Is the “Early Bird” an Insider?

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New York – News this week in the research space has centered on the primary research industry. Both expert networks and channel checkers have been assailed by the Manhattan U.S. Attorney’s Office and the Federal Bureau of Investigation issuing subpoenas.  Subpoenas have been sent by the Manhattan U.S. Attorney’s Office to SAC Capital Advisors, Citadel LLC, Janus Capital Group and Wellington Management, requesting trading, communications and other information around insider trading investigations.

In the equity investment space there are two types of research available to analysts, primary research and secondary research. From an analyst’s perspective, the secondary information might be the financials of the firm and any interaction with management, such as meetings or conference calls.  It should be clear that relying on management and financials generated by management exposes investors to potential fraud of the management team (aka Enron and Worldcom). As such, primary research is a vital informational counterbalance to relying completely on the management of a firm.

 As we have said in previous blogs, the mosaic theory of investment research is a process where an analyst seeks to collect small pieces of non-public information and aggregates these data points to create an informed view on a particular company or security. There is, of course, nothing wrong with this approach. One concern is that regulators (or even legislators) might move to a position where they interpret the definition of what constitutes insider information too strictly, thereby limiting the ability of institutional investors to utilize the mosaic approach. 

Many types of channel checks are completely free of compliance conflicts. For example, having mall teams counting GAP bags across the country on the weekend and then attempting to forecast GAP sales is fair game. Also, talking to store managers about how sales are going, how certain lines are selling etc. is also fair game.  The issue is whether the store managers have been compensated in any way to provide the information. This would imply a conflict of interest for the store managers.

The business press today indicates that expert networks are being investigated to see if they had leaked material non-public information to clients. While expert networks do organize calls between experts and investors, they are not in the business of providing information and, in fact, have undertaken major compliance efforts to ensure that the client and the expert have affirmed that they are not in violation of any laws by engaging in the consultation. The expert network is a tool through which the information exchange can occur. At least from a business model perspective, accusing the expert network of leaking information is analogous to blaming the car for a car crash. It is generally the users that are at fault, not the car.

However, if indeed there were illegal exchanges of information between clients and experts have occurred, the perpetrators should be prosecuted. The regulatory compunction will be to tighten up the insider rules. But is it the rules that failed us?  Or was it the enforcement that failed? Could it be that the rules are too extensive, in terms distorting price discovery in the marketplace?

Perhaps one part of the solution may be to rely on the old adage: “caveat emptor”. Since it is coming up to Thanksgiving, let’s use a football analogy. Football is organized into leagues, depending primarily on the level of play (and pay) of the teams in that league.  When we watch an NFL game, we are not interested in “leveling the playing field” so that a grade school player can compete on an equal footing with the pros. Rule makers could impose a no contact rule, force the faster players to slow down and ask get the larger players to “play nice”, but this would make for a dull game. And after all, there are leagues that allow the grade school players to play with their peers.

 So when a retail investor enters the stock market, that person should be aware they are playing in the big league, where they could get hurt.  And after all, there are other ways to participate in the market through diversified portfolios, such as mutual funds. Institutional investors will always have an advantage over retail investors, because they spend more money to gather information, have better trading systems and have been trained in the application of investment research.  

What is critical for regulators at this time is striking a balance between the free functioning of markets and the avoidance of fraudulent behavior, such as seeking and trading on insider information. Not an easy recipe to get right, but well worth the effort.

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