the tech industry.  They’re not researchers.  They’re not engineers.  They seem to have no detailed knowledge of company strategy.  They’re not veteran marketers with an experience-seasoned view on industry trends.  These are their jobs:

–supply chain manager at Dell–paid $145,750 by PGR

–supply chain manager at Advanced Micro Devices–paid $200,000+

–business development at Flextronics, a contract manufacturer with Apple as a client–paid $22,000

–account manager at Taiwan Semiconductor Manufacturing Company–paid $35,000

They were all mid-level employees who had signed confidentiality agreements with their firms.  The supply chain guys would have had access not only to their own management control computers but those of their suppliers and customers.  The Flextronics guy had access to Apple plans and orders.  The TSMC employee had detailed information about orders from the foundry’s customers, which would have represented most or all of the business being done by the fabless semiconductor design firms who use TSMC.

What do the four have in common, other than working for PGR?  They all had physical access to inside information, which they apparently blissfully revealed to outsiders, sometimes in staccato bursts of phone calls just before earnings were reported.

This isn’t a collection of industry experts.  It’s an industrial espionage ring.

It seems to me yesterday’s announcements are confirmation that this ongoing insider trading investigation is not about borderline or inadvertent violations of securities laws.  Rather, it’s about highly organized, years-long, deeply criminal activity.

more on insider trading

A number of new ( to me, anyway) pieces of information about the current FBI/SEC insider trading investigation have emerged over the past few days.  They are:

1.  Many commentators have noted that the investigation resembles much more closely an FBI operation against organized crime than the “usual” kind of SEC action.  The latter case typically has involved followup from red flags that emerge from SEC monitoring of trading patterns in individual stocks.

In this case, in contrast, the investigation has apparently been going on for three years, involves the FBI, includes wiretapping, and seeks criminal penalties.

No one I’m aware of has publicly drawn an obvious inference from this behavior, though.  If the focus of this probe is organized criminal enterprises, it seems to me that the government will be seeking, or at least threatening to seek, penalties under the Racketeer Influenced and Corrupt Organizations (RICO) Act of 1970.

Under RICO, which requires that prosecutors establish a pattern (meaning at least two acts) of illegal activity, those found guilty can be sentenced to twenty years in prison for each racketeering act and fined $25,000.  They can also be sued in civil court by those they have wronged for triple damages.  Defendants’ assets can be frozen prior to trial (making it hard to pay your lawyer).  The government’s reach is also extended to include all a person’s assets, not just those connected with the legal entity where a crime has occurred.  In other words, if you’ve traded in insider information as an agent of a corporation or partnership, your house, your bank accounts, your art collection, your cars…are all at risk, not just corporate or partnership interests.

RICO has a history of being used in combatting financial markets crimes.  Corrupt junk bond king Michael Milken was indicted under RICO in 1989.  Drexel Burnham Lambert, the firm Milken worked for, was threatened with a RICO indictment as well.  Both pled guilty to lesser charges.

I think RICO is the next shoe to drop.

2.  Former SEC head, Harvey Pitt, has been making the rounds of financial TV shows giving his opinion about what the FBI/SEC are doing.  The most interesting point he makes, I think, is on CNBC, where he points out that this investigation can’t involve a gray area that may, or may, not be insider trading.  For the resources involved in this case, and given all the publicity the agencies have generated, it must concern clearly illegal activity.  (Mr. Pitt says this around minute 3:10 of the CNBC interview.)

Points Mr. Pitt makes in other interviews:  this action is focussed on hedge funds and comes as a result of authority explicitly granted to the SEC by the Dodd-Frank Act.

3.  Don Ching Trang Chu, an employee at  a California-based “expert network”

firm, Primary Global Research, was arrested by the FBI on November

24th and charged with conspiring to distribute inside information.  The way Mr.

Chu’s business is described in the US Attorney’s press release and by

Bloomberg among others, it seems to have consisted in large part in finding

compliant middle-level employees in technology companies.  These

employees would disclose company operating results, sometimes in great detail, to

hedge funds some hours in advance of their being made public in return for money.

In a narrow sense, for a long-term investor the question of whether a company’s

short-term results are 1% higher or lower than the Wall Street

consensus is of little consequence.  The larger issue, however, is that the

perception that monied interests can rig the game in even one aspect can

undermine the public’s confidence in the markets–thereby delivering lower price

earnings multiples for everyone.

And of course, a sheriff must fear that if everyone believes he’s asleep on the job

he’ll be thrown out office and replaced.

This story will likely get more interesting as it unfolds.

insider trading, hedge funds, expert networks and skilled securities analysis (ll)

In yesterday’s post, I wrote about what insider trading and expert networks are.

Why have expert networks flowered over the past decade and been especially favored by hedge funds?

hedge funds

When I started working in the stock market in 1978, it was common for both brokerage houses and large institutional investors in the US to have extensive staffs of analysts.

As the sell side continued to rebuild itself and improve its analytic capabilities after the 1973-74 recession, buy side firms worked out that they could save money by shrinking their own staffs and rely on brokerage house research instead.  Better still, from their point of view, they could pay for access to the brokers’ analysts through commission dollars (“soft dollars”), a tab picked up by money management clients, rather than paying analysts’ salaries out of the management fees clients paid them.

Control of brokerage firms gradually passed into the hands of traders, who regard research as a cost center that produces no profits.  They did what seemed the obvious thing to do and began to lay off analysts.  During the Great Recession of 2008-2009 the steady trickle of layoffs became a torrent–and gutted the major brokers’ analysis capabilities, particularly in equities.

The professional disease of analysts is that they analyze everything, including their own jobs.  Senior people have long known that they’re vulnerable in a downturn, especially since they all are compelled to have assistants who earn a small fraction of what they do–and who can sub for them in a pinch.  Their response?  –in many cases, the senior people hire assistants who look good in business attire and can present well to clients, but who have limited analytic abilities.  As far as I can see, this defense mechanism protected no one during the fierce downturn recently ended.  It may be harsh to say, but “place holder” assistants may be all that’s left in some research departments.

If the cupboard is pretty bare in brokerage house research departments, do hedge funds build their own?

Some have.  But–and this could be nothing by my own bias–a lot of hedge funds are run by former brokerage house bond traders.   Traders and analysts are like the athletes and the nerds in high school.  Very different mindsets.  So hedge funds that are run by traders, and that have a trading orientation, don’t have the temperament or the skills, in my opinion, to build research functions of their own.  They also want information that’s focused strongly on the very short term.  (Is it a coincidence that the subjects of the recent FBi raids are all run by former bond traders?)

They can’t get it from brokers.  They can get it from independent boutique analysts.  But were better to get information about, say, the upcoming quarter for Cisco than from a Cisco employee visiting as part of an expert network.

securities analysis

I wrote yesterday about the immense amount of information publicly available to a securities analyst.  In the US, companies are required to make extensive SEC filings, in which they report on the competitive environment, the course of their own business and the state of their finances.  Some firms hold annual analysts’ and reporters’ meetings–sometimes lasting several days–in which they try to explain their firms in greater detail.  There are trade shows, brokerage house conferences on various industries and–in many cases–specialized blogs that discuss industries and firms.  Publicly traded suppliers, customers and the firms themselves hold quarterly conference calls, in which they discuss their industries and their results.  The internet allows you to reach competitor firms around the world.

Companies also have investor relations and media departments that provide even more information for those who care to call.  Many times these departments also organize periodic trips to major investment centers to meet with large shareholders and/or with large institutional investors.  The talking points for these trips are scripted in advance.   My experience is that the company representatives attempt to create the impression that questioners in the audience have penetrating insights and are forcing the company to answer tough, and unusual, questions.  And people on my side of the table are usually more than happy to believe that this is true.  But in reality the companies tell basically the same things to everyone.

Still, the idea that anyone who obtains inside information is “infected” by it and becomes a temporary or constructive insider as a result has made profound changes, I think, in the way companies and analysts interact.

Let me offer two examples:

1.  In my early years, I ended up covering a lot of smaller, semi-broken companies that senior analysts didn’t want.  It’t actually a great way to learn.  Anyway, I had been talking regularly for about a year with the CEO of a tiny consumer firm that was flirting with bankruptcy.  This CEO was understandably downbeat and our talks were rather depressing.

Then rumors began to circulate that a Japanese firm was interested in buying the firm at a high price (in reality, anything greater than zero would have been a high price).  I called the CEO a couple of days later to prepare for my next report.  He was very cheerful, didn’t have a care in the world, actually joked his way through my questions.  I didn’t need to ask about the potential takeover.  His whole demeanor told me that the rumors were true.

Did I have inside information?  Twenty years ago, the answer would have been no.  I was just a skilled interviewer drawing inferences from the conversation.  Today, I don’t  know.  I suspect the answer is yes.

2.  I’m in a breakout session with the CFO of a company which has just presented at a brokerage house conference and is answering follow-up questions from analysts in a smaller room.  Someone raises his hand and says that for a number of reasons he thinks this quarter the firm will miss the earnings number it has guided analysts to.  He requests a comment.  Most people know the questioner–or at least can read his name badge.  He comes from a hedge fund that is rumored to be short the company’s stock.

The CFO clears his throat, takes a sip of water and says there’s no reason to think the firm won’t easily make its guidance.

I’ve known the CFO for a few years.  He only clears his throat and sips when he’s getting ready to say something that’s technically true, but is misleading  –in other words, a lie.

Do I have inside information.  Again, years ago the answer would have been no.  Today, I’m not sure.  If this were a private meeting with the CFO, I think it’s likely that I’ve got inside information.  But is a breakout session public disclosure?  Does it make a difference if the session is televised, so everyone can see what the CFO is doing?

My uncertainty changes my behavior.  How?

I probably no longer want a private meeting with top management of a company.  I probably don’t want the company to comment on my earnings estimates, or to give any indication that a non-consensus estimate I may have could be right.

I have to rely more on my independent judgment.  I want to be wary of any interaction with company management.  I don’t want any “help” with my estimates (not that I need any).

This is actually good news for individual investors, because the playing field between them and professional analysts has been leveled significantly.

insider trading, hedge funds, expert networks and skilled securities analysis (l)

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.

insider trading

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.)

expert networks

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.