Identifying insider trading sometimes seems like a game of three-card monte: first you see it, then you don’t. A recent settlement by Citigroup with a Massachusetts regulator over leaking internal research to clients raises question about when such disclosure crosses the line into insider trading. Citigroup agreed to a consent order entered by the Massachusetts Securities Division requiring it to pay a $30 million penalty after it failed to have proper procedures in place to protect against the early release of research by the firm’s analysts. One of the analysts, Kevin Chang, gave information to a few institutional investors, most notably SAC Capital Advisors, about a decrease in orders for iPhones that would affect Apple and one of its main suppliers, the Hon Hai Precision Industry Company. The consent order shows how SAC and other institutional investment firms badgered Mr. Chang for his analysis when a competing investment bank issued a research report calling into question optimistic views about the number of iPhones that would be shipped. After revising his estimates substantially downward, he e-mailed those figures to SAC and other large institutional clients on Dec. 13, a day before Citigroup released his revised research report on Hon Hai. Apple shares dropped about 5 percent on Dec. 14. Those actions appear to be a classic insider trading case: leaking material nonpublic information that will affect the price of companies to a few favored investors who can trade ahead of the market. Throw in the fact that SAC, which has been indicted on charges of insider trading violations, was a recipient, and it seems like a slam dunk. One of the largest trades by SAC in its criminal case involves tips from a doctor to a portfolio manager at the firm about disappointing results from a drug trial that allowed SAC to avoid losses and make short sales. So why isn’t this case exactly the same? The difference is that insider trading based on tipping requires the source of the information to violate a fiduciary duty when giving it out. In Dirks v. S.E.C., the Supreme Court said that “the test is whether the insider personally will benefit, directly or indirectly, from his disclosure.” Chang was not a tipper because he made the disclosure in connection with his job as an analyst. He did not receive anything from the firms that received his information. Citigroup prohibits its employees from giving out previews of research. But violation of an internal policy does not turn this case into an insider trading issue, unless there was a special benefit provided by the recipients to get him to release the information. That explains why this is a case against Citigroup and not Chang and SAC. The Massachusetts regulator asserts that the firm failed to properly supervise its analyst to prevent advance disclosure of its research, which means the analyst was acting on behalf of the firm when he selectively disclosed his conclusions about iPhone shipments. This case is similar to a 2012 administrative proceeding brought by the Securities and Exchange Commission against Goldman Sachs, after the firm’s research was selectively disclosed before publication. Goldman had organized “huddles” with its traders and a few select institutional investors in which analysts were encouraged to provide their best trading ideas based on their research. The S.E.C. found that this violated Section 15(g) of the Securities Exchange Act of 1934, which requires firms to implement policies to prevent the misuse of material nonpublic information generated by a firm. Goldman paid $22 million to settle the case, which included an $11 million payment to the Financial Industry Regulatory Authority, known as Finra, over violations of its rules regulating brokerage firms. There are extensive regulations involving how brokers must deal with their research departments. These rules came out of a 2003 settlement to address concerns that investment banks were influencing the reports by their analysts to favor clients. A Finra rule requires firms “to prevent trading department personnel from utilizing non-public advance knowledge of the issuance or content of a research report for the benefit of the member or any other person.” But this rule does not apply to what happened at Citigroup because Mr. Chang never dealt with the trading operation, only clients who are not covered by it. And it is certainly not a violation to generate research that is only made available to a firm’s clients, as long as it goes out to everyone at the same time. SAC has been a highly coveted client for the hundreds of millions of dollars of trading commissions it generates – DealBook has described it as a “Wall Street cash cow.” The firm’s traders no doubt expect that research produced by brokerage firms will be made readily available to it, and analysts like Mr. Chang will respond immediately to information requests. Thus, institutional investors do not need to offer anything to analysts to get their views because brokers want the business so badly that they will bend over backward for their best clients. In both the Citigroup and Goldman cases, it was large institutions that got an advance glimpse of the research. It should not come as a surprise that Wall Street caters to its most lucrative customers because they produce the commissions that keep the trading operations humming. For institutional investors like SAC, which was known to seek out any “edge” it could get in the market, bombarding an analyst with demands for his latest views is probably a daily occurrence. And although advance disclosure of research is prohibited by internal brokerage policies, it is not insider trading when the analyst does not obtain any special benefit but only caters to a valuable client. That puts us in the netherworld of insider trading because the research arm of a broker generates valuable information their biggest clients desperately want, and there is enormous pressure to keep them happy to maintain the flow of trading commissions. But the law requires brokerage firms to protect material nonpublic information at least until it is made widely available. When an analyst does break the rules by selectively disclosing research, it is a violation by the firm but not necessarily by the recipient who trades on such information. So while it might look like insider trading, unless the S.E.C. decides to change its rules to reach those who receive such selective disclosures, it is not a tip that is the basis for pursuing a case.
