Academic research has shown evidence of abnormal trading prior to analyst recommendation changes and forecast revisions, concluding that select market participants were receiving advance notice of the pending research. Although regulators have devoted some attention to this topic, the level of activity is far lower than other insider trading enforcement actions. A low volume of enforcement and a lack of clarity in the rules surrounding research dissemination suggest that selective dissemination remains a lower priority on the regulatory agenda. However, given general interest in insider trading enforcement, this situation may not persist for long.
Academic Research on Selective Dissemination
Academic research on the topic is surprisingly plentiful. An article in the Review of Financial Studies in 2007, entitled “Tipping,” by Paul Irvine, Marc Lipson, and Andy Puckett concluded that institutional investors were getting advance notice of unreleased analyst reports. The study compared the level of institutional trading to the total trading volume of all investors and found that institutional trading increased significantly in the days prior to initial “buy” or “strong buy” analyst recommendations.
“Abnormal buying is related to initiation characteristics that would require knowledge of the content of the report—such as the identity of the analyst and brokerage firm, and whether the recommendation is a strong buy. We confirm that institutions buying before the recommendation release earn abnormal profits. Our results are consistent with institutional traders receiving tips regarding the contents of forthcoming analysts’ reports.”
A paper published in the Journal of Financial Economics in January 2010 titled “Informed Trading Before Analyst Downgrades: Evidence from Short Sellers,” by Stephen E. Christophe, Michael G. Ferri, and Jim Hsieh came to similar conclusions.
The study examined short-selling prior to the release of analyst downgrades and excluded instances that might independently impact share prices such as earnings announcements, revisions to management forecasts or dividend changes. The authors concluded that the data showed evidence of selective dissemination of research:
“Overall, our tests strongly support the informed front-running hypothesis. We document a sharp increase in short-selling immediately before analyst downgrade announcements… The fact that the evidence strongly supports the tipping hypothesis raises serious issues regarding whether some clients of certain brokerage firms benefit from material private information about upcoming downgrades.”
A paper published September 2010 titled “What Do Short Sellers Know?” by Ekkehart Boehmer, Charles M. Jones, and Xiaoyan Zhang confirmed that there is there is heightened shorting activity in the week before downward analyst recommendation changes and also found heightened shorting in the week before downward analyst forecast revisions. However, the authors were unsure whether investors were independently arriving at the same conclusions as analysts, or being tipped.
A paper titled “Lehman Equity Research Tipping: Evidence in the Stock Price Data” published March 2010 by Steven P. Feinstein examined stock prices prior to downgrades made by Lehman Brothers and concluded that Lehman was providing advance notice to clients.
“Based on widely used and generally accepted quantitative methods, I have determined, to a high degree of statistical certainty, that the price behavior of stocks downgraded by Lehman Brothers during 2004 to 2008 indicates that information about imminent downgrades was likely communicated privately to select market participants prior to the public announcements.”
After a Wall Street Journal article titled “Goldman’s Trading Tips Reward Its Biggest Clients” was published in August, 2009, the SEC and other regulatory authorities began investigating Goldman Sachs’ controls on the selective dissemination of research. In April, 2012 Goldman Sachs agreed to pay a fine of $22 million without admitting or denying the SEC’s findings that it violated Section 15(g) of the Securities Exchange Act of 1934, which requires broker-dealers to maintain adequate policies and procedures to prevent the misuse of material non-public information.
The SEC complaint stated that between January 2007 and August 2009 there were hundreds of instances when a ratings change occurred within five business days after the stock was discussed at a huddle or referenced in huddle-related documents. The SEC cited specific instances when publishing analysts recommended stocks during huddles after having drafted reports upgrading the stock from Neutral to Buy, or after having proposed downgrades to stocks to research management.
Rules Regarding Research Dissemination
The disclosures around the regulatory investigation of Goldman’s trading huddles showed confusion among Goldman analysts and others about what was permissible. The reality is that there are no clear regulatory guidelines on research dissemination. In 2008, FINRA proposed rules to govern research dissemination which require registered research providers to “establish, maintain and enforce policies to ensure that research reports are not distributed selectively to internal trading personnel or a particular customer or class of customers in advance of other customers that are entitled to receive the research report.” However, these rules have not been adopted.
Instead, research dissemination falls under general regulations surrounding inside information, which themselves are not clearly spelled out. Complicating the issue around research dissemination is the issue of when research becomes material. Research from publishing analysts at the largest brokerage firms is considered material because it has the potential to be market moving. But what about smaller brokerage firms? Do their recommendations move markets?
Even within the largest brokerage firms, things can get confused between publishing analysts and desk analysts, which sit near the trading desks and generate short term trading ideas. (Perhaps coincidentally, Lehman Brothers was the first major brokerage firm to systematically implement desk analysts for equity research.) If desk analyst research moves markets, does its selective dissemination violate inside information rules?
With the exception of the investigation of Goldman’s trading huddles, which was triggered by an article in the Wall Street Journal, regulatory attention to selective dissemination of research has been minimal, especially compared to the efforts expended on Galleon, Primary Global Research, and other recent insider trading enforcement actions. If the regulatory agenda is to increase scrutiny of hedge funds, then selective dissemination is not as appealing to regulators as current enforcement targets, since selective dissemination primarily impacts investment banks and other research providers not hedge funds.
Nevertheless, research firms cannot assume regulatory ambivalence to selective dissemination will necessarily persist. All it takes is some high profile media attention to get the topic back on the regulatory front burner.