Sell-side research isn’t inside information

By Felix Salmon
May 20, 2012

Ted Parmigiani, a research analyst, was fired by Lehman Brothers in 2005, after he upgraded a company called Amkor from Sell to Neutral. He discussed his upgrade on the firm-wide squawk box at 10am on June 1, and it seems that he was hoping that his upgrade would move the market. He was disappointed: while Amkor did rise that day, it rose before his 10am call, rather than after it. Convinced that the early-morning move was attributable to Lehman insiders and their clients buying Amkor with foreknowledge of his upgrade, Parmigiani started a series of complaints.

First, Parmigiani complained to Lehman superiors; that just got him fired. So he filed a wrongful-termination suit, which got settled out of court. And with his suit behind him, Parmigiani kept on complaining about what had happened. First he went to the SEC, which looked into his allegations and found no evidence of wrongdoing. After striking out with the SEC, Parmigiani complained to Senator Charles Grassley, and also to Preet Bharara, United States attorney for the Southern District of New York. Again, nothing. Finally, with nowhere left to go, and despite the fact that Lehman went spectacularly bust back in 2008, Parmigiani went to Gretchen Morgenson, some seven years after the events in question happened. And this time, he got results, if by “results” you mean a big 3,000-word article in the New York Times.

I’ll let Morgenson explain what Lehman is supposed to have done wrong:

Mr. Parmigiani says traders there were routinely advised of changes in analysts’ company ratings before those changes were made public. That way, Lehman could profit on subsequent market moves. Here is how he describes it: First, research officials tipped off the traders; then Lehman’s proprietary trading desk, which cast bets with the firm’s own money, positioned itself accordingly. Lehman salespeople also alerted favored hedge funds. Only later, he says, were ratings changes made public.

I have to admit that I’m a bit confused with what exactly Morgenson means by the phrase “made public”. I, for one, never had access to Lehman Brothers squawk-box calls, and I’ve never seen sell-side upgrades or downgrades filed with the SEC or be made subject to Reg FD.

Now it’s true that the SEC does consider the news that an investment bank is going to change its rating on a stock to be material nonpublic information, and therefore subject to insider-trading rules. But it’s a very weird, grey-area sort of inside information. Let’s say Lehman upgrades Amkor: is that inside information about Lehman, or is it inside information about Amkor? The news would be very unlikely to affect Lehman stock, so it’s not really the former. But at the same time, no Amkor insiders are involved at all, so it’s hard to see how it can be the latter.

There can’t and shouldn’t be any rule against analysts doing independent analysis on companies, based on publicly-available information. Similarly, 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.

The tricky thing happens when that analyst gets a job at an investment bank, and the individual’s analysis mutates into being the bank’s analysis. There’s a kind of invisible special sauce which a bank pours onto its analysts’ reports: if Joe Schmo puts out a “buy” rating on XYZ Corp on Seeking Alpha, few people will notice or care. But if Mr Schmo gets a job at Goldman Sachs, then that rating can move XYZ shares. And at that point, the SEC starts getting interested.

Now the SEC does not say that banks need to make their research reports fully public. In its complaint against Goldman Sachs “huddles”, for instance, the SEC has no problem with news of upgrades and downgrades being “disseminated broadly to all clients of the firm”. There’s a huge difference, of course, between the set of Goldman Sachs clients and the set of public-company investors, but as far as the SEC is concerned, it seems that if all of Goldman’s clients have a certain piece of information, then that piece of information can be considered to be public information.

Similarly, Morgenson and Parmigiani seem to think that once a call has been made on the Lehman Brothers squawk box, that too counts as public information. If something’s available — in theory — to any Lehman client, then it’s public. If it’s only available to select Lehman clients, then it’s inside information.

Here’s Morgenson:

While insider trading commonly involves nonpublic corporate information, advance warning on research changes can also yield quick, illicit gains. The S.E.C. said as much in a rare research case it filed in 2007 involving an executive at the Swiss banking giant UBS. In that case, eight individuals and three hedge funds were charged with profiting on tips about coming analyst ratings changes — “valuable and material, nonpublic information,” the S.E.C. said. One executive went to jail, and others settled with the S.E.C.

This is disingenuous. The case in question involved individuals, not the bank as a whole: a UBS executive director, Mitchel Guttenberg, was personally tipping off his friends, in return for under-the-table payoffs, about upcoming UBS upgrades and downgrades. In that sense, the case is really about misappropriation rather than about insider trading. As John Carney explains, using the example of Foster Winans:

An employee’s undisclosed and self-serving use of information belonging to his employer to trade securities is a securities fraud. The employee is “misappropriating” the information from his employer and using it for his own personal gain…

If the Wall Street Journal had authorized Winans to leak to his roommate and his stockbroker, no violation would have occurred. In that case, there would be no breach of duty to his employer, which means there’s no misappropriation.

In other words, 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. The Goldman huddle case, in particular, seems particularly thin: the SEC is basically shocked — shocked! — that before an analyst upgraded a company, that analyst was bullish on the company in question. Whereas the rest of us would probably be shocked if an analyst wasn’t bullish before upgrading a company. And in the end, the Goldman huddle case was more about internal controls than it was about inside information.

The fact is that if no corporate insiders are involved, there’s really no good reason at all to prosecute or criminalize anybody using information they’ve obtained to act in the markets. The markets should be a game of people using independently-obtained information and analysis to make their own determinations about what various securities are worth — that’s the best way to maximize the amount of information reflected in the price of those securities.

As the Facebook IPO demonstrated, pricing securities, especially stocks, is always more of an art than a science. Facebook’s underwriters thought they had a pretty good handle on where the demand was for Facebook’s stock, but they were wrong: all those investors were deliberately upsizing their orders just because they knew they wouldn’t get all the shares they were asking for. And because they also reckoned they could lock in a nice profit by selling some of their shares at the very first tick. By the end of the day, Facebook’s banks were being forced to buy back stock, in significant quantities, at the same price they’d sold it.

So let’s let brokerages’ clients trade what they like, so long as they’re not trading on genuinely inside information from the company in question. If we’re going to be serious about the Volcker Rule, and prevent the brokerages from trading for their own account, the least we can do is let them monetize their analysts’ research as best they can.

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Comments
18 comments so far

Further to your point, Felix, *analysis and opinion* from a third party, like an investment bank, is substantively different from factual inside information from a company. It’s somebody’s opinion, not fact. And, given the widespread scorn in which Wall Street’s structurally boosterish sell-side “research” is held, I find it hard to believe early or selective dissemination of same gives anybody a real edge. Lots of hedge funds I know would love to know what a major investment bank’s analyst thinks about a stock before it’s released, just so they could bet *against* that opinion.

Posted by EpicureanDeal | Report as abusive

No wonder they fired the bloke. He was confused about the insider trading rules. How did he climb that far I do not know. Maybe his termination was a long time coming and his actions in this case was the final straw. Good on management to fire him. I wouldn’t want his disloyal a*s on my team.

Posted by gyris | Report as abusive

This issue is not about insider dealing only. Front running your own research is as much a form of market manipulation as insider dealing. No matter how you squeeze it into the language of the regulation any regulator has to block it happening

Posted by SiBar | Report as abusive

This issue is not about insider dealing only. Front running your own research is as much a form of market manipulation as insider dealing. No matter how you squeeze it into the language of the regulation any regulator has to block it happening

Posted by SiBar | Report as abusive

Lots of very good points. Keep it coming. A third of my new book is devoted to a discussion regarding several conflicts of interest in the investment industry. Look for the book in June : Greedometer. Dow 5000. Why nobody sees it coming. regards

Posted by greedometer | Report as abusive

This is a strange post from a blogger I much respect.

I think the point of Morgenson’s article was that to show yet another way in which the market is rigged in favor of insiders at the expense of the average investor. The behavior that you highlight may or may not have been illegal. But please note this was not all that Morgenson wrote about: she also presented evidence of pressure being brought to bear on the analyst to change his assessment in clear violation of the Spitzer settlement.

These banks are so clearly enmeshed in a variety of conflicts of interest. They have shown time and again that they cannot be trusted.

Little by little, regular investors are being driven from the market as it becomes, more and more, a casino rigged on behalf of insiders. This should be a cause of great concern to the very people who most benefit from the financial system: bankers, for instance. And regulators. And bloggers.

But right now it appears only to be of concern only to a few intrepid reporters like Morgenson.

Posted by Fursty | Report as abusive

if you think that advance knowledge of an opinion change from “sell” to “neutral” by a little-known analyst on a stock like AMKOR is an opportunity for big profit you’re naive.

Parmigiani took his info to the SEC, and to Sen. Grassley. He had no luck. So he went to Gret, who specializes in stories critical of Wall Street. She wrote an article about it– IN 2009!
http://www.nytimes.com/2009/02/23/busine ss/23hedge.html

There’s nothing new in today’s article (other than a few updated references to bad banks). Why are we reading about this again?

Posted by randomrant | Report as abusive

Felix, maybe you think there aren’t and can’t be any rules about research reports, there in fact are such rules, imposed by the FINRA. There are restrictions on what research analysts can say to non-research people at the bank, and there are restrictions on trading by research analysts. I don’t think this counts as insider trading per se, but it is very wrong to think there are no rules about this stuff.

Posted by niveditas | Report as abusive

From your article:
In other words, 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

From the Times’ article:
But while insider trading commonly involves nonpublic corporate information, advance warning on research changes can also yield quick, illicit gains. The S.E.C. said as much in a rare research case it filed in 2007 involving an executive at the Swiss banking giant UBS. In that case, eight individuals and three hedge funds were charged with profiting on tips about coming analyst ratings changes — “valuable and material, nonpublic information,” the S.E.C. said. One executive went to jail, and others settled with the S.E.C.

Posted by JimNavadomskis | Report as abusive

Oops hit submit too soon – Clearly there were at least “individuals” at Lehman that could have been prosecuted.

Posted by JimNavadomskis | Report as abusive

Isn’t it clear market manipulation?
The upgrade event is material and its timing non-public.

Whale-like clients receiving that info ahead of time, means non only are non-Goldman clients at a disadvantage but even Goldman clients are at a disadvantage (presumably the “muppets”).

A great way to maximise your commissions would be to let clients know there was a VIP club getting upgrade info early.

Or just front run it through the prop desk.

Posted by TinyTim1 | Report as abusive

It’s not illegal what they were doing. An analysis is not material nonpublic information. However not distributing that research action evenly and at the same time to clients is highly unethical.

Posted by marko12345 | Report as abusive

Marko, from Felix above:
“The SEC does consider the news that an investment bank is going to change its rating on a stock to be material nonpublic information.”

Posted by TinyTim1 | Report as abusive

It can legal or illegal – whatever we as a society want it to be. This not a Constitutional issue. The past cases make it clear that there’s something that feels wrong about this, and it’s punished if there a legal peg to hang it on in a particular case – but it doesn’t fit any explicit definition of an ethical violation in every case.

What is wrong in every case though, IMO – to release such reports and not disclose that the publisher and/or certain others may hold positions in the subject issues, and not disclose that the contents of the report have been made known to others ahead of general release.

Posted by MrRFox | Report as abusive

Mr. Salmon 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, at least not if you are a CFA Charterholder abiding by the 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. 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.

Posted by JJStokes | Report as abusive

I’ve always been interested in understanding this. So I believe the point here is not about Insider trading, but rather unethical practices that fundamentally provide a certain advantage to the firm (even a few minutes is sufficient because they have direct access to a block of stocks and based on volumes even a few cents might be enough to make a profit).

Now my other question is, how is Salmon Barney’s conduct appropriate here. They made a concerted effort to sustain the price at 38. Failing that, the stock would have fallen to 34 on Friday. I would have bought the stock at 34 instead of the 36 I ended up paying at Market-open. Isn’t that inappropriate as well?

Posted by nharish | Report as abusive

nharish, if you thought it was worth buying only at 34 and not at 36, why did you agree to buy it at 36?

Posted by niveditas | Report as abusive

Felix – I love your posts but you are completely wrong here. It is illegal to front run your clients in the fashion described here. Whether it happened or not, or whether it should be illegal or not are different questions.

Posted by Metsox | Report as abusive
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