Late last week, the feds showed up at the home of John Kinnucan and arrested him on charges related to insider trading.
John Kinnucan is an equity analyst who founded his own research firm, Broadband Research, LLC. Firms like this employ analysts to do research on stocks. They then “sell” that research to institutional investors. In case the term “institutional investor” is new to you, it just means hedge funds, mutual funds, pension funds, or any other “professional” money manager.
Since I worked as an equity analyst in the technology sector for over 10 years, I am always fascinated by stories like this because they point to the pressure that analysts are under to uncover differentiated information on stocks. If an analyst doesn’t have an “angle” on a stock, it’s very hard to build up a reputation and get paid.
I’m not condoning Kinnucan’s behavior nor am I stating an opinion on whether he did anything illegal or not. I don’t know him, nor do I know anyone at his firm or any of the people involved in the story. So let’s simply examine the allegations the Feds are making for the purposes of explaining what it all means. Ok? (We're not turning this into a discussion of guilt vs. innocence.)
Institutional investors pay for research by directing trading commissions to the research firms that provide good quality research. Analysts usually need to prove their worth by servicing clients first, and then asking to get paid. It’s a strange world because there is no set price for a particular research report. There is no subscription to an analyst’s research. Money managers just pay what they want to pay by directing commissions.
In many ways, it’s like running a tech blog. If you don’t have good stuff to publish, nobody cares. You won’t get traffic. You won’t generate any advertising revenue.
My point is that providing equity research is a highly competitive business. And if you’re a small guy running your own shop, like Kinnucan, you need to have some kind of edge over the larger research shops in order to get paid. Big money managers don’t just take pity on you because you’re small. They could care less. Help them make better investment decisions and they pay you. End of story.
Of course there are legal ways to gather and sell equity research, and then there are illegal ways to do it. Illegal methods have a much higher potential payoff (since clients who pay for this type of research can generate huge profits), but it can also land you in jail if you get caught. Dangerous game.
So what exactly constitutes illegal activity when it comes to equity research? Disclaimer: I’m not a securities lawyer. That said, you need to understand two things about so-called “information” on a company.
Public versus non-public
Information in the public domain can never get you in trouble. Something written in an annual report, in a press release, stated on a conference call, or otherwise available for the world to access, is safe territory. Investment decisions that you make based on public information are never illegal. Passing on public information is not illegal.
On the other hand, “non-public” information might be illegal to use, but not always. Non-public information is anything that the general public does not have access to.
Material versus non-material
All information is either relevant, or not relevant. Say you come across some “inside” (non-public) information. To know if it’s material you just need to ask yourself, “If the whole world knew this would the stock price react?”
Here are two totally fabricated examples:
The front-end RF power amplifier supplier to Apple told me that they’re shipping 100 million chips to Flextronics for the iPad 3 in March.
My friend who works for Apple told me that the bathrooms are being renovated to include bidets for better employee cleanliness.
Yeah, as you may have guessed, the second bit of “insider” information isn’t something Kinnucan (or any other analyst) would be calling his hedge fund clients about. But the first piece of info? It wouldn’t take a rocket scientist to realize the 1:1 relationship between that type of part and the number of iPads being built. It would certainly be meaningful to Apple stock since it would imply massive shipments above current Street estimates. If the world knew this information, Apple stock would be trading a lot higher.
So it’s the combination of non-public (i.e. insider) information that is “material” to a stock where people can get in trouble.
Oh, and you don’t actually need to make an investment using your material insider information to get in trouble. Telling someone else still puts you on the opposite end of the law. But as we’ll soon discuss, massively publicizing the information seems to keep you safe from prosecution.
Analysts and information
Usually analysts come across material insider information by forming trusted relationships with people in the know. A sales executive at an Apple supplier should have detailed knowledge of how many parts he’s forecast to sell. He’ll be one of the first to hear about a change in forecast. Changes in supply forecasts are highly sensitive and could certainly classify as material inside information.
If an analyst gains access to material insider information and tells a select group of clients, then he is breaking the law.
What makes equity research different than blogging?
You might wonder why an equity analyst can go to jail for leaking insider information to hedge fund clients, but bloggers never seem to get in trouble for publishing details of upcoming product launches that came from obviously-insider sources.
Like I said, I’m not a legal expert, but I see one HUGE difference. It’s about where the money comes from. The business models are totally different.
If a blogger gets insider information and publishes it on his website, he gets paid with a massive increase in traffic, incoming links (which translate to more traffic and website authority). For website owners, traffic equals money (assuming they know how to monetize the traffic).
The blogger is also leaking the information to the entire world in one fell swoop. The value of insider information to a website comes from being the exclusive source of the news. By contrast, the value of insider information to a hedge fund comes from being the exclusive holder of the news, such that profit can be made by trading on the information.
Trading on material insider information is illegal. But nobody seems to get prosecuted for taking insider information and turning it into public information because there is no stock-based profit being made.
Insider trading rules are in place to protect honest investors from getting screwed at the expense of dishonest ones. Bloggers who leak insider information are not helping dishonest investors. They’re just taking traffic away from competitors.
But, if a blogger decided to take his insider information and call up Mr. Hedge Fund and provide exclusive access to this information for a hefty fee before publishing it, you can bet he’d be thrown in jail along with the hedge fund client.
Somehow, I think the blogging community will steer clear from this type of trouble. It just doesn’t make financial sense for exclusive leaks to be sold to unscrupulous investors. It makes far more sense to capitalize on the traffic and authority that it builds.
Chris Umiastowski is a former sell-side equity analyst at Orion Securities and TD Securities. Before that, he was an engineer for Nortel Networks. Chris is co-host of the Mobile Nations Stock Talk podcast.