Views on improving the integrity of global capital markets
21 May 2012

What’s in a Name? Conduct Some Call Insider Trading by Any Other Name Stinks as Much

Posted In: Insider Trading
Jon Stokes

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.


About the Author(s)
Jon Stokes

Jon Stokes is the Director of Ethics and Standards Education at CFA Institute. His responsibilities include design and creation of on-line ethics education, development and maintenance of the CFA Institute Code of Ethics and Standards of Professional Conduct, and the design and management of the CFA Institute Ethical Decision-Making and Giving Voice to Values education programs. Stokes holds a JD degree.

5 thoughts on “What’s in a Name? Conduct Some Call Insider Trading by Any Other Name Stinks as Much”

  1. Marianna Malaspina says:

    Agreed John.
    But it is still not clear to me why this type of action can not be classified as insider trading. These special clients did indeed trade on relevant non public information, in this case the professional highly regarded advice of an analyst. Regardless if the analyst adhered to the mosaic theory. The moment he put together his research, if his opinion is market moving, it is relevant, for all practical purposes.
    If his research had been made public only to his firm’s Clients, that would be IMO fair. After all his only duty is to his firm’s Clients, not to the world! But it should have been made public to the entire firm, not just leaked to some VIP Clients.

  2. Jon Stokes says:

    Thanks for your comment. I agree that the alleged conduct was inappropriate as all of Lehman’s clients had a right to the information. This very conduct is being investigated by regulators with respect to the Facebook IPO.

  3. David Kamons says:

    The issue of disclosure to paying clients prior to public dissemination was adjudicated in a lengthy suit against analyst Ray Dirks and his independent research that discovered that the then hot insurance company Equity Funding was, in fact, a complete fraud. So standards of practice permit disclosure to clients before public dissemination, but require that all clients with a similar service relationship receive notification at the same time.

    The offense in this instance clearly is “front running”. CFA ethical guidelines prohibit the analyst (and by extension the analyst’s firm) from trading ahead of clients. The analyst and a the firm owe a duty of loyalty to place the interests of clients ahead of the firm’s own trading.

    In effect, the firm has a choice: if it wants to trade on the private work of its analytical staff, then it can’t sell this research; if the firm wants to sell research, it can’t permit a prop-trading desk to front-run the clients.

    This is precisely the reason that investors, especially the public clientelle, believe that the insiders have rigged the game and are taking their wealth out of the public markets.

  4. Jon Stokes says:

    We agree with you completely. Thanks for your feedback.

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