ITG is a bellwether for commissions and, with its acquisition of Majestic Research and subsequent purchase of Ross Smith Energy Group, it is a publicly traded example of an agency broker seeking to profit from higher commissions generated through research. Unfortunately, while the commission environment seems to be improving, all does not seem well with ITG’s research operation.

Improved Environment

ITG’s first quarter revenues increased 9% over the fourth quarter results. As in its 4^th quarter call, ITG was cautiously optimistic on the commission environment. This quarter it cited improving inflows into equity assets, a hopeful sign for commissions:

“For the first time in 10 quarters, we witnessed positive domestic equity inflows with active equity managers experiencing an estimated $20 billion in domestic equity fund inflows… While these flows in and of themselves did not amount to a great rotation back in equities, they are improvement over the heavy outflows we’ve seen over the past few years.”

Business Line Results

This quarter marked the first time ITG released financial results for its lines of business, including research. ITG’s 9% revenue increase was driven by a 19% increase in electronic brokerage revenues. Research revenues, however, were down 7%.

The official explanation of the decline in research revenues was bad timing: “Revenues from research sales and trading declined due in part to a decline in project based work and the timing of payment from research accounts that pay on a discretionary or voting basis.”

Product allocations are notoriously difficult for brokerages. If an asset manager directs more commissions to ITG, how much of that is attributable to increased volume and how much to the research product? ITG’s electronic brokerage group, its flagship operation, will believe that any increase will be due to its capabilities and relationships.  And now that internal resource allocations are on the line, the passion gets even stronger.

A Zero Sum Game?

As we noted when ITG first announced its product profitability review in February, business line analysis is typically not flattering to research. Now that ITG has decided run its business based on product profitability, the existing culture will tend to favor electronic brokerage rather than research. The risk is that the win/win of trading and research turns into a zero sum game where trading will prosper at the expense of research.

When asked by an analyst about the decline in research, ITG CEO Bob Gasser suggested that some of the benefit from research was being booked with electronic brokerage: “I think the overall dynamic – some of that [revenues] shifted into the brokerage world, in some cases the electronic brokerage world has benefited from a higher rate card, if that’s the client’s preference in terms of how they want to interact with us, and pay for the various products and services they consume.”  In other words, some of the benefit of ITG’s research is showing up in the electronic brokerage revenues.

Management Turnover

Here is another clue that research is becoming a losing proposition at ITG: research management departures. Tony Berkman, who was the CEO of ITG Investment Research and previously CEO of Majestic Research, left ITG this month. According to his LinkedIn profile, Tony is now an employee at an unnamed hedge fund.

Terry Gardner, the ex-CEO of Soleil Securities, who was recruited to be the COO of ITG Investment Research after the Ross Smith acquisition, also left ITG this month. According to LinkedIn he is doing consulting.

Research operations are run by co-heads Jie Zhang (a 9-year veteran of ITG and Majestic before that) and Jim Jarrell (formerly president of Ross Smith Energy Research, which he joined in 1999).

The departures of Berkman and Gardner, both experienced research managers with track records of running large research operations, suggests that all is not well with ITG Investment Research.

New York, NY – Last week, JP Morgan Chase sent a formal letter to global market data vendor Bloomberg LP, requesting five years of internal logs verifying what data the firm’s journalists had accessed about how the bank’s employees had used the terminal. JP Morgan also sought confirmation of the controls that have been put in place to keep this from occurring again.

Background on the Issue

In a formal statement, JP Morgan Chase said, “Our legal department sent a formal request to Bloomberg to verify exactly what information reporters had access to and confirmation of their controls to prevent future breaches.”

The request by JP Morgan came last week after it became known that Bloomberg journalists had long accessed information about the usage patterns of its subscribers. This transpired because executives at Goldman Sachs had expressed concern over the practice to Bloomberg after one of the firm’s reporters shared the terminal login habits of one of Goldman’s executives to another.

This acknowledgement has sparked both concern and anger across Wall Street as traders and investment bankers have wondered what types of proprietary data Bloomberg’s journalists have had access to.

Bloomberg says that its reporters have historically had access to a user’s login history, help desk inquiries, and how many times different computer programs were accessed.

Bloomberg’s Response

Matthew Winkler, the editor-in-chief of Bloomberg News publically apologized last week, explaining that this access can be traced to long-time practices at Bloomberg News. “Our reporters should not have access to any data considered proprietary. I am sorry they did. The error is inexcusable,” Winkler wrote in an op-ed.

In an internal memo to Bloomberg employees sent last Friday, CEO Dan Doctoroff also expressed his apologies, writing: “Client trust is our highest priority and the cornerstone of our business, and we are deeply committed to ensuring the complete integrity and confidentiality of our clients’ data in all situations and at all times.”

Last week, Bloomberg also said that it had restricted its journalists from accessing any information about its terminal subscribers, including the information they had previously been able to access. In addition, Bloomberg said that it had appointed Steve Ross, a senior executive responsible for the day-to-day operations of its market data terminal business, as its first dedicated compliance chief.

As a result of this scandal, Bloomberg has been in contact with executives at a number of their large customers, including JP Morgan, Goldman Sachs and Morgan Stanley in an effort to convince them that they were addressing this issue and that their firms’ proprietary data had always been kept confidential.

The Market’s Reaction

Thomas Nides, Morgan Stanley’s vice chairman explained their firm’s interactions with Bloomberg management on this issue, saying: “They’re assuring customers this was a mistake and that they’re going to rectify that. We want to make sure we have all the facts, but right now we’re taking the company’s assurances,” that the issues with use of customer data didn’t extend to trades or instant-message conversations.

Goldman Sachs’ President Gary Cohn has also spoken extensively with Bloomberg management about this issue. Last week he told the media that the bank does not have a major concern about the issue.

Despite these expressions of confidence in Bloomberg’s response, some are not so convinced. Citigroup used this development as an excuse to move its foreign exchange traders from using the Bloomberg messaging service to their own internal chatrooms. In addition, some Wall Street traders have started discussing whether the big banks should try to form a cooperative that could compete with Bloomberg.

Integrity’s Assessment

We are not convinced that a mass exodus to an alternative market data platform is likely over the near term as the Bloomberg terminal has become deeply imbedded in the workflow of many sell-side and buy-side firms. However, we would not be surprised if some clients use this development as a reason to emphasize a competing provider like Thomson Reuters, FactSet or S&P Capital IQ.

We do believe that this scandal, on top of the news a few weeks ago that Thomson Reuters was sending out certain data earlier to specific clients, is likely to prompt market data firms and their Wall Street clients, to become much more sensitive to the potential compliance risks associated with the use of these previously “safe” information sources.

Independent research firms took the top two spots in the latest WSJ Research Awards, but overall independents were under-represented in the rankings. Investment bank research, which tends to be more biased toward buy ratings than independent research, performs well in bullish environments.

Morningstar placed first in the latest WSJ Best on the Street survey, with 16% of its analysts qualifying for awards.  Fully 10% of its analysts were top in their sectors, an impressive feat.  Morningstar’s research is historically oriented toward retail investors, but Morningstar has been gaining traction with institutional investors, particularly smaller asset managers poorly serviced by investment banks.

Standard & Poor’s Capital IQ was second, with 9% of its analysts qualifying.  S&P’s equity research has finished in the top ten of the WSJ survey eight times in the last eleven years.

Other than the top two finishers, independents were relatively scarce in the overall results (see table below).  Sidoti & Company, a leading small cap specialist, placed ninth.  Independent research firms represented only 9% of the 69 firms recognized in the awards, a significant drop from the 2012 survey in which 30% qualified.

The 2012 survey reflected the difficult market environment in 2011, when sell orders were key in performing well.  But in 2012, with the stock market moving higher, buy recommendations were king.  Investment banks, which are quick to say buy and loathe to say sell, performed much better in the 2012 environment.

The survey measures the performance of BUY and SELL recommendations, which generally ranks low on the list of attributes that are important to institutional investors.  However, recommendations are valuable for retail investors, so it is fitting to see retail-oriented providers such as S&P Capital IQ and Morningstar garnering multiple awards.

Nomura appointed the former head of UBS’s global equity research to run its European equity research after a major shake-up that led to nearly 20 employees being cut from its research team. Alan MacDonald, who was UBS’s head of global equity research from 2001 to 2005, now heads Nomura’s research in Europe, the Middle East and Africa, according to Financial News.

The move follows major cutbacks in Nomura’s coverage, including the elimination of its analysts covering the utilities, retail, pharmaceuticals and medical technology sectors. The reorganization also removed the former head of equity research, Graeme Pearson, and his deputy. Most of the firings occurred before bonuses were paid.

Nomura is said to be concentrating on sectors most of interest to its Asian clients. The cuts came after the bank announced plans to integrate its equities business with Instinet, the agency broking firm that pioneered electronic trading, in May 2012.

Nomura is known for its stop and go approach to equities, but, in the shrinking commission environment, all brokerage firms are feeling pressure on their equities businesses.

New York, NY – Last week, Senator Charles Grassley (R, Iowa) spoke on the floor of the Senate about his investigation into a potential leak about the Centers for Medicare and Medicaid Services reversed decision regarding Medicare Advantage payments and his interest in re-introducing legislation regarding the political intelligence industry.  The following is the text of his speech and our comments.

Grassley’s Floor Speech on Political Intelligence – May 8, 2013

Mr. President, with the passage of the STOCK Act last year, Congress made an important statement: When it comes to insider trading laws, there is no special exemption for Congress. If anyone in government provides confidential information to someone for the purpose of trading on it, that is insider trading.

It is illegal if the information is both material and nonpublic.  The word “material” means a reasonable investor would want to know it before investing. “Nonpublic” means the information has not been released to the general public. To violate the law, the person making the disclosure must have a duty to keep the information secret.

Frankly, there is very little information in Congress that must be kept secret. Of course, that is a good thing. Unlike the executive branch, most of what Congress does is public immediately. But disclosing material nonpublic information can be a crime. Even if it is done intentionally, people might be investigated before getting a chance to clear their name.  And there is a big difference between material nonpublic information and an expert’s educated guess about what a government agency might do.

We now know that Wall Street has been harvesting expertise and tidbits of information from Washington, DC, for years while keeping us largely in the dark. In fact, the political intelligence industry is so big and so opaque that the Government Accountability Office was unable to quantify it or judge its size despite 1 whole year of investigating.

Political intelligence firms extract pieces of information from the government and use that intelligence to make money on Wall Street. Each detail a political intelligence firm gathers may not be material or nonpublic on its own, but the purpose of collecting and analyzing those details is to get an edge in the markets over other investors.

That is not illegal, and I have never suggested that it should be. People should not be discouraged from sharing information and opinions about how our government operates. We should be more transparent, not less. The less open and transparent government is, the more opportunities there are to exploit government information for profit in the markets.

I have been investigating the role of political intelligence firms in the early release of information about Medicare Advantage rates prior to the public announcement on April 1st. There has been some confusion over the scope of my inquiry, so I want to be clear.  There are reports that the Securities and Exchange Commission is investigating whether material non-public information was released about the Medicare Advantage rates. My interest is much broader than that.

Political intelligence is not the same thing as material non-public information. Gathering political intelligence includes a lot of activity that falls short of material non-public information. So, just because I am asking questions about how certain information or expert opinions flowed to these political intelligence firms, does not mean I am accusing anyone of any wrongdoing.

I am not seeking to ban the gathering of political intelligence. I am not suggesting that if someone was the source for some piece of political intelligence, that the source did anything illegal. But, the goal of these firms is to get an edge on other investors, and that should be understood by everyone who communicates with them.

This investigation has shed a great deal of light on the political intelligence industry. I hope to use this information to improve the legislation on political intelligence disclosure that I plan to re-introduce with Representative Slaughter. I am trying to learn how these political intelligence firms function by using this real-world example, so that I can write better legislation on disclosure.

To be clear, I am not focused on examining whether particular Congressional staff acted properly with regard to their professional duties.  Any reports to the contrary are simply inaccurate. What I think we need is more transparency.  Government officials need to know what happens with the information they provide to outside parties. I want to arm government officials with knowledge about who they are talking to.

My inquiry started with Height Securities, the firm that put out an alert 18 minutes before the markets closed on April 1st. That alert caused a huge spike in the health insurance stocks that stood to gain from the rate announcement.

I initially learned that an email on April 1st from a healthcare lobbyist to the analyst at Height Securities looked like the basis for the flash alert that moved the markets. In the interest of full disclosure, it has been reported in the press that the lobbyist was formerly on my staff.  But, I continued to press for more information.  I learned that Height paid for his expertise on healthcare, although his entire billing amounted to only 1.75 hours of work before sending the email on April 1st. I learned that the Height analyst had also communicated with two other healthcare policy experts before putting out his alert to the market.

Then, I learned that the Centers for Medicare and Medicaid Services (CMS) had already made its decision to reverse the rate cuts much earlier, two weeks before the Height Securities alert.  The press has reported that there were major spikes in options trading on March 18th and March 22nd. Options trading is one way folks on Wall Street make big bets on a stock when they think they have a sure thing.

March 18th happens to be the first trading day after CMS made its decision internally. March 22nd happens to be the day that CMS transmitted its draft decision to the White House more than a week before the public announcement. On that date, the circle of people in the administration who would have known about the CMS decision expanded significantly.

This suggests that political intelligence firms may have obtained key information for their clients in mid-March, not just the day of the announcement on April 1st.  The press also reported on the possible involvement of another political intelligence firm, Capitol Street. Capitol Street arranges conference calls between investors and governments experts.

In addition, I have asked two major hedge funds mentioned in the press whether they profited from trades in advance of the rate announcement. So the scope of my inquiry is broad. It is not focused on particular people.  It is focused on the facts.

The Securities and Exchange Commission is also investigating. It is their job to determine whether any material non-public information was passed to Height or to anyone else in this case. That is not my job.  I am working on legislation to make the political intelligence industry more transparent. I am gathering facts to inform that legislation.

Remember, political intelligence does not necessarily involve material non-public information. But, people in government need to know who they are talking to and what they will do with your information. That is why it is so important to ensure that political intelligence relationships are transparent. Even if the information you provide is merely an educated guess, it can still move markets. It can still create an impression that a fortunate few are making money from special access to insiders.

If political intelligence transparency is passed, government officials would be more fully informed when they provide expertise to these firms about how the information might be used. But as things stand, without transparency, you do not necessarily know what firms like Height Securities or Capitol Street do with the information you provide to them.

You don’t know if they have a contract with a lobbyist who is bringing in some other client for a meeting. You don’t know that your discussion with that lobbyist’s client might be repeated to people who are looking for an edge in the stock market. What you think may be an innocent detail or an educated guess may move markets.

At the end of the day, that is what these firms want to exploit.  That is what they are after. That is what they sell. They should be honest and upfront with people about how they make money. Lobbying disclosure isn’t perfect, but it has brought more transparency to the process.

Now, we need political intelligence disclosure too, for the same reasons.  Transparency increases the public’s ability to trust that we are working for them, not for just for special interests. That principle should apply just as much to special interests on Wall Street as it does to special interests on K Street.

Integrity’s Comments

Senator Grassley wanted to make it clear in his floor speech last week that he IS NOT accusing anyone of wrongdoing in the CMS case, nor is he interested in banning political intelligence firms.  He is also saying that political intelligence is not necessarily the same as material nonpublic information.

Grassley, in his speech, was clear that his primary interest in investigating political intelligence firms Height Securities and Capitol Street, law firm Greenberg Traurig, and various hedge funds mentioned in a Wall Street Journal article on the subject is to “gather intelligence” so he can draft better legislation to have political intelligence firms purportedly register like lobbyists do.

Grassley was also extremely clear about why he thinks registration of political intelligence firms would be a good idea.  In his speech he explains:

“If political intelligence transparency is passed, government officials would be more fully informed when they provide expertise to these firms about how the information might be used. But as things stand, without transparency, you do not necessarily know what firms like Height Securities or Capitol Street do with the information you provide to them.  You don’t know if they have a contract with a lobbyist who is bringing in some other client for a meeting. You don’t know that your discussion with that lobbyist’s client might be repeated to people who are looking for an edge in the stock market. What you think may be an innocent detail or an educated guess may move markets.”

He believes that additional legislation is needed to create transparency about the type of information that investors glean from Washington DC.  He also wants government officials to be able to know if the people they are communicating with and providing information to are using this information to make profitable investments.

While the Senator is clear about why he wants more transparency on the political intelligence space, I have a few problems with Senator Grassley’s arguments.  First, I am confused why the Senator believes government officials need to know when the information they are providing is going to potential investors versus to any other type of constituent?   Shouldn’t everyone have unfettered access to the same information about what is happening in Washington DC?

The only reason I can find is that the Senator wants to discriminate in some way against investors versus every other type of interested party.  Perhaps this is because he is concerned about the negative perception that is created when stories like the one about the CMS reversal breaks.  This seems to be consistent with his comments that, “It [political intelligence] can still create an impression that a fortunate few are making money from special access to insiders.”

The Senator also argues that transparency for the political intelligence industry would, like the transparency created for lobbyists under the Lobby Disclosure Act (LDA), be a good thing to rebuild the public’s trust and confidence in Washington.

However, I think comparing political intelligence firms to lobbyists is an unfair comparison.  The LDA was created because of the extreme conflicts of interest that exist between lobbyists who lobby on behalf of special interests and the lawmakers themselves who could financially benefit from those lobbyists and their clients through political donations.  These relationships demanded transparency.

Political intelligence firms, however, typically don’t have the same conflicts of interest when it comes to their Washington sources as lobbyists do with lawmakers.  While political intelligence firms and hedge funds could provide political donations to Washington insiders who share information with them, these donations are typically small in nature (and they are already covered by laws limiting and tracking political donations).

Clearly, Senator Grassley is convinced that political intelligence firms, and the institutional investor clients who hire them, warrant some level of special attention and transparency.  Perhaps this is because many of these firms – and particularly those from the hedge fund community – have attracted a growing distrust among the public given the significant number of insider trading investigations and convictions that regulators have obtained over the past few years against them.

Certainly, it is pretty easy for Washington to hold hedge funds up as the poster child for Wall Street excesses and misdeeds.  Very few will feel sorry for them.  Unfortunately, political intelligence firms are getting caught in the cross fire.

Gerson Lehrman Group, the leading expert-networking firm, recently hired a former Securities and Exchange Commission enforcement lawyer to lead its compliance effort. Michael King, a former Enforcement Division lawyer based in the SEC’s Fort Worth, Texas office, was named GLG’s chief compliance counsel, reporting to general counsel Laurence Herman.

Last time we checked, GLG employed 22 people in its legal and compliance departments.  Many of the compliance professionals are based in GLG’s large Austin Texas office.

GLG has not has not been accused of any wrongdoing in the insider-trading investigations. GLG was identified as the firm that connected former SAC Capital Advisors portfolio Mathew Martoma with the doctor who allegedly passed him tips about Alzheimer’s drug trials.

The SEC’s complaint against Martoma, CR Intrinsic Investors LLC, an affiliate of SAC, and Dr. Sidney Gilman, explicitly references the compliance safeguards that GLG has in place.  According to the complaint, Gilman received training from GLG on the prohibitions of Federal securities law, and was repeatedly reminded not to share non-public information with clients.  Further, GLG sent emails to Gilman explicitly listing bapineuzumab, the drug in a Phase II trial, as a topic that Gilman was “not allowed to discuss.”

According to the complaint, Martoma and Gilman scheduled their consultations through GLG to coincide with meetings of the clinical trial’s Safety Monitoring Committee (SMC).  Martoma allegedly misled GLG on the topics being discussed.  Between 2006 and 2009, Martoma apparently had 42 consultations with Gilman arranged by GLG.  Gilman was paid $108,000 by GLG during this period for his consultations with CR Intrinsic, including an additional 17 consultations with others in the organization.

Gilman has pleaded guilty and is cooperating with authorities.  Martoma has pleaded not guilty.  CR Intrinsic agreed to pay a settlement of $616 million while neither admitting nor denying the charges against it and the settlement has been tentatively accepted by the federal judge overseeing the case.

New York, NY – The investigation into a potential leak of information from the Centers for Medicare & Medicaid Services regarding an important policy decision reversal announced early last month continues to be the topic of numerous newspaper articles last week.  All this coverage has prompted many in the media to weigh in on these stories.  However, amongst all this coverage, we have seen conflicting views about whether information obtained from Washington DC “insiders” can be considered MNPI and thus prompt an insider trading charge.  The following is the start of a discussion on this topic. 

Insider Trading Basics

Those of you who are regular readers of this blog know that the prohibition against “insider trading” is based on obtaining material non-public information or MNPI to either trade on or to pass along to others who then profit from this information. 

Traditionally, insider trading was directly associated with the misuse of material non-public information about a public company or the market for a public company’s securities.  However, in the past few decades, regulatory action and case law has expanded the definition of insider trading to other securities markets – including government bonds, commodities, and other public securities. 

In addition, it has become clear that market moving information other than that directly associated with a public company, including government economic releases, or information about regulatory and legislative developments obtained from Washington DC insiders, could also be considered MNPI.

Is It Material?

Information is considered material if there is a substantial likelihood that a reasonable investor would consider it important in making a decision to buy or sell a security.  In addition, material information, when disclosed, is likely to have a direct effect on the market price of a public security.

Examples of material information in the Washington context might be information that a merger was approved by Congress as happened in 1985 with the approval of the Standard Oil of California merger with Gulf Corp. to form Chevron.  From 2004 to 2006, Congress considered creating a trust fund to cover medical costs and resolve asbestos-related lawsuits.  During this period, the changing prospects for this bill had a direct impact on the stock price of companies like USG Corp., W.R. Grace & Co. and Crown Holdings.  CMS’s recent reversal of a decision to cut Medicare Advantage payments was also information which, when released, had a huge impact on the price of a few healthcare stocks.

Of course, it must be noted that obtaining or trading on information that is solely material DOES NOT make it insider trading.  In fact, most investors trade regularly on material information including the passage of certain key bills, the release of corporate earnings results, or the reporting of major economic releases.  For material information also to be MNPI, it must meet a few other key thresholds.

Is It Non-Public?

Insider trading does not take place unless someone trades on (or passes along) information that is BOTH material and non-public.  Information is non-public when it has not been disseminated in a way which makes it available to investors generally.

Information is public once it has been reported on a broadly distributed news source such as the Wall Street Journal, New York Times, or other widely disseminated publications.  In more recent years, public dissemination of information has also included distributing it via the Internet.  In fact, recently, the SEC admitted that a corporate executive did not violate Regulation Fair Disclosure by disseminating market moving company information on his personal Facebook page.

Besides being broadly disseminated via a news outlet or the internet, investors must then have a reasonable time to react to the information before it is considered “public”.

However, many in Washington argue that most of the information collected by policy research, political intelligence, or lobbyists on behalf of investors cannot be MNPI because a number of legislators, staffers, and lobbyists generally know about it and are discussing it.  Unfortunately, this view is not consistent with the definition of “public information” that has historically been accepted by the courts. 

In other words, the mere fact that two or three dozen people know about a development inside the beltway does not mean that is public knowledge.  Therefore this information could be found to be MNPI if all other conditions are met.

Is It In Breach of a Duty?

Trading on or passing along information that is both material and nonpublic might not be considered to be insider trading unless one more rule is broken.

Under the “misappropriation theory” an individual is guilty of insider trading when they either provide or trade on “material non-public” information in violation of a “duty of trust and confidence” owed either to the company who the information is about, or the person who disclosed the information. 

Traditionally, this fiduciary duty of trust applied to an issuer’s directors, officers and employees, investment bankers, underwriters, accountants, lawyers and consultants, as well as other persons who have entered into special relationships of confidence with an issuer of securities.

Historically, it was unclear whether there could be insider trading when it came to information collected from political insiders.  Many argued that Members of Congress and their staff did not have a “duty of trust and confidence” to keep information private.  Consequently, without a violation of this duty, there is no insider trading according to the misappropriation theory. 

However, on April 4, 2012, this all changed when President Obama signed into law the Stop Trading on Congressional Knowledge Act (the STOCK Act).  In Section 3 of the STOCK Act, the fiduciary duty required for insider trading liability under the misappropriation theory was established.  The relevant language in this section said that:

“Each member of Congress or employee of Congress owes a duty arising from a relationship of trust and confidence to the Congress, the United States Government, and the citizens of the United States with respect to material, non-public information derived from such person’s position as a Member of Congress or employee of Congress or gained from the performance of such person’s official responsibilities.”

The Act also specifies that “Members of Congress and employees of Congress are not exempt from the insider trading prohibitions arising under the securities laws, including section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.” The Act further directs ethics committees in all three branches of government to clarify that insider trading violates their internal ethics rules.

Ultimately this means that information provided by a member of Congress or employee of Congress about a material nonpublic development that they learned while doing their job, might be considered a violation of insider trading law if it were traded on, or if it were passed on to someone else who traded on this information.

Summary

So what does this all mean?  In our view, trading on or passing along information collected from political insiders, such as Members of Congress, their staff, or employees of Federal Agencies could run afoul of insider trading law if that information is deemed both material and generally not known.  Consequently, we believe that investors who use this type of information need to assess it on the same basis as they would any other type of market moving information. 

We also think that research firms that collect information from political insiders, whether as an input into their own research, or as direct intelligence for their clients, need to adopt a formal and rigorous compliance process to identify and potentially quarantine any information which they see as both market moving and broadly unknown.  Unfortunately, our research shows that many research firms that engage in this type of information sourcing disregard this risk and don’t have great compliance controls in place.

Clearly the rules have changed and insider trading is now more possible than ever with information gathered from Washington political insiders.

Co-founder Nancy Lazar has left ISI Group to form a new macro research shop, Cornerstone Macro LP, taking with her François Trahan of Wolfe Trahan.  They are joined by ISI’s policy team, Andy Laperriere and Roberto Perli, which has been ranked #1 in Institutional Investor’s policy category for the past 2 years.

Nancy Lazar’s defection is surprising given her three decade tenure with Ed Hyman.  Lazar started working for Hyman at CJ Lawrence, after graduating from Kalamazoo College in 1979.  They left CJ Lawrence in 1991 to co-found International Strategy & Investment Inc., now known as ISI Group.

Andy Laperriere also had a long history with ISI, having joined the firm in 1999, fresh from a stint as a congressional staffer to Dick Armey.  Laperriere has been a top-ranked policy analyst for the last 10 years.

Lazar and Laperriere are not the first defections from ISI.  Jason Trennert left ISI where he had previously been its top-ranked Chief Investment Strategist in 2006 to form Strategas Research Partners LLC.  François Trahan joined Ed Wolfe in 2010 to form Wolfe Trahan after being Trennert’s replacement as Chief Investment Strategist at ISI.   Chris Senyek left ISI as a top-ranked head of Accounting & Tax Policy research in 2011 to join Wolfe Trahan.

As we noted at the time, the reported issue behind the defections wasn’t pay but ownership.  Ownership in ISI is tightly controlled by Ed Hyman.  However, Nancy Lazar was an owner of ISI, so it is likely that other factors came into play with her departure.

Meanwhile, Wolfe Trahan as reverted to Wolfe Research, and announced that Chris Senyek has been promoted to Chief Investment Strategist and Lead Quantitative Analyst.   He will also continue heading the Accounting & Tax Policy research team.

Cornerstone Macro press release: http://www.cornerstonemacro.com/press-releases/top-ranked-macro-veterans-lauch-cornerstone-macro-lp/.

Wolfe Research release: http://www.businesswire.com/news/home/20130429006727/en/Wolfe-Research-Names-Chris%C2%A0Senyek%C2%A0Chief-Investment-Strategist-Lead

In the wake of CFRA’s spinoff, Institutional Shareholder Services Inc. (ISS), a leading proxy research provider, announced it is now distributing third party governance research. The move underlines the question of how well forensic research fits with governance-oriented research.

ISS announced that it has opened its ProxyExchange(TM) platform to third party research and data providers including executive compensation analysis from Farient Information Services, a subsidiary of Farient Advisors, a consulting firm specializing in executive compensation.

Farient Information Services is headed by Jack Zwingli, who led GMI Ratings for a period after the merger of GMI, Audit Integrity and The Corporate Library, the latter founded by two ex-ISS employees, including ISS co-founder Robert A.G. Monks. Small world.

ISS will also distribute research two non-U.S. proxy research providers: UK-based PIRC (Pensions Investment Research Consultants, Ltd.) and Germany’s IVOX.

Last month, ISS’s parent MSCI announced it was selling CFRA, which had been integrated with ISS. The disposal of CFRA and the addition of executive compensation data and international proxy research send the signal that ISS did not find CFRA a good strategic fit. Should we conclude that forensic research is not a good fit with governance research?

The reality is that governance research and forensic research have different consumers within institutional investors. That, combined with the fact that governance research is equally important outside the investor community, make for different product and distribution requirements. Clearly, ISS had trouble reconciling those, or perhaps didn’t bother. It appears that the absence of CFRA is allowing ISS to focus more on its core market.

New York, NY – A few weeks ago, a case involving a Canadian investment banker who figured out about an upcoming merger on his own and profitably traded on this information, has settled his case with both the SEC and the Ontario Securities Commission.  While the two regulators agreed that the banker acted illegally, they came to different conclusions about whether he misappropriated and profited from inside information.

Background of the Case

The two cases, filed separately by the Securities and Exchange Commission and Canada’s Ontario Securities Commission were against Richard Bruce Moore.  Mr. Moore worked at Canadian Imperial Bank of Commerce in several capacities during his 20 years at the bank, before moving to UBS Securities Canada in 2012.

These cases involved trading in Tomkins plc, a British maker of auto parts, before it received a takeover offer from the Canadian Pension Plan Investment Board (CPPIB) and a private equity firm, Onex Corp., in July 2010.  The takeover offer led the share price of Tomkins to rise 27%, from $13.87 to $17.67 a share.

At the time, one of Mr. Moore’s investment banking clients was the CPPIB.  Unbeknownst to Moore, the CPPIB was planning to make an offer for Tomkins in conjunction with Onex Corp.  In dealing with one of the CPPIB’s senior
representatives, Mr. Moore learned that the pension board was considering a significant transaction, but that Moore’s employer, CIBC, would not be involved in the deal.

Although there were rumors that Tomkins would be taken over, Moore learned a number of general facts from the CPPIB’s representative that enabled him to determine who the merger target was.  For example, Mr. Moore learned from his contact at the CPPIB that the pension board was looking for US$2 billion in financing involving a company in Europe and the U.S.

The “final piece of information” behind Mr. Moore’s investment in Tomkins, was after he saw the pension board representative speaking with someone at a charity event.  The pension board representative refused to introduce them or even identify who he was speaking with.  In a separate conversation, a third party identified the unknown person as the chief executive of Tomkins.  Mr. Moore concluded that the CPPIB was planning to make a merger offer to Tomkins.

Based on this assessment, Mr. Moore started buying Tomkins stock through an offshore account, ultimately buying 212,000 shares, valued at £508,249.90.  His trades included buying American depositary receipts in the company that were traded on the New York Stock Exchange.  This gave the S.E.C. jurisdiction over the case.

The Ontario Securities Commission’s Ruling

The Ontario Securities Commission (OSC) concluded that Mr. Moore traded improperly in Tomkins shares. In its settlement with Mr. Moore, it stated that at no time did the pension board representative “ever provide Moore with any material, generally undisclosed information.”

Instead, the regulator said he “ought not to have made use of information obtained in part by virtue of his position as an employee of a registrant prior to its general disclosure to the public.” In doing so, the commission said, Mr. Moore acted “contrary to the public interest.”

The OSC said in its complaint that Mr. Moore’s conduct “fell below the standard of behaviour expected from someone in Moore’s position and given his extensive experience in the capital markets industry.”

The regulator explained that Mr. Moore purchased the shares of Tomkins in two brokerage accounts in Jersey, a Channel island, and did not disclose the offshore accounts to CIBC “as required by its compliance policies.”

The OSC did not find that Moore engaged in insider trading with regards to Tomkins, but only that he acted inappropriately given his position in the securities industry.  This is partially a result of the fact that in Section 76 of the Ontario Securities Act, a defendant is required to be “in a special relationship with a reporting issuer” when trading in its securities to be guilty of engaging in insider trading.

The OSC fined Moore $300,000 and barred him from future involvement in the securities industry.  Click here for more information about the OSC’s settlement with Mr. Moore.

The SEC’s Ruling

The SEC, however, concluded that Mr. Moore’s actions were in fact, insider trading.  The SEC argued that Moore either knew, or was reckless in not knowing, that the information that he traded on regarding the Tomkins merger was both material and non-public.  Click here for more details about the SEC’s complaint.

In addition, the SEC argued that this information had been acquired in the course of his employment with CIBC, and that Moore had knowingly or recklessly misappropriated this information about the merger from CIBC for his personal benefit by purchasing Tomkins ADRs ahead of the announcement that Tomkins had received an acquisition offer.

In other words, the SEC claimed that by pulling together different strands of information about the impending deal from a client, Mr. Moore had “misappropriated that information from his employer by purchasing Tomkins securities.”

The complaint alleges that, purely through his purchase of the ADRs, Moore realized illicit gains of more than $163,000.  As a result, the SEC ordered Moore to pay over $340,000 in disgorgement of profits, penalties, and interest.  Moore also agreed to a ban from associating with any broker, dealer, investment adviser, municipal securities dealer, or transfer agent, and from participating in any penny stock offering.

Click here for more details about the settlement the SEC reached with Mr. Moore in this case.

Consequences of these Settlements

Clearly, the actions taken by Mr. Moore appear to be fishy.  After all, he made a large investment in the stock of Tomkins plc shortly after gaining information that was not public, resulting in a quick profit.  In addition, he hid his investment in Tomkins by opening up and trading through secret brokerage accounts that he did not inform his employer about.  Moore also made a huge bet involving almost one-third of his net worth showing that he believed the information he had obtained was extremely valuable.  Finally, Mr. Moore was employed in the securities industry.  All of these facts seem to indicate that Mr. Moore’s activity had to be questionable, if not insider trading.

Despite these facts, it doesn’t appear that Moore crossed any of the traditional lines which indicate that insider trading has occurred.  First, Moore did not obtain confidential information from any source at the pension board about the Tomkins merger, as was made clear by the OSC.  Moore merely put together a number of disparate facts and rightly came to the conclusion that the CPPIB was planning to acquire Tomkins.

In addition, Moore did not glean any information from CIBC in this case, because the bank was not involved in the transaction in any way.  Regardless of this, the SEC concluded that Moore misappropriated the information he collected from his employer because he was able to get that information only due to his position as a banker for CIBC.

Ultimately, in this case the SEC seems to be saying that the mosaic theory doesn’t always apply.  This is particularly if you get information as a result of your job which enables you to deduce something going on at another company who happens to be your client (a little convoluted don’t you think?).  If you profit from information gathered in this manner, you can be seen to violate the insider trading prohibition.

In our opinion, the SEC’s case against Mr. Moore shows that it is continuing to take an extremely aggressive approach to bringing insider trading cases by pushing the limits of what constitutes illegal activity.  The lesson we think market participants should learn from this case is that you should be extremely careful if you learn something about a public company, even if you do so by reaching the conclusion as a result of putting together a number of clues, if that information enables you to generate a quick profit.  Clearly the regulators are trying to make the case that profiting in this way must have resulted from some type of illicit activity.