A reader recently asked me about the mechanics of insider trading – out of pure curiosity, I hope, with no criminal intent! When do companies “know” what their quarterly numbers will be? How do they maintain them in secret? What prevents in-the-know employees (not to mention any NDA’d companies doing diligence) from taking advantage of what they know?
At the risk of providing a how-to guide to insider trading, today’s post answers these questions and gives some pointers on what’s permissible to ordinary knowledgeable people.
First, let’s consider Google’s recent leak of a draft third quarter earnings report as an example. That was a classic “oops” moment, when someone at its financial printing company pushed the wrong button and the data were filed with the SEC (and hence the wire services) before they should have been. Typically this information is “embargoed” properly (just like with PR firms and news outlets), so a mistake like this doesn’t happen. But let’s talk about the key issue here.
Don Berwick, former head of CMS, made a remark in a totally different context, but highly relevant to insider trading (and much more) at the Health Evolution Partners Leadership Summit this year:
“When values are strong, rules aren’t necessary; when values are weak, rules are ineffective”.
The rules in this case refer to insider trading.
SEC rules clearly prohibit “beneficial insiders” (such as corporate officers) from buying or selling stock based on “material non-public information”, of which clearly an earnings release would be a textbook example. It also requires others, such as a printer, investment banker, or PR agency employee to be considered “insiders,” thus owing a fiduciary duty of confidentiality.
In a case of a PE investor doing diligence on a target company, before even disclosing the name of the target, the banker typically requests the investor to sign a NDA (non-disclosure agreement) specifically stating that they would be a beneficial insider and bound to certain rules. In the case of corporate employees below the officer level, information is kept on a strictly need-to-know basis and public companies typically have codes of conduct and even blackout periods during which time the company’s stock can’t be traded.
That said, insider trading is a fact of the equity markets and simply can’t be completely prevented. In my experience, information often leaks. I’ve seen stocks move up or down in anticipation of good or bad news too many times to believe it’s a coincidence or simply an example of market efficiency. The SEC is focusing more on this phenomenon, and with the help of Big Data, is getting ever better at locating suspicious trades and catching more perpetrators.
The recent high profile case of Rajat Gupta – the former leader of McKinsey (of all firms) who sat on multiple boards and was convicted of passing secrets to the Galleon Partners hedge fund — is a case in point. The Gupta case involved wiretaps and a lengthy investigation, though. What about everyday cases? They, too, can be detected in the data.
For example, if you’ve never shorted a stock (sold it, anticipating it will go down) and then suddenly do so for an unusually large amount of money, and then by great coincidence, it then does go down, you might get a call from the SEC. Because options allow even greater leverage (you can buy or sell options for many more shares for the same amount, because they have expiration dates), options activity is scrutinized even more heavily. The SEC has made some fairly impressive busts, even tracing Eastern European shill buyers to Goldman Sachs junior bankers.
In spite of the SEC’s increasingly sophisticated watchdog activities, we don’t know what we don’t know. In a recent conversation I had with a former US Assistant Attorney General who focused on white collar crime, she estimated that less than 1 percent of insider trading is actually caught.
Even so, it’s a bad idea and I recommend against it. If the unethical nature of insider trading doesn’t stop you, consider that the penalties are harsh and the publicity career-destroying. Further, it’s not the victimless crime some see it to be. Information asymmetry to this extent is patently unfair, and further, it erodes the public’s faith in the capital markets that drive our economy.
A better (and entirely legal) way to trade on semi-proprietary knowledge is one which I expect most readers of HIStalk can easily do. If you think, “Wow, this EMR strategy is terrible. There’s no way it can be sustained,” or, “Wow, this is the best product I’ve seen in my career,” and you do some research on the stock and see it’s expensive or cheap relative to its peers and historical trading range, maybe it makes sense to buy or short the company.
If you do it, though, spend only amounts you can afford to lose. This is high risk, and sometimes an investment thesis takes longer to play out than you expect.
A cautionary note to the physician readers of this blog. If you’re participating in a clinical trial and have knowledge about the compound and its manufacturer, trading on that knowledge is another no-no, as the even more recent case of SAC Capital trading on a clinical trial result showed (or will show once the indictments are finalized).
This was a great question. My thanks to the reader to who asked it! If you’re curious about another investment, Wall Street, or investment banking-related topic, please let me know and I’ll use it as a future blog topic.
As we recover from Thanksgiving, I wish everyone a great holiday season. Near-term events that are investor-relevant include the RSNA conference this week, the ever-popular JP Morgan Healthcare Conference, and the bet-worthy question of who’s going to buy Allscripts and what they will pay.
Ben Rooks spent a decade as an equity analyst and six long years as an investment banker. In 2009 he formed ST Advisors to work with companies on issues that don’t solely involve transactions. He has been a beneficial insider countless times (but never traded inappropriately) and appreciates e-mail.