Mirabile Dictu: SEC Finally Going After Business of Selling Inside Information

Yours truly has complained off and on over the years about “consulting” and “research” firms whose entire business model revolves around the procurement and sale of inside information. These companies solicit consultants, who in the vast majority of cases are employees of major corporations, to provide insight into what is going on at their employer’s operations. These vendors are generally smart enough to make their consultants sign various waivers, which have the effect of shifting liability on to the hapless chump paid a couple of hundred dollars an hour for an hour or two for information worth vastly more than that. They are effectively exploiting the contract worker’s lack of understanding of the finer points of SEC regulations and corporate policy.

We first wrote about this abuse with weeks of starting this blog, in January 2007, when a Wall Street Journal investigation of the biggest player in this space, Gerson Lerman, led to an investigation by the New York attorney general, Eliot Spitzer (the SEC reportedly had investigations underway, although it was not clear whether Gerson Lehrman was a focus). The two paragraphs from this January 2007 post are extracted from a contemporaneous Wall Street Journal piece, the balance is our commentary:

Regulators are focusing on whether consultants who are or were employed by public companies have shared nonpublic information with the investors they talk to, either knowingly or unintentionally…

In a page-one article on Gerson, The Wall Street Journal reported in November that Gerson consultants employed by public companies sometimes are unaware of their own companies’ restrictions or have a hazy understanding of what qualifies as nonpublic information….

A colleague who once ran one of the biggest international research operations says that this sort of, ahem, research is as suspect as it sounds. Hedge funds and investors use Gerson and its lot for “channel checking,” that is, they ring up people at companies who are buyers of certain goods to see what kind of orders they are placing. It’s not hard to see why employers would object to this information being shared. First, the employee has no right to trade on his employer’s data. Second, information on how certain products are selling could also give an early warning of the company’s overall revenue trends. Third, disclosure might damage its relationships with suppliers.

You can see why this information is prized. It’s clearly non-public; the only question is whether it is confidential, and the answer is likely to be yes.

Why did the SEC and Eliot Spitzer take so long to act on this one? Hard to know, but our guess is that, unlike the insider trading cases, these breaches of confidentiality don’t lead to huge trades. It’s more like a death of a thousand unkind cuts. But as Gerson and its ilk extended the reach of their operations, and became more visible, the powers that had to be were forced to act. Faith in the markets rests on the (often mistaken) belief that the participants have (or can have if they spend the time) reasonably equal access to information. Gerson Lehrman makes a mockery of that idea.

The Wall Street Journal reports tonight that, years later, the SEC investigation is finally bearing fruit, although the Gerson name is nowhere to be found in this initial leak. So the question remains whether the SEC is merely going to go after the sloppiest actors in this space, or intends to take down this entire dubious category. From the Journal:

Federal authorities, capping a three-year investigation, are preparing insider-trading charges that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders and analysts across the nation, according to people familiar with the matter.

The criminal and civil probes, which authorities say could eclipse the impact on the financial industry of any previous such investigation, are examining whether multiple insider-trading rings reaped illegal profits totaling tens of millions of dollars, the people say. Some charges could be brought before year-end, they say….

One focus of the criminal investigation is examining whether nonpublic information was passed along by independent analysts and consultants who work for companies that provide “expert network” services to hedge funds and mutual funds. These companies set up meetings and calls with current and former managers from hundreds of companies for traders seeking an investing edge….

Among the expert networks whose consultants are being examined, the people say, is Primary Global Research LLC, a Mountain View, Calif., firm that connects experts with investors seeking information in the technology, health-care and other industries. “….

In another aspect of the probes, prosecutors and regulators are examining whether Goldman Sachs Group Inc. bankers leaked information about transactions, including health-care mergers, in ways that benefited certain investors, the people say. Goldman declined to comment.

Independent analysts and research boutiques also are being examined. John Kinnucan, a principal at Broadband Research LLC in Portland, Ore., sent an email on Oct. 26 to roughly 20 hedge-fund and mutual-fund clients telling of a visit by the Federal Bureau of Investigation.

“Today two fresh faced eager beavers from the FBI showed up unannounced (obviously) on my doorstep thoroughly convinced that my clients have been trading on copious inside information,” the email said. “(They obviously have been recording my cell phone conversations for quite some time, with what motivation I have no idea.) We obviously beg to differ, so have therefore declined the young gentleman’s gracious offer to wear a wire and therefore ensnare you in their devious web.”

The email, which Mr. Kinnucan confirms writing, was addressed to traders at, among others: hedge-fund firms SAC Capital Advisors LP and Citadel Asset Management, and mutual-fund firms Janus Capital Group, Wellington Management Co. and MFS Investment Management. SAC, Wellington and MFS declined to comment; Janus and Citadel didn’t immediately comment. It isn’t known whether clients are under investigation for their business with Mr. Kinnucan.

The investigations have been conducted by federal prosecutors in New York, the FBI and the Securities and Exchange Commission. Representatives of the Manhattan U.S. Attorney’s office, the FBI and the SEC declined to comment.

I would expect less rather than more from this effort. Even though any prosecution of unsavory practices is welcome, this report sounds as if the investigators are focusing on the worse abusers, rather than seeking to make a broader case against the entire practice.

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  1. Paul Repstock

    Oh Yves. This is so pathetic, so utterly pathetic.
    One would have to wonder why the Sec bothers to put on such children’s theater.

    You are in the business. You must see it every day. The only people ever prosecuted are the ones so low on the ladder that they cannot drag anyone else down wth them.

    When Joe Investor seesWarren Buffet playing golf with CEO’s of giant corporations, and hears National vice presidents pumping companies. When the Mark Cuban’s walk unscathed and company presidents drag their firms through the mud to lower share prices only to pump them again a year or two latter or opposit.

    The profit structure of IPO’s is well known to the least sophisticated investors. And the markets are played like scales on a piano.

    The dart board and a blindfolded thrower are the only way to win.

    1. Paul Repstock

      It’s a rant and a whine. I know it. But, if anyone wants to try refute me, I’ll quote chapter and verse..enough to gum up this blog for a week.

      I’m a starry eyed fool who had some idea that investors were lending their money to corporations in return for a fair share of profits. I’m also a very slow learner. It took me over twenty years to finally realize that my only relevance in this machine was to provide grease for the gears.

      If indeed the Sec proceeds with this effort, it will be only to provide the price verification for the markets which I posted about a couple of days ago. It will be interesting to see if they can achieve one more confirmation of P T Barnum’s maxim.

      1. Rex

        “I’m a starry eyed fool who had some idea that investors were lending their money to corporations in return for a fair share of profits. I’m also a very slow learner. It took me over twenty years to finally realize that my only relevance in this machine was to provide grease for the gears.”

        I was with you on that naive delusion. It’s a ubiquitous myth that may have once been somewhat true. Seems more and more clear that old Vegas is a better model, back when they could rig the odds and skim huge amounts.

        I’ve also found myself thinking that Enron was a prototype experiment, deliberate or just an accidental tutorial, that set a lot of the course for global theft 2.0. Take it really big and buy insurance against the big downsides like suicidal guilt or jail time.

        1. readerOfTeaLeaves

          I’ve also found myself thinking that Enron was a prototype experiment, deliberate or just an accidental tutorial, that set a lot of the course for global theft 2.0. Take it really big and buy insurance against the big downsides like suicidal guilt or jail time.

          Ditto on the hunch that Enron was the prototype.
          As for the really big downsides; it’s my view that we’re dealing with predators and people whose emotional processing capacities are… ‘impaired’ to say the least.

          But IIRC, some hedge funder (Galleon?) was found to have been playing the markets, then siphoning profits off to the Tamil Tigers or some other group perpetrating violence.

          On one level, the SEC may be trying to put some kind of trust back into the markets. (Strikes me as a fool’s task, but so what?)

          But on another level, given the volumes of money floating around at the speed of optic fiber, it cheeses me no end to watch US taxes go up for wars in the Middle East, plus endless bases around the globe, while the financial warfare goes on unabated, unexamined, uninvestigated. So if the SEC even scratches the surface of that level of criminal conduct, so be it.

    2. Yves Smith Post author


      I wrote on Cuban, and he was pursued incorrectly.

      An insider has a duty of care to the corporation. It clearly extends to directors and officers, and people who have contractual relationships that require them to keep confidential information confidential. It may also extend to employees, depending on the nature of their duties; some companies are very explicit about requiring employees to keep information confidential. The problem is this is often not communicated in an consistent fashion, which firms like Gerson exploit.

      Cuban was not an insider. A company director called him and gave him inside information (I’m foggy on the details, but I think it may have even been with the intent of freezing his position) and said he couldn’t trade on it. Cuban basically told him (not in those words) that the problem of him breaching confidentiality was his problem, not Cuban’s. He hadn’t asked for confidential treatment as a condition of having the conversation.

      1. Paul Repstock

        On Mr, Cuban; I beg to differ. As a significant shareholder. Holding a major position in the float. (I have the numbers somewhere as I was somewhat impacted by it).

        The ‘inside information’ given to him so far as I was able to asertain, was that the company needed money badly, and would Mr. Cuban be willing to take a part of a new share issue which the company was going to sell. Mr. Cuban within hours sold his holding in such a fashion that the share price plumeted and the company was not able to raise any significant money on the new issue.

        Now, I guess your perspective is different from mine, I’m not rated as a ‘professional investor’ I don’t have clients or take commisions. From where I stand, it would certainly appear that Mr. Cuban intentionally drove the share price down. The fact that an apparently incompetent or compromised company executive gave him information which set up the process, did not free Mr. Cuban from his obligations as a significant shareholder.

        I think we are seeing a similar situation in the European bond market. I sort of sadly laugh at the labling of the lesser European economies as PIGS. The real “pigs” are the ones who have engineered a closed loop system in the bond market over there and are now talking down and devaluing the periferal economies and thereby driving up the yeilds. What now appear to be untouchable/risky instruments will fatten these “Pigs” for generations.

        1. Paul Repstock

          Adds and further to::..I should have taken the hint you gave to search the archives. Given the large time lapse between the “alleged” offence and the indictment, I think that there may well be a huge political component to procecting Mr. Cuban. This however, in no way does anything to support the SEC’s objectivity in the current ‘war on insider trading’. I expect this campaign to be as effective as the ‘War on Poverty’ and many other government operations.

        2. Steve Hamlin

          “On Mr, Cuban; I beg to differ…your perspective is different from mine”

          Well, the law appears to say otherwise, your perspective and opinion on the matter notwithstanding.

          You may disagree with the law, but to most knowledgeable observers other than the SEC, the law does not make what Cuban did illegal. He was not an insider according to the law, and thus had no obligation to not sell.

          You don’t like it, I hear you, but the rules in place are what they are. Argue for expanded legal duties of significant shareholders, if you believe so, but don’t argue for a incorrect application of the laws that exist simply because you are offended by Cuban. Justice for all.

  2. Ted K

    I’d be very curious to know how often you catch Nina Mehta’s reporting???? I have to confess I don’t read her as much as I ever intend to, but everytime I catch one of her reports I am pretty well impressed with her topics and style. Any thoughts—positive or negative, about her writing/journalism??? Very curious your thoughts on her.

    1. Ted K

      When she copies links from others posts she rarely fixes it. So often you see the links are messed up. I guess it’s some video link. I’ve raked her over the coals for that at least 3 times and she doesn’t seem to think it’s an issue. I’ve made some big mess-ups online myself (mostly commenting on blogs when I was drinking) so I can’t criticize her too harshly, but I think Yves would do a great service to herself if she was more consistent to fix those copied links.

      1. Yves Smith Post author

        I have no idea where that stray code came from, it most certainly was not in the 2007 post. I didn’t have the foggiest idea how to insert videos in Jan 2007, so there was no video in that.

        Will clean up now.

  3. thedukeofurl

    The interactive flash image displays perfectly in a browser but the problem came when Yves copied and pasted the text (which included the image) into the Blogger text field, which will not display it. A similar thing happens should you copy and paste this article into a Word document. This is an historical inheritance from when word processors were oriented only to print, an orientation that is now out of date.

    1. Yves Smith Post author

      I’m in WordPress, but the same principle applies. I’m also working on an old computer now which is misbehaving (in terms of screen display of my input window) which is NOT helping matters. I had laptop hard disk catastrophic failure last week and have to wait 2 weeks to see if the hugely expensive data retrieval of my old computer will work, and I don’t want to start using my new computer till I’ve loaded my old data and programs in.

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