Push to Combat Insider Trading May Go Too Far

Last week, BlackRock, the asset management giant, agreed to a settlement with New York State to stop conducting surveys of investment analysts.

The state’s attorney general, Eric T. Schneiderman, cited the settlement as a wider effort to crack down on what he called “insider trading 2.0.” His focus is on those who might be getting a peek at market-moving information before it reaches the rest of the investment world.

Mr. Schneiderman is pushing to expand what can be considered insider trading subject to prosecution to reach what he called in a September speech “road-rigging, market-manipulating” conduct. But this effort may also end up blurring the already thin line between permissible securities analysis and illegal conduct.

BlackRock had regularly conducted a survey of analysts at brokerage firms to gauge their views on companies they followed. The firm then pooled the information to ascertain whether this information generated any signals about the direction of stock prices. In effect, it was analyzing the analysts, much as the FiveThirtyEight blog looks at many different polls to make its own forecast of election results.

Gathering information from others and then aggregating it to estimate how a company’s stock might perform is proper, and something a good analyst should do. A BlackRock document quoted in the settlement stated that it was “only interested in public information” as part of its survey, which showed that it was not the firm’s intention to obtain confidential information.

But Mr. Schneiderman’s investigation also revealed that “the survey program’s design allowed it to capture more than previously published analyst views, including nonpublic analyst sentiment that could be used to trade ahead of the market reaction to upcoming analyst reports.” So while it was intended to pull together only the public views of analysts, it also might have given BlackRock access to a bit more information that was not publicly available.

Still, even that might not constitute traditional insider trading. Just gleaning a tidbit of information regarding possible changes in an analyst’s sentiment about a company might not rise to the level of being material, another requirement for proving a violation. Materiality means that information would be considered important by an investor, and a single analyst’s potential shift in outlook might not be enough.

The settlement does not identify any specific instances when BlackRock misused information from it survey to its benefit, and the firm did not admit or deny any violations. The order found that the survey obtained only information “that could reveal forthcoming revisions” by analysts.

The real concern appears to be that BlackRock took advantage of its powerful position as the largest asset manager in the world to entice analysts to respond to its survey, gathering information that a much smaller player in the market might not be able to obtain. The settlement notes that its size helped “ensure that brokerage firms would respond to the survey program.”

That has nothing to do with insider trading, but the new approach advocated by Mr. Schneiderman is putting an emphasis on informational advantages and not just buying and selling based on material nonpublic information. A settlement last July with Thomson Reuters takes the same approach by prohibiting the company from selling early access to one of its economic indicator to high frequency trading firms two seconds before other subscribers.

Is the prohibition on insider trading really concerned about the misuse of information? Or is it trying to create an equitable market, the so-called level playing field, so that one investor does not have an impermissible advantage over others?

There are many advantages that are not improper, even if they give some investors a chance to profit on information not available to others. Warren E. Buffett certainly has an advantage over other investors - his decision to buy a company’s shares usually drives up its price once his trading is revealed, but no one would claim he acted improperly.

The traditional view of insider trading focuses on the impropriety of obtaining material nonpublic information and then trading on it, or tipping another person, in breach of a duty of trust and confidence. Mr. Schneiderman’s new approach raises the question whether it should also include some trading by those who create confidential information and then use it to their own economic advantage.

The difference between “obtaining” and “creating” is crucial because market analysts are in the business of generating information about companies that allows their clients to trade profitably based on it. So at what point might the creation and use of one’s own information be considered wrongful?

The Supreme Court recognized the importance of stock analysis in Dirks v. S.E.C., pointing out the role that “analysts in general can play in revealing information that corporations may have reason to withhold from the public,” which it said was “an important one.” The Securities and Exchange Commission had adopted rules to limit potential conflicts of interest among analysts to prevent bias from creeping into their reports so that the markets obtain a fair assessment of companies.

Analysts are certainly not immune to insider trading charges. The recent spate of prosecutions of hedge funds that conducted extensive analysis of companies that included inside information to gain an “edge” shows that a violation occurs when nonpublic information is used as part of that process.

For example, the former hedge fund billionaire Raj Rajaratnam offered the defense of the “mosaic theory” at his trial on insider trading charges to argue that any nonpublic information he might have received was just one small piece of his hedge fund’s analysis of a company’s prospects. The jury rejected that argument in convicting him, and he is serving an 11-year sentence.

Gathering public information to generate an analysis of a company is not insider trading, at least as long as any report is not improperly leaked to others so that they can take advantage of it. But if the analyst obtains confidential information, then the line for insider trading may have been crossed.

BlackRock did not engage in traditional insider trading because it is unclear whether it ever knowingly obtained confidential information through its survey. The fact that analysts might be willing to share their private sentiments regarding a company comes closer to the line, but does not appear to have crossed it.

Mr. Schneiderman’s focus on those who create information and then use it to get ahead of the market may be an effort to move the line for what constitutes insider trading to capture more conduct that gives some traders an advantage. But unlike improperly obtaining confidential information and then using it to trade, this approach may create even more uncertainty for analysts and investment firms that are trying to figure out what is permissible research and what is “insider trading 2.0.”