At what point does scuttlebutt become insider information?

[Musicwhiz]

Business Times - 01 Dec 2010

At what point does scuttlebutt become insider information?

(NEW YORK) On Wall Street, it is called the 'mosaic theory'. Every day, professional investors and research analysts work the phones to ferret out information about companies that can't be found by simply reading news releases.

Some will walk through shopping malls interviewing Gap store managers, for example, to gauge how sales are going. Others might monitor sales of certain component parts in Asia to determine how many iPads Apple might sell this quarter.

Investors use multiple tidbits of non-public information from various sources to build a 'mosaic' to try to get an edge on other investors. For better or worse, that is what passes as 'research' in the finance world.

Amid a wide-ranging investigation by the Securities and Exchange Commission (SEC) and federal prosecutors into hedge funds and the 'expert networks' that supplied them information, some investors may be asking themselves if their 'mosaics' may soon be considered 'insider trading'.

'The SEC's recent enforcement docket reflects a belief that certain buy-side investors' investment activities were rife with insider trading violations, and that there are more to be found,' the law firm Fried Frank wrote in a note to its clients last week titled 'Avoiding Insider Trading Risks in Fundamental Investment Research'.

Indeed, the mosaic theory itself is one of the central defences in the insider trading investigation of Raj Rajaratnam, founder of the Galleon Group. 'Throughout his career, Mr Rajaratnam has worked tirelessly as permitted by the securities laws to build a mosaic of public information about the companies he follows,' his lawyer said.

In other words, Rajaratnam and many others who subscribe to the mosaic theory contend that none of the individual bits of scuttlebutt they pick up constitute material insider information; the edge they get, they say, comes from putting it all together. That's the 'value add', in Wall Street parlance.

(In the Galleon case, it must be noted, there is evidence that the information being passed was more than just various assembled data points; it included tips on pending mergers and earnings announcements - which fall in the traditional definition of insider trading.)

When young analysts are trained on Wall Street, they often read the CFA Institute's standards and practices handbook, which declares: 'The idea behind the mosaic theory is that each individual piece of information is non-material by itself: An individual piece of information would not move the price of the security if disseminated in a public press release. Taken together, however, the bits of information can form a meaningful mosaic. This practice is perfectly legitimate.'

But is it? While it has long been considered standard practice to ask the local Gap store manager how sales are going, the store manager's answer may actually fall into a grey area.

According to most white-collar lawyers, the ultimate test is whether the information is 'material'. (There's also a question of whether the manager is breaching his or her fiduciary duty to the company by providing such information.) In truth, knowing the sales at one Gap store isn't material because the company has some 3,100 stores around the globe. However, if you went store to store and managed to find out sales figures for 1,000 of them, you might have something closer to 'material' information. -- NYT

[hmwes]

Hi all,

Sorry to be bringing up an old topic. But I was wondering if scuttlebutt through the business grapevine as advocated by Philip Fisher can really be practiced in reality even by investment professionals?

Can the professionals as per the article clipping "Every day ... work the phones to ferret out information about companies that can't be found by simply reading news releases."?

I know that the above can be partially achieved with resources only available to professionals like direct access to company management, paid industry research, expert network, factories tours etc ...

But for professionals to claim that as part of their research process they also speak to the research target competitors, ex employees, suppliers, customers, distributors etc, isn't it a bit far fetched?

Afterall, would not these parties have direct and indirect interests vested with the listed company and are bound by some kind of constructive or legal obligations to keep the affairs of the company they have dealings with confidential and secret?

For example, if a listed company is my customer, would I not be worried that I may say the wrong thing and end up crossing my customer? As a competitor, why would I tell you my assessment of a fellow competitor strength and weakness for free?

The vested interests of these parties would be self preservation of their business relationships with the listed company and not as an informant to the fund manager. How much information value can then a professional fund manger extract out of such scuttlebutt?

Perhaps more experienced forummers can shine light on the issue? Was curious as I have seen some fund management house marketing such scuttlebutt work as part of their research strength but wondering if they are exaggerated?

Thanks!

[mrEngineer]

Two words: Human Psychology

A typical example of leaked material "insider information" over the pub

Person A: Hey I heard your competitor XYZ is doing this product in Indonesia pretty well and I bet your company is not doing as well.
Person B (agitated and egoistic): Come on, this is defintely not true. Our sales are almost hitting the roof.
Person A (trying his luck to probe further): Wow! I always wondered how the margins of such business in Indonesia are how much
Person B (now trying to show off): Well, you can say the EBITDA margin will be XXX

You can imagine how much information one can gather by talking to the company sales, traders, biz dev, finance, operations etc.

Sometimes even during AGM, one can already fish out quite alot of "material" information if you know your stuff and the business well. Expert people tends to feel unchallenged most of the time and will divulge more to remain being experts when they are challenged.

[Jared Seah]

mrEgineer,

Good one! The key is "if you know your stuff and the business well"

All the published (free or paid) research will do us no use if we have no idea what we are reading!?

And all we do is merely following the calls of other people. Which is not so different from buying on rumours