Inside Information: To Trade or Not to Trade?

 

The recent raft of criminal charges brought by U.S. security regulators against consultants, investment managers, and other investment professionals, as well as the  long sentences imposed in high-profile cases brought by the Financial Service Authority in the United Kingdom, have again highlighted the continuing issue of insider trading. In the GCC, the regulation governing insider trading is in most cases light and in some markets non-existent. GCC exchanges are retail dominated with trading behaviour often either sentiment led or heavily influenced by market rumour generated from insider information. Trading on privileged information is commonplace  eroding market credibility . It is heartening to see that the Saudi CMA has started taking actions against insider trading by imposing finesbut they are still relatively small. As GCC markets continue to court institutional investors, against steep competition from other markets, the need to have firm policies to curb insider trading has become crucial. It is also an essential step in the development of the region’s stock markets.

 Following an earlier article in the Financial Times (FTfm supplement) Mr. Raghu Mandagolathur, President of CFA Kuwait and Michael G. McMillan, CFA Institute analyse the elements of insider trading to distinguish improper conduct from legitimate investment analysis.

 

What is inside information?

Generally, inside information, or material non-public information, is information not disseminated to the public that would likely affect the price of a security or that reasonable investors would want to know before making an investment decision. The materiality of information is a function of its substance and specificity, as well as the reliability of its source. Information that is ambiguous, has a tenuous effect on the price of a security, or originates from an unreliable source, is relatively less material.

What are some common examples of inside information?

The most common types of inside information concern intelligence about a company’s financial health or stability (earnings, revenues, bankruptcies, etc.); changes in a company’s structure arising from a merger, acquisition, or  joint venture; and a company’s new products , processes, licenses, patents, etc. 

What is wrong with trading on inside information?

Security market regulation is designed to promote the fairness, efficiency, and integrity of security markets. Trading—or inducing others to trade—on material non-public information erodes investor confidence in capital markets by supporting the idea that those with insider information and special access can take advantage of the investing public. 

Investors tend to avoid capital markets that are perceived to be “rigged,” thereby impairing liquidity and efficiency. As a result, most developed capital markets have enacted laws that prohibit trading on inside information.

Who might have access to inside information?

Anyone who has a direct or indirect relationship with a company may have special access to or become aware of information that is both material and non-public. Service providers (e.g., consultants, auditors, and investment bankers) may have access to material non-public information about both a company’s internal and financial activities. In addition, people who have no connection with a corporation may be given inside information either accidentally or purposefully by those who have a direct or indirect relationship.

Does relying on “industry experts” constitute insider trading?

There is nothing inherently wrong with hiring a company that arranges conversations between analysts or hedge fund managers and those who offer legitimate expertise to assist investors in making investment decisions. The information provided by experts can be part of the “mosaic” of information gathered by analysts or investment managers to assist them in the process of investment decision making. This type of information can include economic or industry forecasts.

Even if a piece of non-public immaterial information takes on significance when combined with primary research or other non-public immaterial information, the information may still be considered immaterial.  This concept is known at the mosaic theory. 

 How does one legitimately use “expert networks”?

In recent expert network cases, the misconduct alleged by U.S. prosecutors involved such material nonpublic information as detailed earnings, gross margins, and other confidential information leaked by insiders. 

Before hiring an expert network company, one would be wise to conduct due diligence to determine whether public company employees are engaged as consultants and whether the expert network company has in place sufficient policies and procedures to ensure that material nonpublic information is not being leaked or otherwise passed on to clients.

What are some precautions portfolio managers might take?

Before making an investment decision or recommendation, investment professionals should consider whether the information is widely known or available to the public. Has it been disclosed to only a select number of people?  

To evaluate whether information is material, consider whether the information would be likely to affect the price of a security if it were known or whether a reasonable investor would want to know the information before making an investment decision. The information’s substance, specificity, and reliability contribute to its materiality.

Consider the source of the information, as well. If the information has been provided by someone with either special access or a duty to keep the information confidential, it is likely to be reliable and thus inside information.