Mosaic Theory or Painting by the Numbers?

The initial hysteria over the “vast” insider-trading scandal has waned somewhat in recent days. Early indications pointed to an assault on the so-called “mosaic theory” and other types of primary research tools. A particular target was the so-called “expert networks” the industry founded around providing investors with access to a network of experts with significant expertise in a particular industry, disease, science, information technology, or the like. The hype suggested an indictment of the entire model — that these networks are passing off insider information under the guise of practicing the mosaic theory.

However, a careful review of the public documents related to the U.S. Securities and Exchange (SEC) investigation suggests a much different story. While the federal case against Don Ching Trang Chu (“Don Chu”) does involve a hedge fund consulting with an industry specialist from one of these expert networks, the complaint sets forth a clear case of garden-variety insider trading. As alleged, the expert network’s representative was fully aware that quarterly earnings information was being provided before the company’s formal release, and the implication is clear that the expert network firm and hedge fund investor clients were also aware that these weren’t just unusually prescient predictions.The wiretapped conversations are almost comical in their revelation. Indeed, on one notable call, the hedge fund investor (who agreed to be recorded) compliments the firm for finding experts who are “spot on,” to which a representative from the expert firm responds, “Yeah, he is one of our most liked guys.” I‘ll bet.

From all indications, application of the mosaic theory is not at issue here. Analysts need not fear that informed and insightful analysis, founded on primary research, is suddenly inappropriate. Fashioning that mosaic, however, does not include painting by the numbers. We are confident that, as the investigation unfolds, honest research will prevail.