Does Primary Research = Insider Trading?


New York – Today’s Wall Street Journal reports that discount retailer Big Lots, Inc. has sued Retail Intelligence Group, a channel checker who provides primary research to institutional investors, for “illegally pinching information out of store managers.”  This lawsuit reinforces the perception among reporters and others we speak with that primary research is equivalent to insider trading.  Expert networks, channel checks and other primary research techniques are primarily set up to uncover non-public information, information that is not yet widely known or incorporated in financial markets.  Isn’t this illegal?

Inside the Insiders

Let’s start with the legality.  Insider trading begins with insiders.  Under US law, insiders are not just company executives or directors, but include lawyers, investment bankers or others that receive confidential information in the process of performing a service for a company.  It also encompasses those who “misappropriate” confidential information from their employer, such as when Wall Street Journal reporter R. Foster Winans traded in advance of “Heard on the Street” columns.  Insider trading occurs when shares are traded on the basis of material non-public information in violation of some duty of trust.

A recent example is Yves Benhamou, who is accused of passing information about a drug trial he was running for Human Genome Sciences (HGS).  If true, Benhamou would be guilty of violating his fiduciary duty in administering the trial.  For this reason, expert networks explicit prohibit the passing of material non-public information.  If Benhamou participated in Guidepoint Global’s network, as the WSJ has alleged, he would have signed an agreement which forbids the passing of material non-public information as well as explicit language forbidding the passing of information about clinical trials, among other prohibitions.

Partly for this reason, it appears from published accounts that when Benhamou is alleged to have tipped portfolio managers, he did so outside the expert networks.  The other reason he would be inclined to circumvent the expert networks if passing material non-public information would be that they maintain audit trails of all conversations between clients and participating experts.

Non-Public Information = Illegal?

All well and good, you say, but how seriously can we take the compliance processes of expert networks and other primary research providers when the whole appeal of primary research is essentially finding non-public information that isn’t widely recognized yet?  Isn’t everything done through an expert network essentially illegal?

This brings us to security analysts, whose job it is to identify mispriced stocks through a process the CFA Institute labels mosaic theory.  Analyzing a company can be compared to creating a mosaic; that is, by assembling small bits of nonpublic information together, large and meaningful conclusions can be drawn.  Here is an excerpt from the Level 1 CFA materials on Ethics and Standards:  “The idea behind the mosaic theory is that each individual piece of information is nonmaterial by itself: an individual piece of information would not move the price of the security if disseminated in a public press release. Taken together, however, the bits of information can form a meaningful mosaic. This practice is perfectly legitimate, and it is encouraged.”  Full text here.

Mosaic is an apt description for how we see analysts using primary research.  For example, analysts following YUM Brands might speak with KFC store managers in China.  Store managers have non-public information, but they have no knowledge of the aggregated earnings for all of YUM’s brands.  If you issued a press release summarizing a conversation with each of the store managers, it is unlikely that they would move YUM share price. However, taken collectively and combined with knowledge of KFC’s contribution to earnings, currency rates, and other factors, the analyst begins to formulate a view on how strong YUM’s upcoming earnings might be.  Think of the mosaic theory as a way for analysts to do their jobs and use nonpublic information without feeling like they are at risk for liability under insider trading law.


Big Lots, Inc. (BIG) has different ideas about mosaic theory, and its suit, filed with the assistance of prestigious Cravath, Swaine & Moore, asks for an injunction against Retail Intelligence Group (RIG) to prevent “wrongfully induced” snooping.  According to BIG, “Legitimate research firms do not seek to obtain nonpublic information to tip off selected investors at the expense of others.”

RIG issued a report questioning BIG’s outlook on October 20th.  The report was based on interviews with 72 Big Lots store managers and forecasted quarterly sales to rise 1.8%.  Nine days later BIG’s share price fell 5.4%.  On November 4th, BIG reported third quarter earnings with the company CEO warning of ‘inconsistent sales trends’ and sales growth of 2.4%.  The stock fell another 6% on heavy volume.

In other words, RIG’s report was accurate and timely.  BIG claims that it was also illegal, apparently based on three arguments: 1) it was based on nonpublic information, 2) its employees were illegally induced to disclose trade secrets and 3) the report was selectively disclosed.  We doubt the nonpublic argument will get very far because of mosaic theory.  The argument about employees has more weight if BIG had explicit policies defining what it considers confidential which were well communicated to employees.  RIG’s modus operandi is not to pay for the information it collects, so if there is an issue here it would be whether RIG induced employees to violate clearly defined company regulations. Selective disclosure is a more interesting argument, which requires a separate discussion.

BIG would not be the first issuer to try to intimidate security analysts with negative views.  Biovail (now Valeant Pharmaceuticals) and sued Gradient Analytics in 2006 for allegedly colluding with hedge funds to drive down their stocks.  The SEC investigated and found no wrongdoing on the part of Gradient.  Valeant recently settled with Gradient, issuing a statement that Biovail’s original litigation against Gradient was ‘regrettable’.  We would not be surprised if the BIG – RIG case plays out similarly.


Insider trading is a broad topic which is mostly defined by case law rather than clear regulatory statutes.  Because of the gray areas surrounding the definition of insider trading, it is easy to be swept up in the emotion surrounding what the WSJ is billing as the mother of all insider trading cases.  However, current US law does not prohibit the collection of nonpublic information, provided it is done consistent with the mosaic theory.  Channel checkers like RIG, expert networks and other primary research providers are designed to facilitate the collection of mosaic information.  If material non-public information gets conveyed through these channels–and it is not yet clear that it has—it would be contrary to the rules and procedures these firms have established.  Most importantly, the intrinsic purpose of these firms, which is to help uncover nonpublic information, does not violate insider trading regulation.  Yes, BIG, legitimate research firms DO seek to obtain non-public information.


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