Views on improving the integrity of global capital markets
28 March 2014

Informing the “Favored Few”: The Muddy Waters of “Material Nonpublic Information”

My personal investment decisions do not move the markets. No one but my wife cares about what stock I’m about to buy or sell. But that is not the case with the investment plans of large activist hedge funds, which often invest in companies and pursue a very public agenda to change how the target company is managed. An interesting article in yesterday’s Wall Street Journal noted that activist investors sometimes share their strategies with a “favored few fellow investors” to try to build constituencies for their planned campaigns, while ordinary investors and stockholders remain “in the dark.” The article points out that, on some occasions, this advanced knowledge has apparently moved the stock price prior to public announcement of the trade. According to the newspaper’s investigation, “stocks often move in the days just before activist investors tell the world what they are up to.”

Whether a large or influential investor is about to buy or sell a stock seems to be a classic example of “material” information. If the investor hasn’t announced those plans yet, that material information would also be “nonpublic.” After all, if Warren Buffett were to buy or sell his share in a company, wouldn’t a reasonable investor want to know that information? In the landmark insider trading case against R. Foster Winans, the columnist was convicted and ultimately imprisoned for leaking the contents of his “Heard on the Street” column in the Wall Street Journal to a group of brokers, knowing that his opinion, when published, would influence the price of stock.

There is a “buddy system among activist investors,” according to yesterday’s Journal article because “high profile investors who know each other don’t want either to get blindsided by another’s investing — or to blindside others.” But when does strategizing with other investors to get them on board with your activist plans morph into tipping fellow investors about an upcoming trading position that could move the price of the stock once disclosed? The US SEC has begun looking into hedge funds profiting ahead of public disclosure of an investment stake, according to the article.

The WSJ article also looked at Muddy Waters, the research firm that examines companies to look for business fraud, accounting fraud, and fundamental problems. According to the Muddy Waters website, the company offers “freely published investment research” that “peels back the layers” to assess “a company’s true worth” by slicing through the “opacity and hype.” The reports may be freely available, but according to the Wall Street Journal, on at least one occasion three investment firms paid the company to see the contents of one report in advance. The firms made profitable trades on that sneak peek, correctly betting that once Muddy Waters published the research, the stock price would tumble.

Are these all just more examples of how knowledgeable, connected Wall Street insiders take advantage of the unaware investing public to rack up big profits?

At first glance, the advance knowledge of the Muddy Waters report may seem similar to the facts of the Winans case. However, there is nothing wrong with investors paying research firms to diligently scrutinize companies to look for information not generally known in the market, analyze that information to develop an investment recommendation, and then to profit by that opinion. The free flow of information leads to efficient capital markets. As stated in the CFA Institute Standards of Practice Handbook, when a particularly well known or respected analyst forms an investment opinion, that opinion alone may have an effect on the market and be considered “material” information. But according to the handbook, “the analyst’s hard work, paid for by the client, generated the conclusions. . . . 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.”

Indeed, Muddy Waters’ website states that “as of the publication date of our reports and research, Muddy Waters, LLC . . . along with our clients and/or investors and/or their clients and/or investors has a short position in all stocks … covered herein, and therefore stands to realize significant gains in the event that the price of either declines.” Muddy Waters clients pay for the company’s diligence, experience, and expertise. So, if you want to benefit from Warren Buffett’s opinion, invest in Berkshire Hathaway. And if you want to benefit from my stock picking prowess . . . you may want to check with my wife first.

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About the Author(s)
Jon Stokes

Jon Stokes is the director of Professional Standards at CFA Institute. His responsibilities include developing, maintaining, and providing interpretation on the organization’s Code of Ethics and Standards of Professional Conduct, Asset Manager Code of Professional Conduct, and other ethics codes and standards. He has designed and created on-line ethics education programs for CFA Institute, including the CFA Institute Ethical Decision-Making and Giving Voice to Values education programs. Stokes has led numerous in-person and online ethics trainings for members, societies, and investment professionals and contributes to the ethics curriculum at all three levels of the CFA Program. He holds a JD degree.

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