Impactful information is not always insider and insider Information is not always impactful!

One of the perils of living in New York is that it is home to two of the highest profile law enforcement officers in the United States, the US attorney for the Southern District of New York (the Justice Department’s lead person in the city) and the New York State Attorney General. Both positions attract smart lawyers, who are politically ambitious, and not surprisingly, they use these positions to maximize their media exposure. While the current position holders, Preet Bharara (as US attorney) and Eric Schneiderman (as NY AG) are either Democrats or appointed by Democrats, my rant is a non-partisan one, since Rudy Guiliani and Chris Christie launched their political careers from the US attorney perches (Christie used the Newark post).

Insider Trading 2.0

While Mr. Bharara has been busy going after hedge fund managers for crossing the insider trading line, it is Mr. Schneiderman who caught my attention last week with two highly publicized actions. He first announced an agreement with 18 investment banks, including JP Morgan and Goldman Sachs, that their equity research analysts would no longer participate in surveys that allowed some of their preferred clients to get advance looks at analyst sentiment changes. A few days later he announced a crackdown on high frequency trading and in particular, the practice of paying data providers to get information milliseconds before the rest of the market. He then wrapped up both actions in a neat little package and came up with a doctrine that he termed Insider Trading 2.0, with his justifications for why it was merited. While Mr. Schneiderman's motives may be noble (or at least they sound good), I don't think that he has thought through either the principles behind this new doctrine or the potential consequences. 

Insider Trading: The evolution of the concept

The US has the most stringent rules and regulations on insider trading and it is worth looking at how the law has evolved since its beginning. The first restrictions on insider trading were included in the Securities Exchange Act (Section 16(b)) of 1934 and were a reaction to the market crash of 1929 and the perception that company insiders had contributed to the market devastation by holding back information from investors and trading for personal profit. The original laws were directed at corporate insiders defined to include managers, directors, employees and large stockholders (owning more than 10% of the shares) and were designed to prevent them from trading on "material, non-public" information ahead of the rest of the market. A side effect of that law was the requirement that insiders, when trading legally on their company stock had to report such trading to the Securities Exchange Commission (SEC) in a filing (Form 4).

In the years, through a series of changes primarily from court interpretations of the law, the law has broadened to include a much larger group of investors.

Mr. Bharara's big wins against hedge funds have come from within the conventional confines of the insider trading law. Thus, in the case against Raj Rajratnam, the government argued and was able to prove that he was the recipient of inside information passed on by Rajat Gupta, then a director at both Goldman Sachs and Proctor and Gamble. In the more recent legal tangle with Mathew Martoma, a trader at Steve Cohen's SAC Capital, the core of the case was that he "seduced" and "corrupted" two doctors to provide him with confidential information about the results of clinical trials, which he then proceeded to use to trade in Elan and Wyeth, two pharmaceutical companies.

I am not a lawyer and the intricacies of some of the legal wrangling in these cases go over my head, but the overall tenor seems to be clear. While the initial focus of the law was on the individuals doing the trading (and whether they were insiders), it has shifted to the information being traded upon (and whether it is material and non-public). In effect, the insider trading laws, as structured now in the US and enforced by the SEC, are more laws that restrict trading ahead of impactful information than insider information.

Impactful information

Rather than use "material information", a legal term, I will start with a broader term that I will title "impactful" information, i.e., information that can be expected to impact the stock price. To make an assessment of whether this information can be legally traded on or should be classified as insider trading, we need to first categorize this information. As I see it, a company's stock price can be impacted by six types of information which I will classify into three sub-groups: fundamental, technical/trading and processed information.

a. Fundamental information

From an intrinsic value standpoint, the value of a company is altered by any information that can affect its cash flows, expected growth and risk, and that covers a lot of potential news. Sub-dividing fundamental information, the information can be about the company, it can be about the entire sector or it can be macro or market-wide information. Within each sub-group, there can be different sources of data.

Company-specific	1. Company: The most obvious source of information is the company itself, with earnings reports being the most frequently used vehicle for delivery of that information. In addition, companies sometimes make public announcements about investments (new projects, JVs and acquisitions) and dividend policy (dividend changes, stock buybacks etc.) 2. Outsiders: Some company-specific information is unearthed by investors and analysts in the course of doing research on the company, without accessing either company insiders or proprietary corporate data.
Sector-wide	1. Other companies in the sector: Earnings and investment announcements by other companies in the sector can be used to reassess investor expectations of market potential and profitability. Thus, the announcement by one auto company of higher-than-expected earnings can lead investors to push up expected earnings (and prices) at other auto companies. 2. Sector research: There are sector experts and consultants whose job it is to collect information about the overall sector and analyze it, with the intent of assessing sector trends and prospects.
Macro economic	1. Government: The biggest source of macroeconomic data (interest rates, inflation, economic growth) is the government through its many institutions. 2. Private entities: There are private entities that also generate macroeconomic data that markets react to. In the US, for instance ADP (a publicly traded company) produces a monthly national employment report and the Conference Board reports a composite index of leading economic indicators.

b. Trading information
In an efficient market, the only news that affects prices is fundamental, but in the markets that we live in, it is an undeniable truth that there is other information that affects prices. Putting my trading hat on,  information on trading volume, trends in trading, the identity of the traders and order flow can all affect prices.

Momentum (Trading volume/details)

1. Stock exchanges: The trading exchanges are the primary suppliers of data on trading volume and order flow (limit order). In addition, they also have data on short sales and bid ask spreads that may affect prices. 2. Private brokers/dealers: There are some private brokers and dealers who keep track of subsets of trading data. In some cases, they trade on this information and in others, they offer them to others (for a price).

Mood/Sentiment

1. Private entities: Many charting services collect data on investor sentiment on companies (bullish/bearish), primarily from surveys and provide this to subscribers. 2. Option exchanges: There are sentiment measures based on option prices and volume, especially by relating call option to put option values. The data is held by the option exchanges.

c. Processed information
In the final grouping, I would include processed information, i.e., analyst/investor reports and statistics based upon the processing of raw information from any of the sources listed above. Again, while this should have little or no impact on stock prices in an efficient market, these reports sometimes do affect stock prices.  For instance, sell side equity research analysts use an aggregation of all of the data listed above, in conjunction with their own views, to generate earnings estimates and recommendations (buy/sell/hold) on the companies they track. That information is often picked up by the press and made public, affecting stock prices.

The trade off
Breaking down impactful information into its component parts provides us with a framework for assessing insider trading laws and restrictions. In fact, there are some who adhere to the ends of the spectrum. A subset of free-market economists, led by Milton Friedman, has argued that investors should be allowed to trade on all types of impactful information and that there should be no insider trading laws. This case is best made in Henry Manne's numerous writings on the topic, including his book on insider trading. At the other end of the spectrum are those who believe that all impactful information is essentially insider information and trading on it should be restricted or banned.

To provide a template for assessing the different views of insider trading, I propose five guiding principles (some of which you may view as hopelessly utopian) that should guide our choices:

Guiding Principle 1: Information revealed by companies about their prospects should be unbiased, complete and be provided to markets in a timely fashion. 

Guiding Principle 2: There should exist a strong external information market (outside investors and analysts), investing resources to collect additional information and process it, with the intent of supplementing, complimenting and challenging corporate news releases.

Guiding Principle 3: The market reaction to the information should be appropriate (reflecting what that information reveals about the future prospects of the company) and immediate (with the price change, if any, happening instantaneously).

Guiding Principle 4: At any point in time, the market price should reflect all of the information, private or public, about a company.

Guiding Principle 5: Investors should perceive the information/pricing/market processes as fair. If investors perceive the trading game to be fixed in favor of some investors over other, they will withdraw from the market.

Using these principles, you can see why the limiting arguments are both problematic.

• The Manne/Friedman argument is built on the presumption of an efficient market and with the implicit assumption that guiding principle 4 (that the price reflect all available information) is the dominant one. However, it has its costs. Company insiders may hold back information so that they can trade on it (undercutting proposition 1), there is no incentive to develop a strong external information market (since insiders capture the rents) and investors may stop participating in the market if they perceive the game to be fixed. Over time, there will both less information and liquidity in this market.
• Classifying all impactful information as insider information, and banning trading on it, may improve investor perceptions of a fair market, advancing proposition 5, there be no incentive for outsiders to invest resources in collecting new information. Even if they do, there will be a black market for illegal (but impactful) information, which in turn will also undercut market efficiency both in terms of having the information being reflected in the market price and the speed with which it is reflected. That will also allow "illegal" insiders to capture more rent from their information.

A good insider trading law walks the fine line between fair and free markets and that has to come from a sensible break down of impactful information into the clearly illegal (insider information), the gray middle (where you have to look at the facts of the case to make the judgment) to the legal (impactful information).  As I see it, here is the breakdown:

Clearly Insider (should be regulated)	Gray area	Not insider (should be left to market forces)
1. Company news releases, including earnings reports and investment announcements. 2. Macroeconomic data from government and quasi-government entities.	1. Exchange data on trading volume, short sales and order flow. 2. Premium news, where news services provide preferred customers with information earlier than others.	1. Analyst earnings revisions and recommendations. 2. Investment newsletters 3. Survey-based data/indicators 4. Sector research/reports 5. Privately generated macroeconomic indicators

I think that insider trading rules should clearly apply to company-generated information and that governments should not play favorites, with macroeconomic data. I also believe that anyone (analysts, investment advisors, data services) who expends time and resources to collect their own data or do their own research should be free to reap the benefits of that data, either by trading on it themselves or selling it to others, to trade on. I have mixed feelings about exchanges selling privileged access to trading data (volume, order flow, short sales). While exchanges, at least in the US, are private entities, the trading data is a by-product of their primary business, which is to facilitate market trading. Offering preferential access to this data to their best or biggest traders strikes me as not only unfair but also not merited, since there was no investment made in collecting this data. In the same vein, news services that offer premium data feeds (for a price) to preferred customers are trying to exploit information that they had no role in gathering or processing and should be held accountable. In either case, I don't it is insider trading laws that they are guilty of breaking, but they are violating their fiduciary responsibilities (to traders, on the part of exchanges, and to the data collecting entities and  customers, for news service).

Impactful Information 1.0: The Analyst Case

To see why Schneiderman’s attempts to constrain equity research analysts really neither fits the definition of insider trading nor is merited, let’s look at the business of sell side equity research. Investment banks hire and pay equity research analysts who are given subsets of stocks (sectors and subsectors) to follow and analyze. Analysts have to estimate the earnings that these companies will be reporting in the near term and make judgments on their relative pricing (not valuation). In making these judgments, they are already barred from getting "material, non-public" information from the companies that they analyze, under both insider trading laws and SEC rules. (See Regulation FD) While you may be cynical about analysts actually following these rules, recognize that if they break these rules, you don’t need Insider Trading 2.0 to crack down on them. Insider Trading 1.0 will do. 

Analysts expend resources collecting data, processing it and converting it with varying degrees of skill into earnings estimates and stock recommendations. If their work has any merit, these estimates and recommendations, when made, should have an effect on stock prices (thus making it impactful information). It is at this stage that they outrage Mr. Schneiderman by making these estimates and recommendations available only to preferred clients, i.e., the clients who can be expected to deliver trading commissions to the investment bank. The NY attorney general seems to view analysts as public service providers, whose job it is to collect and process information for the market. It is not. The investment banks that hire them and pay for their research are not charitable institutions and are entitled to be selective about who gets to see the information first. In fact, if analyst revisions/recommendations are insider information, because they have price impact and thus cannot be offered to clients, where exactly do you draw the line on active investing and trading? If my skill is valuing companies and it is perceived to be good enough that my recommendations affect stock prices, am I barred from starting a paid newsletter? After all, my information is impactful and my clients will therefore be getting that information ahead of the market.

Impactful Information 1.0: The High Frequency Trading (HFT) Case

High frequency trading has become a catch all for high volume, computer-based trading. Stories such as these feed into the presumption that HFT is an immensely profitable enterprise, where the purveyors make huge profits by trading ahead of the rest of us. In his broadside against HFT, Mr. Schneiderman seems a little confused about what aspect of high frequency trading he finds more unfair, the fact that computers can trade faster than rest of us or that the HFT systems get information (and pay to get it) milliseconds ahead of the rest of us.

While I do have some sympathy for Schneiderman on the advance information being procured by HFT traders, to make a judgment on whether Insider Trading 2.0 is, in fact, merited, I would like to know what information is being acquired, and from whom. If the data is coming from a government agency (the Fed, Labor Department), I agree that information should be made available to all investors at the same time (though our legislators seem to have no qualms about trading on that information ahead of time). If it is a private entity, I find it hard to believe that insider trading laws actually apply. For instance, one of the examples provided by Schneiderman was of Reuters letting HFT clients buy Consumer Confidence survey (conducted by the University of Michigan) numbers a few milliseconds ahead of the rest of the market. Without entering the debate about whether this information has a market impact, it would seem to me that the problem here is that Reuters is not sharing that revenue with the University of Michigan. If the University of Michigan had chosen to offer this advance peek data for a price to customers willing to pay the price, how can that be considered insider trading?

The Greater Good?

Elliot Spitzer, in his high profile assault on sell-side equity research, a decade ago, and Eric Schneiderman in recent days have framed their actions as being in the interests of fair markets and protective of small investors. You can put me in the skeptical camp because the only group that does not seem to come out ahead from these actions is small investors. In spite of all of the ink that was spilt and the legal costs that were created by Spitzer’s crackdown on conflicted equity research, I don’t believe that sell side equity research is any less conflicted than it was (though the bias is hidden deeper and is more subtle) or of higher quality. After Schneiderman’s forays into Insider Trading 2.0, I remain convinced that small investors will have gained nothing from his crusade and will perhaps have lost access to information that used to be available.