doing securities analysis vs. getting inside information

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.



a revealing insider trading ruling in Japan

insider trading in Japan

Yesterday’s Financial Times outlines a judgment made last week in a Japanese insider trading case.  The newspaper misses what I think is the main story, however.

the recent verdict

An institutional portfolio manager at Chuo Mitsui Asset Trust and Banking was found guilty of receiving, and acting on, insider information about an upcoming issue of new stock by a publicly listed company.  The PM made ¥14 million ($170,000) for his clients by trading on the tip.


They were:

–the PM’s employer, Chuo Mitsui, was fined ¥50,000 ($600)

–there was no requirement of forfeiture of profits illegally made

–no penalty of any type either for the portfolio manager who received the tip or the broker who gave it.

The article goes on a bit about how, in the mysterious way Japan works, the nominal fine may have sent a powerful symbolic message that therefore the penalties may be more severe than a foreigner might suppose.  I think the nominal penalties do send a message, though not in the way the FT believes.

Oddly enough, the newspaper contrasts this fine with the ¥1.15 billion ($14 million) fine levied against Yoshiaki Murakami for trading on inside information about a half decade ago.  But it doesn’t realize that this contrast is the real story.

the Murakami saga

Mr. Murakami is a naive former civil servant who believed traditional Japanese corporations badly needed restructuring.  He formed an asset management company about ten years ago.  Its purpose was to be a gadfly that could prompt corporate/social change, while making money for clients at the same time.  One of Mr. Murakami’s targets–his last–was Nippon Broadcasting System.

Mr. Murakami bought a very large position in NBS.   He approached the company with suggestions about how to improve very weak corporate results.  He also asked for a board seat.

Management ignored Mr. Murakami.  It called on the “usual suspects”–suppliers, customers, domestic institutional investors–for support by buying NBS stock themselves, or at least by refusing to sell to Mr. Murakami.  Effectively isolated, Mr. Murakami approached a somewhat sketchy internet entrepreneur, Takafumi Horie of Livedoor, for aid.

Livedoor told Mr. Murakami in a private meeting that it intended to build a stake in NBS itself.  The declaration made Mr. Murakami an insider of Livedoor.  Despite this–he later claimed he didn’t understand the implications of his inside knowledge–Mr. Murakami bought more NBS.

Livedoor subsequently launched a hostile bid for the company.  It failed.  During the battle, Mr. Murakami realized that traditional holders of NBS wouldn’t tender their stock, so he sold his for a ¥3 billion ($36 million at today’s exchange rate) profit.

Mr. Murakami was charged with insider trading and found guilty.

penalties for Mr. Murakami?

They were:

–a ¥1.15 billion ($14 million) fine

–forfeiture of all profits from selling NBS, which amounted to ¥3 billion ($36.5 million)

two years in jail, later commuted to three years of probation.

why the sharp differences in the two cases?

Why should the punishment for insider trading be so startlingly different in these two cases?

Two factors stand out to me:

–the lesser one is that the Murakami case involved much larger amounts of money–although that doesn’t explain why there was no censure of the Chuo Mitsui portfolio manager or of the broker, and no forfeiture of illegal profits.

–the real difference, I think, is that Mr. Murakami was not part of the establishment.  Worse, he was a critic of the traditional social order.  By exposing its failings, he threatened the status quo.  In contrast, both the broker and the Chuo Mitsui portfolio manager were working within the shadow system of favors and obligations that the establishment uses to feather its own nest and keep itself in power.

the real story

That’s the real story here–stubborn defense of the traditional economic order, even after two decades-plus of resulting economic stagnation.

Hedge funds are sweeping homes and offices for bugs

security sweeps

…not the biological kind that infest beds, but listening devices.

According to the Financial Times, security firms in the New York City area are experiencing a surge in requests by hedge funds to have their offices and, in some cases, the homes of key firm members, swept for hidden surveillance devices.  This is apparently the hedge fund response to the continuing stream of arrests of industry employees on charges of insider trading.  In many cases, the SEC and FBI have cited, as justifications for the arrests, recordings of telephone calls they have made, in which the arrested parties either receive or solicit inside information that they subsequently trade on.

not so smart

This security sweep activity is more than a little crazy.  But it does illustrate two things, I think:

–the fact that the SEC/FBI tactic of making fresh arrests every few days instead of doing everything at once is having its desired effect of instilling fear into the hedge fund community, and

–it gives us some insight into the character of the management of at least some hedge funds–not that we necessarily needed this confirmation.

Why is it crazy?

First of all, the cases I’ve read about have involved a cooperating individual telephoning into hedge fund offices from, say, his home or the local FBI office and trying to get the recipient of the call to make incriminating statements.  In all these cases, the recording is done at the caller’s location.  A sweep for hidden spying devices, like in movies about the Cold War, would find nothing.

Second, legal wiretapping would be done from the telephone company premises, not from the hedge fund offices.  Same result–a sweep finds nothing.

Finally, the people who run security agencies are mostly former police officers, or FBI or Secret Service agents.  Part of their stock in trade is the cordial relations they maintain with their former colleagues.  It would be hard to believe that the FBI doesn’t have a complete list of the hedge funds who have called to have their offices swept (talk about dumb).

says something about the industry, though

At least part of this panicked reaction is hedge fund managers seeing what happens to assets under management when someone in a firm is accused of insider trading–the assets are immediately yanked by clients.  But it also shows the lack of organization, or the immaturity, of the firms in question.

what to do?

What should hedge funds be doing?  I have two observations–really three:

top management sets the tone

In any firm, all employees look to the top management for cues on what acceptable performance is.  If the boss signals that it’s ok to lie, cheat and steal to get performance, regular employees will likely respond by doing so.  Academic research suggests that a significant proportion of hedge funds do this–that they’re are willing to exaggerate their education, experience and performance to try to attract clients (look under my “hedge fund” tag for evidence).  In my mind, such firms are lost causes.

compliance training is key

In the SEC-regulated world, all investment professionals are required to have periodic training in compliance, that is, on the ins and outs of securities laws and the standards of conduct they require.  The fact of this training, and the care management takes in organizing and conducting it, goes a long way to set the ethical tone of a firm.  In fact, to my mind this is the fastest way for a top management to set standards for behavior.

bug sweeps send a bad message

What message does sweeping the office for bugs send to employees?  I don’t know exactly, but it certainly isn’t that the firm is highly ethical and has nothing to hide.

insider trading and ETF stripping

insider trading

Over the past couple of months there has been a constant drip, drip, drip of news conferences by the SEC on the topic of its ongoing investigation of insider trading.   Most have been to announce arrests of hedge fund-related professionals accused of this white-collar crime.  The “timed release” nature of the news flow has several objectives that I can see:

–it unsettles as yet uncaught lawbreakers, perhaps causing them to make foolish mistakes that will make their apprehension easier,

–it discourages anyone tempted to trade on confidential company information,

–it burnishes the reputation of the SEC as guardian of the securities markets, and, of course,

–it keeps unflattering stories, such as the one that the agency’s own financial statements have chronically failed to meet minimum government standards, off the front page.

ETF stripping

One the of the latest SEC announcements involves something new to me–ETF stripping. What is it?

The securities exchanges and their regulators maintain continual computer surveillance of public market trading, both of securities and derivatives.  They look for unusual patterns in volume or price movement that may indicate insider trading.   For example, three days before a merger announcement, trading in near-term call options of the target firm spikes to 5x normal volume; or the day before a surprisingly bad earnings report, puts for the stock of the company in question do the same thing.  Such deviations from the norm ring alarm bells and prompt the regulators to investigate who was trading and why.

According to the SEC, one way traders on inside information have been able to outwit this surveillance has been by buying shares in a sector ETF that contains their target stock, and shorting all the other names the ETF contains.  They end up owning only the name they want to.  But they don’t show up on the regulators’ screens as owning the target stock at all.  Instead, they’re seen as holding an index security (the ETF) and a bunch of short positions.

my thoughts

I have several thoughts:

–Most traditional investors can’t short stocks.  For those who can, there’s a very good chance that clients would notice and question the synthetic construction of a long position through ETF stripping.  So the SEC is talking about hedge funds here.

–Hedge funds would presumably piece the trading out to several brokers so that no one counterparty sees the entire picture.

–ETF stripping would be particularly hard to find if it were done by the trading desks of brokers, particularly those who act as intermediaries for ETFs and are constantly buying and selling both ETFs and their component securities.  Trading costs would be the lowest for such brokers, as well.

–There’s no reason to go to the trouble of ETF stripping other than to try to evade regulatory scrutiny.  So the practice seems to me to be a two-edged sword.  On the one hand, the chances of being detected are lessened.  On the other hand, the ETF stripper is like the burglar caught in the bank after hours with safe-cracking tools.  If caught, he can’t claim he’s there by accident.

–I can’t imagine the SEC figured this out by itself.  Instead, I presume the agency learned about ETF stripping through an arrested inside trader who offered information in exchange for a lesser sentence.

It will be interesting as this story develops to see how widespread the practice has been.


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.