Trading Huddles, Selective Disclosure, and Front Running

New York, NY – Last Monday, the Wall Street Journal published a front page story revealing that Goldman Sachs’ research analysts have been regularly sharing short-term trading calls that, at times, have contradicted their longer term public views on a stock, with the firm’s best clients.  As a result of this story, the Securities and Exchange Commission, the Financial Industry Regulatory Authority (FINRA), and Massachusetts’ chief financial regulator have all commenced their own investigations into this practice.

The Facts of the Story

According to the Wall Street Journal story, for the past two years Goldman Sachs has been holding weekly “trading huddles” where analysts have been meeting with the firm’s proprietary traders and other staff to discuss short-term trading opportunities that might be of interest to some of Goldman’s larger, more active institutional clients. 

The surprising fact that came to light in this story is that many of the trading tips identified in these meetings were not consistent with the analysts’ published recommendations on the stocks.  Since the “trading huddle” program was started in 2007, Goldman has supplied hundreds of “trade ideas” to the firm’s traders and their top buy-side clients.

The Wall Street Journal article highlighted two such cases.  The first took place in early April 2008, when Goldman Sachs research analyst Marc Irizarry had a published “NEUTRAL” rating on mutual-fund company Janus Capital Group. But at an internal “trading huddle” that month, Irizarry told a number of Goldman’s traders that the stock was likely to rise ahead of the quarterly earnings report.

The following day, Goldman staff called about 50 of their largest clients with this “trading idea”.  Some of the clients that received this tip included hedge funds Citadel and SAC Capital Advisors.  Goldman’s other clients didn’t find out that Mr. Irizarry was positive on Janus until six days later when he formally raised his rating on the stock.  By this time Janus’ share price had already jumped 5.8%.

At the same “trading huddle” in early April 2008, Goldman analyst Thomas Cholnoky said that he favored MetLife Inc. over the other stocks in the insurance group.  However, shortly after the meeting, Mr. Cholnoky released a research report that reiterated his “NEUTRAL” rating on MetLife.  Strangely, one week later, Mr. Cholnoky raised his rating on MetLife to a BUY.   In addition, Goldman added MetLife to its “America’s Buy List” of top stock recommendations.

Goldman’s Explanation

Of course, comments from Goldman management suggest that they don’t see any problem with the “trading huddles” or the selective disclosure that arises from sharing these stock tips with a few of their best clients.

According to the WSJ article, Goldman spokesman Edward Canaday said these stock tips were merely “market color” and that they were based on a fundamental view that is consistent with the analysis published in Goldman’s research reports.

Canaday explained that “analysts are told that any comment at a meeting that could result in a change in a rating, earnings estimate or stock-price target ‘must be published and disseminated broadly to all clients.’ He adds, however, that it is rare that tips arising from the meetings reach that threshold.  He says ratings changes after the meetings also are rare.”

Responses from Others

As you might guess, some of Goldman’s smaller customers weren’t happy after learning that Goldman’s larger clients have been privy to stock tips from these “trading huddles” they have not received.  The real question is how many clients will Goldman lose in the wake of this story?

Despite this, some investors say that Goldman Sachs is not alone in showing favoritism to its largest most profitable customers at the expense of smaller clients.  Many Wall Street firms provide their largest clients with insight and information that others don’t receive.  These market participants argue that as long as there is no deception involved and clients aren’t being misled, then it will be difficult to make a case against Goldman that will stick.

However, not all Wall Street firms restrict their “trading ideas” to a limited clientele.  Morgan Stanley sends out e-mails to thousands of clients describing its short-term trading strategies, and it posts this information on its Web site.  The firm decided not to call their clients with these trade ideas for fear that this would create concerns over selective disclosure.  Morgan Stanley also discloses that it issues these short-term trading ideas in its regular research reports, and that these tips could be “contrary to the recommendations or views expressed in this or other research on the same stock.”

Regulatory Reaction

As we mentioned earlier in this article, in the wake of last week’s Wall Street Journal article, the Securities and Exchange Commission and examiners at the Financial Industry Regulatory Authority (FINRA), have asked Goldman Sachs for more clarity on the “trading huddle” practice and the details outlined in the WSJ article.

In addition, William Galvin, Massachusetts’s secretary of the commonwealth, has subpoenaed Goldman Sachs, demanding more information on the firm’s “trading huddles”.  Mr. Galvin has said that he is concerned that the stock tips provided as a result of these meetings have disadvantaged some of Goldman’s customers.

Some argue that the trade ideas generated from Goldman’s huddles could be senn to be illegal if a preceding formal rating change makes it appear that some clients were given advance warning of a stock’s movement while others weren’t.  Of course, this would be difficult to prove without considerable further investigation.

Another concern of some regulators is whether Goldman’s traders acted on the tips generated from the “trading huddles” before these trading ideas had been communicated to clients.  This will lead regulators to investigate Goldman’s policies for managing the appropriate handling of these tips.

Integrity’s Perspective

It is clear to the team at Integrity Research Associates that Goldman’s providing trading tips to its prop traders and largest customers disadvantages the clients who don’t get these recommendations.  What makes matters worse is that, at times these smaller clients have made investment decisions based on Goldman’s longer-term research, which has been at odds with the firm’s current views of those stocks.

However, in our view, one of the most damaging facts to arise from this story is that in at least a few instances, Goldman’s analysts changed their formal research ratings shortly after they revealed these changes in tips to a select group of clients.  Consequently, both Goldman’s largest clients and the firm’s proprietary traders could front run this information before the public learned of Goldman’s ratings changes.

Of course, sell-side analysts have always needed to serve multiple masters, including corporate issuers, investment bankers, traditional “long-only clients”, active hedge funds, and their own proprietary traders.  However, the pressure to serve the prop desk (and certain profitable hedge fund clients) must be particularly strong at a firm like Goldman Sachs which generates close to 10% of its profits by trading for its own account. 

The question that came to mind after reading last week’s Wall Street Journal story is, “Have the pressures of serving these masters in a difficult market environment created new conflicts of interest for sell-side research departments to put the firm’s own interests ahead of the interests of their clients?”  We will have to wait and see what the regulators discover as they investigate the Goldman “trading huddle” case.