Last week, the star witness in the government’s insider trading case against SAC portfolio manager Michael Steinberg faced tough questioning from Steinberg’s lawyer in an effort to discredit earlier testimony against him. Clearly, part of the government’s case is based on their view that Steinberg directed this former SAC analyst to seek out illegal inside information. The issue at hand is whether the “edgy” information Steinberg sought was really illegal?
The Steinberg Case
Jon Horvath, a former SAC analyst previously pleaded guilty and is cooperating with government prosecutors in the insider trading case against Michael Steinberg, the highest-level employee at SAC to face criminal charges over alleged insider trading.
Steinberg is charged with five counts of securities fraud and conspiracy to commit securities fraud on charges that he traded in Dell and Nvidia shares based on insider information supplied by Horvath. Steinberg denies any wrongdoing.
In last week’s questioning by Barry Berke, Steinberg’s lawyer, Horvath stated that following a bad recommendation he made in 2007, Steinberg directed him to find “edgy” information on public companies.
Horvath said that Steinberg told him: “What I need you to do is get edgy, proprietary, market moving information so we can make money on these stocks.”
During Berke’s cross examination, Horvath also testified that he probably did not tell Steinberg specifically that he was obtaining and feeding him illegal inside information that he had obtained from an analyst at another hedge fund who was feeding him tips.
The Problem With Edgy Information
Clearly the prosecutors have assumed that the “edgy” information Horvath is speaking about is a code word for “illegal insider information”. While we don’t intend to make any judgments about this insider trading case, we would like to discuss what Horvath’s comments reveal about the government’s take on buy-side research.
We believe the government has difficulty accepting the concept that any investor should have an “edge” over anyone else. In other words, there should be a level playing field for all investors, even when it comes to the information they use to make investment decisions with.
However, full-time investment professionals spend millions of dollars to hire the smartest analysts, buy the fastest computers, purchase the best data and research, and conduct extensive proprietary analysis which they hope will result in a profit, for themselves and for their investors.
On the other hand, retail investors don’t have the same resources to pour into their investment decision making process. Consequently, retail investors typically find it difficult to consistently outperform professional investors because they don’t have as good information.
The team at Integrity Research believes it is important for institutional investors to try and obtain “edgy, proprietary, market moving information” to help them and their investors profit on their investments. In fact, we would argue that professional investors who cannot obtain an information edge over average investors should not be in business.
We also believe that everyone, even the average investor, benefits when an institutional investor digs up “edgy, proprietary, market moving information” on a public company as the share price of this stock moves more quickly to an equilibrium price as a result of this extensive research process versus remaining at an inappropriate level.
Consequently, we think it is completely justifiable for investors to survey store managers, speak with company employees, query lobbyists, or hire industry consultants to determine what the risks are for the stocks they are researching.
Traditional Insider Trading
Of course, we are not arguing to eliminate the traditional crime of “insider trading” where investors illicitly obtain and trade on nonpublic information about pending mergers, quarterly financial results, or other material developments from corporate insiders. This, in our mind, is hardly research. However, over the past few years we have seen situations where the regulators have clearly overreached in their attempts to level the playing field.
One step regulators could take to address this issue is make the line clearer about what is and what is not illegal insider information. Most compliance officers we have spoken with over the past few years have vehemently complained that the US regulators’ approach of keeping the line between legal and illegal behavior unclear with regards to insider trading creates as many problems as it stops.
Unfortunately, we think regulators enjoy the lack of clarity that currently exists on this topic as it gives them considerable latitude in investigating potential enforcement cases.
In our view government prosecutors currently look askance at any investor who aggressively seeks out “edgy, proprietary, market moving information” to trade on. We, however, think this way of thinking might be a little off base, particularly since most investors are just trying to conduct rigorous research while staying within the lines. Unfortunately, US regulators have made this process even more difficult as they refuse to show the market exactly where those lines really are.