Stock Research Rules May Be Unaffected by U.S. Probe

U.S. attorney general Eric Holder
An Asia technology specialist at Primary Global Research LLC, which matches investors with industry experts, was accused of leaking inside information as part of what U.S. Attorney General Eric Holder called a “very serious” criminal probe of illegal trading on Wall Street. Photographer: Steve Pope/Bloomberg

Rules for analysts researching stocks probably won’t be affected by the U.S. insider-trading investigation that has resulted in the arrest of one “expert-network” employee, securities lawyers and law professors said.

An Asia technology specialist at Primary Global Research LLC, which matches investors with industry experts, was accused of leaking inside information as part of what U.S. Attorney General Eric Holder called a “very serious” criminal probe of illegal trading on Wall Street. Investigators have raided three hedge funds and subpoenaed money managers including Janus Capital Group Inc.

The actions, which are an extension of federal cases filed last year that have yielded 14 guilty pleas, are raising questions about whether regulators are redefining what constitutes legitimate stock research, especially the practice of digging up small pieces of information to create a broader understanding of a company, industry or trend. That’s probably not the case, according to lawyers and academics.

“I don’t think the rules are changing,” said David S. Stone, head of the corporate and securities practice at Neal, Gerber & Eisenberg LLP, a Chicago law firm. The Securities and Exchange Commission is focusing “on a different group that has previously not been in the limelight.”

While investigators haven’t detailed what they’re examining, their work has had an immediate impact on Wall Street research practices, said Michael W. Mayhew, founder of Integrity Research Associates LLC, a New York firm that tracks trends in investment research.

Business Stalls

Expert networks have grown into an industry with $450 million to $500 million in revenue in the past year, Mayhew estimates. The crackdown has caused much of their business to disappear, Mayhew said.

“Use of their services has been suspended or stopped, because their clients are concerned,” he said.

The growth of expert networks -- from eight firms a decade ago to 40 today -- is part of a drive by hedge funds and other investors to be more aggressive about gathering information. It’s not the idea of expert networks that may be illegal, but how they are used, and particularly which experts investors consult.

“Analysts have become very sophisticated,” said Perrie Weiner, international co-chairman of securities litigation at law firm DLA Piper LLP in Los Angeles. “The question is: When you have expert analysts digging deeper than average analysts would dig, at what point have they dug too far?”

Chu, Kinnucan

Don Ching Trang Chu, 56, a wireless broadband expert and employee of Primary Global, was arrested on Nov. 24 on charges he provided insider information to a hedge-fund manager who was cooperating with the government. Chu, who had worked at the Mountain View, California-based firm for seven years, was dismissed, said Dan Charnas, a spokesman. Chu’s attorney James DeVita has declined to comment.

The Federal Bureau of Investigation questioned John Kinnucan, who runs Broadband Research LLC in Portland, Oregon, and gets most of his information by talking with people who do business with companies. Kinnucan, 53, said the FBI asked him to secretly tape a conversation with a fund-manager client they were targeting. He refused and has spoken out against the government’s tactics.

“The Justice Department evidently would like to retroactively criminalize research activities which have been complicitly condoned by the SEC for years,” he said in an interview. “If I don’t raise my voice, nobody will because everyone has gone underground.”

‘Violation of Duty’

Asked to comment on whether the definition of insider trading is evolving, John Nester, an SEC spokesman, said in an e-mail: “Illegal insider trading is the act of trading, or causing someone to trade, on the basis of material nonpublic information in violation of a duty.”

Securities experts said that, in recent cases, the key phrase is “in violation of a duty.” The rumor mills of Wall Street or Silicon Valley -- or even company holiday parties -- have always been places to glean information on public companies. Such information is illegal to trade on when it comes from someone who had a duty to keep it secret.

The issue isn’t when research analysts talk to a company’s competitors or industry experts, or when they survey hundreds of customers, said Christopher Robertson, a partner at the law firm Seyfarth Shaw in Boston. Legal trouble comes when they get information from people -- current or former employees, attorneys or consultants -- who are obliged to remain quiet.

Richard Lee

Research networks routinely have a policy against connecting investors with employees of public companies if clients are looking to invest in them, said Mayhew of Integrity Research. He said that networks can’t be sure their clients are being honest about their intentions.

Primary Global’s Chu facilitated the passing of insider tips about Atheros Communications Inc., Broadcom Corp. and Sierra Wireless Inc. to Spherix Capital LLC, a hedge fund run by Richard Choo-Beng Lee, according to the government’s complaint. Lee had been cooperating with another investigation, started in 2009, looking at the Galleon Group LLC, a hedge fund based in New York.

Chu had found ways to “obtain inside information,” such as sales and contract figures, from public companies before they released quarterly results, according to the complaint. The information probably came from people who had a duty to keep it private.

Many other research methods remain legitimate, said Harold Gordon, a partner at the law firm Jones Day in New York.


“There is still room for good, fundamental research,” Gordon said, especially when analysts “piece together a portrait of how a company is doing” based on various sources of information like surveying competitors, monitoring parts orders or freight shipments. “Going out and finding information about a company without going through insiders has always been permitted,” said Stone of Neal Gerber.

One area of confusion among legal experts and analysts is whether store managers or other low-level employees can be legal sources for research data. Insider information is only illegal if it’s material, meaning it would be significant enough to move a stock price.

“If you’re really low in the food chain, the amount of information you have is arguably not material,” said Eric W. Orts, a management professor who specializes in legal studies and business ethics at the University of Pennsylvania’s Wharton School in Philadelphia.

Store Managers

Prosecutors can argue that, while each manager may not possess material information, a survey of hundreds of managers yields important information that an investor may act on, Stone said.

“You get into gray areas when you start surveying store managers,” he said. Another question is whether store managers or other low-level employees are prohibited by company policy from responding to such surveys and would be speaking “in violation of a duty.”

The answer can vary by company, and many employees probably don’t know their own company’s confidentiality policies, Orts said. “There needs to be better information given to employees about what their responsibility is.”

With so much firepower aimed at getting better information to investors, there may be an inevitable temptation for some to push research to its legal limits.

“If your whole job is to get an edge on information,” Orts said, “there are a lot of people tempted to step over that line.”

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