Research is not illegal, and it’s a mistake to confuse legitimate practices with willful insider trading.
By Kurt N. Schacht, contributor
Trust in capital markets has been shaken once again with the developing federal investigation against a range of institutional investors and hedge funds for possible insider trading. Coming on the heels of the global financial crisis, the investing public once again has reason to doubt the integrity of capital markets. Are markets rigged in favor of insiders and those who can afford to buy their insights?
Investment professionals are also uncertain what to make of the developing investigation. The prospect of visits from federal agents, subpoenas, and the accompanying media attention may give pause over financial analysts using the long-established practice of constructing a “mosaic” from a broad range of information to support an investment thesis. If the mosaic is polluted by inside information, the entire research product is put in jeopardy.
It would be a mistake to confuse legitimate research efforts with willful violations of existing insider trading laws. Federal regulations are clear: Regulation FD prohibits companies from disclosing material meaningful information on a selective basis, ensuring that everyone has equal access to information as it is disclosed. Rule 10b5(1) under the Securities Exchange Act of 1934 prohibits buying or selling securities on the basis of material nonpublic information.
Based on what we know about the government’s current allegations, it appears that both of these longstanding rules have been violated.
What does appear to be new in the current cases is the way this insider information has been procured. If so-called “expert networks” arranged for corporate insiders to share information improperly with investors who should have known better, we urge the full weight of the law to punish both those who provided and those who acted upon the illegal information.
But expert networks themselves aren’t the problem. Analyzing the prospects of a business or an industry founded on highly technical information is challenging, and expert networks offer opportunities for securities analysts to go beyond their usual circle of contacts to learn about technologies, business dynamics, and trends. Genuinely useful information can be shared that is well within the limits of the law, contributing pieces of the investment mosaic without compromising privileged or confidential information.
Deciding what is and isn’t important and assembling the mosaic appropriately is the skill that underlies successful securities analysis. Perhaps because the stakes are so high for financial gain, temptations to cross the line into the use of illegal information are unsurprising, yet unforgivable.
Legitimate research practices will survive
In a larger context, in-depth research of companies and securities prices is vital. After all, markets exist to allocate capital productively, encouraging strong and innovative companies and discouraging the weak. Impeding the ability to understand a company’s potential would create inefficient capital allocation. Meanwhile, public trust in markets is equally important, and effective rules against unfair practices like insider trading exist to justify investor confidence.
There is some irony in the current focus on independent research firms like the expert networks. In the aftermath of the dot-com bubble, conflicts of interest among analysts associated with investment banks and brokerages were identified, and a legal settlement funded hundreds of millions of dollars to spur independent investment research.
The lesson is that substance matters more than form: be it a well established brokerage or independent research firm or expert network company, both producers and consumers of investment research need robust protections in place to comply with the spirit and letter of the law. Investors should know what information is permissible and take steps to limit their information gathering appropriately. Research providers, especially those who use independent contractors in some fashion, must be diligent in building in safeguards to the process to prevent even inadvertent sharing of insider information.
And backstopping it all must be the credible threat of fair, swift enforcement of the laws on the books. Beyond the current news of developing cases, it’s essential that our elected representatives allocate meaningful budget appropriations to beef up securities law enforcement resources.
While the latest investigation is not good news, investors should take comfort in the level of attention being paid to these cases up and down Wall Street. Smart securities analysis that reflects novel insights about a company or an industry will always be in demand and will always be worth paying a fair price for — on the other hand, shortcuts that cross the line will be dealt with sternly under current insider laws. There should be no in-between.
Kurt Schacht, JD, CFA, is managing director of CFA Institute, where he oversees advocacy activities and efforts to develop, issue, and maintain the highest ethical standards for the global investment community.
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