Practical analysis for investment professionals
24 May 2012

How to End Insider Trading: More Guidance and Fuller Disclosure

It seems like you can’t pick up a newspaper these days without reading about a new insider trading investigation. Just as Robert W. Kwok, a former Yahoo executive, plead guilty to one count of conspiracy to commit securities fraud, the trial of Rajat K. Gupta was getting underway. Gupta, a former director of Goldman Sachs and Procter & Gamble, stands accused of leaking secrets about both companies to his former friend, hedge fund manager Raj Rajaratnam, who was convicted of insider trading last May.

The recent spate of court cases reflects efforts by the SEC to crack down on hedge fund traders, analysts, lawyers, and other financial market participants who trade or traffic in confidential information. And, according to Reuters, the FBI has enough hedge fund informants to keep it in the insider-trading investigation business for at least the next five years.

Needless to say, none of these headlines are helpful in restoring the public’s trust in the investment industry. So what can be done to put an end to this practice?

Many people believe that harsher penalties, such as longer sentences, would act as a more effective deterrent to insider trading. I don’t buy that. Although stiffer prison sentences might help at the margin, I don’ t think that it would be effective because it only raises the stakes. Do you think that Rajaratnam would have forgone trading on insider information if the penalty was 25 years in prison instead of 15? It doesn’t appear that those involved even thought about the consequences of getting caught.

After reading the SEC and FBI charges in these recent cases, it appears to me that the individuals involved knew exactly what they were doing and that they willingly and purposefully traded and trafficked in inside information. It appears that the only question they were asking was, “Can I get away with it?” Rajaratam relied on the “mosaic theory” to defend his actions; he claimed he was using public as well as nonmaterial, nonpublic information as the basis for his trading decisions. But his defense went down in flames when the prosecution played tapes of secretly recorded telephone conversations between Rajaratam and his cabal of tipsters.

A second solution for curbing insider trading is for investment firms to offer ethics training and place a greater emphasis on ethical behavior. A primary objective of such training is to make people more aware of their own behaviors, increasing the likelihood that they will recognize an ethical dilemma and take action before it becomes destructive. Ethics training focuses on grey areas and addresses the question of what you should or shouldn’t do, instead of what you can or can’t do.

Ethics training also tries to prevent “good” people from doing “bad” things. Doing the right thing can be difficult when you work for a firm that built its business model trading on illegal stock tips, as was the case at Sonar Capital, according to the Harvard-educated hedge fund manager who testified against his former employer last June.

Full disclosure: I provide ethics training on behalf of CFA Institute. And while I believe that this training is important and that all employees should participate, it is by no means a panacea. It will not, on its own, curb the type of behavior that we have been witnessing lately.

Which brings me to a third and potentially more aggressive solution: more guidance and fuller disclosures by corporations. This solution is based on the old adage, “Follow the money.” Quite simply, people traffic in insider information because it is lucrative. Stock prices are information driven. The golden rule — “He who has the gold, rules”  —  has been displaced by the information rule: “He who possesses inside information, generates positive alpha, outperforms peers, and beats benchmarks.” In other words, inside information is a very valuable resource. It has become the drug of choice on Wall Street. The best way to wean investors off of this drug is to decriminalize or devalue it.

Information is “material” if its disclosure would probably have an impact on the price of a security or if reasonable investors would want to know the information before making an investment decision. Examples of material information include earnings, mergers/acquisitions, innovative products, new licenses/patents, changes in management, significant legal disputes, and so forth.

In my view, the easiest, least expensive, and most effective way to reduce information trafficking would be for public companies to be more open and honest with investors and shareholders by providing fuller disclosures and greater guidance about their business. This would reduce a large amount of material nonpublic information and the value that is placed on it. Corporations should have a policy to disclose any information that could affect its stock price as soon as management and the board of directors become aware of it. Since this information is going to eventually become public, why not disclose it immediately instead of tempting some to selectively disclose it. (Think Regulation FD on steroids.)

Let’s face it: the primary function of expert networks is to provide high-quality information (drugs) about a company to well-heeled users (hedge funds, analyst, etc.) that they can’t get from anywhere else. If corporations were proactive about disclosing the type of information that networks are paid so handsomely to provide, there would be no need for them.

This solution came to me after reading a Wall Street Journal article written earlier this year by Baruch Lev, the well-known professor of accounting and finance at New York University’s Stern School of Business. Lev urged companies to provide more guidance about their earnings and other financial matters because it would benefit investors — and corporate management and directors — by reducing the number of shareholder lawsuits and providing the financial markets with more data to work with. According to Lev, companies should provide guidance “only when they can predict performance better than analysts.” (Shouldn’t management always be able to predict their company’s performance better than analysts?) In addition, Lev says that increased guidance should be “part of a broader practice of disclosure that gives investors insight into the company’s plans and progress.”

When it comes to quarterly guidance, the issue of greater disclosure is particularly challenging. CFA Institute advocates strongly for investors to take a long-term view, and when companies deliver quarterly guidance, it simply enables “short-termism.” The greater message here is that there is a lot more information to learn about a company than simply whether or not it will beat the Street’s consensus estimate for a given quarter. In his article, Lev even writes, “Most guidance isn’t short-term. It forecasts several quarters ahead, giving companies a chance to fill in details that wouldn’t show up in regular financial reports.”

If everyone has access to the same information, the value declines markedly. Regulation FD was a good step in addressing this problem. However, until this asymmetry is completely addressed, in my view, insider trading is likely to continue.

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About the Author(s)
Michael McMillan, CFA

Michael McMillan, CFA, is director of ethics education at CFA Institute, where he is responsible for creating, sourcing, and developing educational content for CFA Institute members and investment professionals in the area of ethics and professional standards. Previously, he was a professor of accounting and finance at Johns Hopkins University’s Carey School of Business and George Washington University’s School of Business. Prior to his career in academia, McMillan was a securities analyst and portfolio manager at Bailard, Biehl, and Kaiser and at Merus Capital Management. He is a certified public accountant (CPA) and a chartered investment counselor (CIC). McMillan holds a BA from the University of Pennsylvania, an MBA from Stanford University, and a PhD in accounting and finance from George Washington University. Topical Expertise: Financial Statement Analysis · Standards, Ethics, and Regulations (SER)

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