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.

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.