Has The U.S. Gone Too Far In Enforcing Insider Trading Laws?

Dec 6 2010 | 2:48pm ET

By Mikhail Iliev, Who's In My Fund? -- The recent U.S. government probe of insider trading at hedge fund firms is threatening to change the very meaning of insider trading. While previously only market-moving information was under the insider trading microscope, now, for the first time, the government is questioning the legality of any type of information.

In doing so, authorities are coming dangerously close to criminalizing market research itself.

What Is Insider Trading, Anyway?

Today’s economy runs on information. Investors clutch at every tiny bit of it, however fragmented or seemingly irrelevant, as if it were the latest Steve Jobs pronouncement. Sometimes such information turns out to be a very important piece of news about a company that could move the price of its stock.

The most valued information is one that is both important enough and not widely known. The law defines such a valuable nugget as “material non—public information” and puts it at the heart of every insider trading case.

Now, if you are a certain type of person and you have a nugget in your hands, the government says you are not supposed to use that nugget for personal benefit. For instance, if you have negative news about a company that no one else has, you are not supposed to sell your shares in that company until the nugget becomes public news.

At first, only company officials, their investment bankers and lawyers—called insiders—were banned from using nuggets for personal gain because they had a commitment to the company not do so.

In time, federal regulators expanded the reach of the law to outsiders who were “tipped” by an insider about a nugget. The insider was called a “tipper” and the outsider a “tippee.”  Tippees did not have a commitment to the company yet were banned from using the nugget if they knew the source had such a commitment.

Next, the net was cast even wider to outsiders who never received a tip from an insider.

The textbook case, U.S. v. O’Hagan, was about a lawyer who was not an adviser to a company himself, even though his law firm colleagues were. He ran afoul of the insider trading laws when he took important information on that company from a printer belonging to the law firm. The government considered this theft of confidential information rightfully owned by the law firm which employed the lawyer. The thieving outsider was prosecuted as if he was an insider.

In sum, in the past investors would break the law only if they broke a commitment not to trade or if they knew their source had a commitment to keep the information secret or if they stole the information from their employer, who had a commitment to keep it secret.

That was then, this is now. With the recent offensive on insider trading, traditional notions of what it means to violate the law may be going out the window.

Is the U.S. Government Aiming to Cripple Market Research?

The government’s aggressive attempts to enlarge the reach of insider trading laws may make most market research criminal.

In classical insider trading law, there was a clear line between ill-gotten and legitimate information.

“Being better informed than your competitor is not a crime per se” Dewey & LeBoeuf insider trading expert Christopher Clark explained to whosinmyfund.com. “However, if you have gotten information that is both important and confidential from somebody who you knew had a commitment to keep the information secret, then you have an unfair advantage and cannot use it to trade.”

That bright line has been blurred in two significant ways.

The government is going after any confidential information, however unimportant it may be.

In the recent sweep, the U.S. looks to be focusing on hedge funds that use bits of information they have received from "expert network" companies. One way these companies assist hedge funds and others is by performing “channel checks.”

A “channel check” is a type of research ranging from counting cars in a store’s parking lot to talking to current and former managers in the company’s supply chain to estimate future production plans.

These checks may reveal if companies are ramping up or slowing down production, or whether they are winning or losing customers for components and parts they supply to others.

The datapoints that come from these “expert networks” may often be confidential but are small and individually unremarkable - how much would counting cars in parking lots move a company’s stock? Assembled together by a keen observer, however, these bits may aggregate to a very meaningful whole.

While the end product is the typical target of insider trading inquiry, the insignificant building blocks of information are far from the law’s traditional hunting ground.

Another way the line between good and bad market research is being blurred surfaced in a bizarre recent case in Florida.

Several employees of a railroad company were charged for engaging in insider trading in their company’s stock before the public announcement that their company would be acquired by the Fortress Investment Group. 

No one, certainly no insider, told the employees the company was on the block. The employees just noticed “there were an unusual number of daytime tours” of the rail yard with “people dressed in business attire.” Also, one of the employees was told to do something he had never done before—a tally of all the locomotives, freight cars and other inventory owned by the company, and how much they were worth.

From these circumstantial, individually insignificant bits which, importantly, were not a secret, the employees pieced together the juicy fact that their employer was up for sale.

Such piecing together is integral to most market research. There is no doubt that Galleon’s founder developed networks of sources, including fund investors knowledgeable about technology companies. These investors would have provided Galleon with enough insight and bits of “grapevine” information on customers and suppliers for it to get stock ideas. And it’s likely none of that information would have been confidential.

And so it becomes increasingly impossible to tell where the line between legal and illegal research lies. In fact, authorities seem to be telling hedge funds and other traders, ‘I don’t care how you know that precious nugget, I just care that you know it.’

This may be an ominous development, according to investment management and securities law expert Michael Renetzky. “Finding out material data on a company is the endpoint of any proper market research, and trading on it is one of the few ways hedge funds and other traders gain a competitive edge on other traders,” Renetzky told whosinmyfund.com.

Traditional insider trading rules banned people from getting the precious nugget from insiders or from their employer. Now hedge fund traders and other analysts may not be able to get it though analysis of insignificant and freely available data, either.

If research is stymied, how can individual traders express differing opinions on the value of a stock? Would there even be differing stock values or would the stock just stay fixed to one “fair value” until a company releases its public disclosure?

It may be too early to draw definitive conclusions about where this is going.

In its complaint against the Florida employees, the SEC tried to stay inside traditional insider trading law. It implied that anything the employees could know about a potential sale should be confidential because they had signed the company’s Code of Conduct.

And the only formal complaint filed against a so-called expert in the recent probe is careful to allege that what the expert told his client hedge funds was both material and non-public.

“Authorities may just be trying to cast their net out as wide as possible in the initial probe,” Renetzky said, “and when it’s time to argue their case they will retract to the typical insider trading elements which call for material non-public information.”

But the sheer size of the probe, Renetzky added, coupled with tactics like raids of hedge fund offices and pervasive use of wires will chill market analysis even if just for two or three years until the cases get resolved.

The government itself has recognized the role of market research in a healthy financial market. As early as 1983, the SEC said that “[analysts’] initiatives to ferret out and analyze information redound to the benefit of all investors.”

The U.S. Supreme Court, in Dirks v. SEC, also acknowledged the reality that charging people for using material nonpublic information may inhibit aggressive research. Imagine the effect of charging somebody for trading on any kind of non public information. Or trading on any information, period.

Mikhail Iliev is a contributing editor of Who's In My Fund?, a site which groups hedge fund investors by investment, allowing them to communicate directly and discretely with each other in a secure environment and share news and opinion on their investments. Mikhail practiced law for 11 years as an associate at Dewey LeBoeuf, LLP and as Senior Vice President at KBC Financial Products. He has extensive experience in the field of securities law and private investments and has advised clients on financing and offering matters for domestic and offshore funds, mergers and acquisitions and securities regulation. He is also a visiting professor at Segal Graduate School of Business in Vancouver, Canada where he has taught courses on securities regulation and ethics.

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