Proposed U.S. Legislation Would Ban Primary Research

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Two Democratic U.S. senators introduced proposed insider trading legislation which is extremely broad and would effectively ban primary research.  Separately, an insider trading bill introduced in the House of Representatives has a more narrow definition — although broader than the current common law definition — and would not have the same effect on investment research.  It is still too early to say how either bill will fare.

Stop Illegal Insider Trading Act

U.S. Senators Jack Reed (D-RI) and Bob Menendez (D-NJ), two senior members of the Senate Banking Committee, co-sponsored the Stop Illegal Insider Trading Act which aims to define the offense of insider trading with a bright line rule: if a person trades a security on the basis of material information that he or she knows or has reason to know is not publicly available, then he or she has engaged in unlawful insider trading.

Under the Stop Illegal Insider Trading Act, it would be irrelevant whether a trader knew of a source’s fiduciary duty or whether the source derived any personal benefit for tipping the inside information.  What would matter is whether the trader knew or had reason to know that he or she had an “unfair advantage” in obtaining material information that was not shared with the broader public.

The bill also would prohibit anyone from communicating non-public information if it was reasonably foreseeable that someone would trade on it.

Ban Insider Trading Act

Representative Stephen Lynch (D-MA), a member of the House Financial Services Committee, introduced legislation to make it illegal to trade “based on information that the individual knows or should know is material inside information.” Inside information is defined more narrowly than the Senate bill:

“The term ‘inside information’ means information that is —

(i) nonpublic; and

(ii) obtained —

(I) illegally;

(II) directly or indirectly from an issuer with an expectation of confidentiality or that such information will only be used for a legitimate business purposes; or

(III) in violation of a fiduciary duty.”

In other words, it would be legal to obtain non-public information provided you did not get it illegally (such as hacking), or from an issuer with an expectation of confidentiality or in violation of a fiduciary duty.  The big change from the current common law definition is that the House bill does not require “a personal benefit to any party.”  It also says that anyone who “intentionally discloses without a legitimate business purpose” inside information to another person is guilty of insider trading.

Reaction to 2nd Circuit Ruling

Both bills are a reaction to the December ruling by the 2nd U.S. Circuit Court of Appeals in New York which said that prosecutors must prove a trader knew the source of a tip received a benefit in exchange for the information.  The court also narrowed what constitutes a benefit, saying it must be of “some consequence” and cannot be only friendship.

The ruling has led to a reversal of convictions or the dropping of charges for seven of the 93 insider trading defendants pursued as part of a crackdown by Manhattan U.S. Attorney Preet Bharara’s office since 2009.

Politics

Policy research firms in Washington tell us that Republicans have not decided whether they support insider trading legislation or would prefer to leave the law to the courts.  It is likely that the Newman case will go to the Supreme Court.  Congress may choose to wait for that process to finish before moving forward with legislation.

Washington sources will be watching Senator Chuck Grassley (R-IA) as a bellwether because Grassley has been proactive on insider trading related topics.  In addition, the House Financial Services Committee will be hearing testimony from SEC Enforcement later this week and Representative Lynch, who is a member of the committee, will almost certainly prompt discussion of his bill.

Our Take

The proposed Senate bill would equate primary research with insider trading.  Primary research seeks to identify non-public information without the use of insiders, relying on sources such as industry experts or market research on the upstream or downstream supply chain.  Expert networks, channel checks and other primary research techniques are set up to uncover information that is not yet widely known or incorporated in financial markets.

One type of primary research uses investigative journalists who by definition are trained to uncover non-public information.

Regulators and prosecutors have increasingly embraced a vision of creating a ‘level playing field’ in which less informed investors would not be harmed by better informed investors.  The Senate-sponsored Stop Illegal Insider Trading Act seeks to guarantee that all investors would participate on a level playing field.

A wholesale ban on primary research would make the U.S. stock market less efficient.  Analysts would be constrained to use only information which publicly traded companies choose to release.  Techniques to independently test or challenge information from publicly traded companies would be largely banned.  Misleading or fraudulent information from public companies would be more persistent, and ultimately more damaging to investors when dis-proven.  In other words, the U.S. stock market would begin to resemble the Chinese stock market where fraudulent public companies are not uncommon.

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About Author

Sandy Bragg is a principal at Integrity Research Associates. He has over thirty years experience as an investment research professional. Prior to joining Integrity in 2006, he was an Executive Managing Director at Standard & Poors, managing S&P’s equity research business and fund information properties. Sandy has an MBA from New York University and BA from Williams College. Email: Sanford.Bragg@integrity-research.com

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