In an article in the Sunday New York Times, “Is Insider Trading Part of the Fabric?,” reporter Gretchen Morgenson, seemingly throws another log on the bonfire of recent insider trading cases that is engulfing the reputation of the investment profession. Morgenson describes in detail the allegations of Ted Parmigiani, a former analyst for the defunct Lehman Brothers, whose market-moving recommendation on a technology company was “leaked” to Lehman Brothers traders who acted on the recommendations for the firm’s proprietary account and select clients before the recommendation became “official.”
In the article, Parmigiani is quoted as saying that Lehman traders “were routinely advised of changes in analysts’ company ratings before those changes were made public.” This is evidence, according to Parmigiani, that the SEC’s “widespread [insider trading] net has a very big hole in it.”
But is this an example of insider trading? Who was the insider? What was the information that was material and non-public? Let’s assume that the investment recommendations of Parmigiani, as an analyst for a major (at the time) investment house, would affect the price of the security. In other words, a reasonable investor would want to know what Parmigiani thought of the stock before making an investment decision — making his opinion material information. Let’s also assume that Parmigiani engaged in extensive, thorough, diligent, and legitimate research efforts to reach his conclusions. After all, that’s what Lehman, and its clients, paid him to do. Does Parmigiani have a duty to disclose the fruits of his research to the public? Is it insider trading if he selectively discloses this “material” information to only Lehman clients?
Not according to the guidance in the CFA Institute Standards of Practice Handbook, which offers the following analysis:
“When a particularly well-known or respected analyst issues a report or makes changes to his or her recommendation, that information alone may have an effect on the market and thus may be considered material …. The analyst is not a company insider, however, and does not have access to inside information. Presumably, the analyst created the report from information available to the public (mosaic theory) and by using his or her expertise to interpret the information. The analyst’s hard work, paid for by the client, generated the conclusions. Simply because the public in general would find the conclusions material does not require that the analyst make his or her work public. Investors who are not clients of the analyst can either do the work themselves or become clients of the analyst for access to the analyst’s expertise.”
The NYT article ominously warns “that those in the know can get rich before the rest of us know what happened.” Well when it comes to primary research, that’s the whole point. Investment professionals diligently piecing together public information, research, interpretation, and analysis to create a big picture “mosaic” that leads to a yea or nay investment conclusion. The analyst may use these conclusions derived from the analysis as the basis for investment decisions even if those conclusions would have been material inside information had they been communicated directly by the analyst to the company.
While the alleged actions of Lehman traders, as described by Parmigiani, may not be inside information they certainly seem to constitute an example of a firm looking out for itself at the expense of its clients. Lehman traders allegedly traded for their proprietary account ahead of disseminating the research reports to its clients. And then only gave “a lucrative heads-up” to favored clients, who presumably could most enrich the company with brokerage commissions and fees. So while insider trading is the wrong label, when it comes to following self-serving, profit-seeking motives over duty to clients, the conduct is just as egregious.
Reuters finance blogger Felix Salmon, commenting on the NYT article, contends that, in the case of legitimate, independent research, “once that analysis has been done, the analyst can do what she likes with her analysis. She can trade the stock, she can write it up, she can talk to hedge funds about what she thinks, she can sell it to clients, she can make it public. Or, she can do all of the above, in any order she likes.” Not exactly. According the ethical principles of the CFA Institute Code of Ethics and Standards of Ethical Conduct, you can’t front-run your clients, and you can’t selectively disclose recommendations. Clients must be treated fairly, meaning that investment recommendations are disseminated in such a manner that all clients have a fair opportunity to act on every recommendation. Firms should design an equitable system to prevent selective or discriminatory disclosure.
Salmon says, “As far as I can tell, no one has ever been successfully prosecuted for the crime that Morgenson and Parmigiani are so upset about here — the crime of giving information about ratings actions to some clients before other clients.”
If the investment profession is ever going to overcome the negative public perception that firms are looking out for themselves at the expense of their clients, maybe they should.