Is Primary Research Immoral?


New York – If non-public information isn’t necessarily illegal, surely it is unethical?  Don’t high priced expert networks and other primary research providers disadvantage small investors?   Aren’t hedge funds getting an unfair advantage? Investigators led by Preet Bharara, the United States Attorney for the Southern District of New York, seem to think so.   Ultimately regulators – or the courts – will have to decide how fair markets must be, a decision which will impact how investment research gets done.

The New Sheriff

The collapse of Drexel Burnham in the ‘80s gave us Rudi Giuliani, the dot com collapse in 2000 gave us Eliot Spitzer, and the recent financial crisis has now given us Preet Bharara, who is the mover and shaker behind the current investigations.  Bharara was appointed the United States Attorney for the Southern District of New York in 2009, overseeing more than 200 lawyers.  Bharara had previously worked as a prosecutor in the Southern District from 2000 to 2005.

Bharara oversees cases against terrorists, organized crime and narcotics, but he has bet his career on insider trading. Insider trading is a passionate topic for Bharara, as evidenced by remarks to the New York Bar last October:  “Disturbingly, many of the people who are going to such lengths to obtain inside information for a trading advantage are already among the most advantaged, privileged, and wealthy insiders in modern finance. But for them, material non-public information is akin to a performance-enhancing drug that provides the illegal “edge” to outpace their rivals and make even more money. In some respects, inside information is a form of financial steroid. It is unfair; it is offensive; it is unlawful; and it puts a black mark on the entire enterprise.”

Note that the concept that something that provides an investment edge is unfair and unethical.  This view encompasses not just material non-public information, but any non-public information.  This leads us directly to the notion that primary research, which unquestionably can be a source of alpha, is inherently unethical, unfair, and illegal.

How We Got Here

Ironically, regulatory attempts to create a level playing field such as Regulation Fair Disclosure have increased investor interest in primary research.  This happened because all the small, non-public mosaic bits became more valuable when company insiders weren’t whispering earnings guidance to their favorite security analysts.  Another regulatory initiative, the Global Research Settlement, has shifted more security analysts from the sell side to the buy side, also increasing demand for primary research.

The problem is how far do you go?  Is the goal for all investors to have exactly the same information? Do you ban Goldman Sachs’ proprietary research because it is more costly than most individual investors can afford?

Or is it permissible for investors who do more work and due diligence to profit from it?  Some hedge funds saw through the mortgage-backed securities bubble and profited from that.  In some cases, their due diligence involved speaking to ratings agencies, investment bankers and mortgage lenders, sources that an individual investor would not typically be able to access.  It is painful for investors who lost money as a result of the sub-prime debacle to see John Paulson make billions, but does that make Paulson unethical?

Challenging the Concept of Insider Trading

Some economists and legal scholars have argued for the removal of insider trading regulation.  According to Milton Friedman, laureate of the Nobel Memorial Prize in Economics: “You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that.”  For example, an Enron would have come to light more quickly if insiders had been permitted to sell more freely.

Charles Gasparino argues that insider trading is largely a victimless crime: “Once someone starts trading on the information, the markets digest the trades — prices rise (or fall), sharing the impact of the tip in a process known as ‘price discovery.’ Yes, the guy with the tip makes money and people without the tip can lose money — but they’re going to lose money anyway, because they made a bad market bet, based on other information that turned out wrong.”

One proposal is to legalize insider trading while regulating stock trades placed by insiders. Any trade made by an employee, officer, director, or privileged professional (accountant, lawyer, investment banker, etc.) of a company is entered into the trading system with a special flag and counter parties would be able to adjust their bids and offers accordingly.  A small insider trade would probably get close to the market price but if a lot of insider trades started appearing, market players would quickly realize that something was going on.  The stock price would change quickly, eliminating the advantage of the inside information, and allowing the stock market to reflect the true value of the company.

Another problem is that insider trading concepts largely do not apply to financial markets other than equity markets.  In the real estate market, for example, a geologist has no obligation to disclose the fact that there is oil on your property when he offers to buy it, unless you hired him in the first place.  Commodities markets have little insider trading restrictions other than front-running.


Investigators are tapping emotions generated by the recent financial crisis to help fuel their insider trading investigations.  Ironically, the regulatory impulse to create fair markets has been a major factor in the rise of primary research tools such as expert networks or channel checkers.  Now investigators find these tools distasteful and are vigorously pursuing them.  However, we argue that primary research is neither inherently illegal nor immoral.  Ultimately, markets need information to be efficient, and tools that facilitate primary research have a rightful place in the market.


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