Not a day goes by that we don’t read about the SEC’s deepening investigation into insider trading and its heightened scrutiny of expert networks. To some this is little more than a witch-hunt fueled by a chastened-yet-highly-motivated regulator; to others this is a boon to rooting out information asymmetry that has created an increasingly uneven playing field among investors. As always, the truth lies somewhere in between, but I believe to truly understand the issues one needs to look at the underlying principles: efficiency and fairness.
Many market theorists have argued that “insider trading” (e.g., acting on information that is not publicly available) enhances market efficiency, smooths price volatility and reduces the likelihood of price shocks arising from unexpected events. Where insider trading was once thought to be the province of people skulking around, listening to whispers from company executives, placing trades and delivering bags of money representing a share of the winnings, there is now an entire industry that has emerged to institutionalize the collection of hard-to-obtain information: expert networks. Note that I distinguish between hard-to-obtain information and material non-public information, thought the SEC is currently doing a deep-dive into whether such hard-to-obtain information has, in fact, crossed into the realm of material non-public information. So the “If it looks like a duck…” test has gotten much more complicated. Ivan Boesky and Dennis Levine - now that was insider trading and looked like it without much analysis required. However, are phone calls to professionals with domain expertise insider trading or simply gathering additional research towards validating or invalidating an investment thesis? Well…
From a theoretical perspective, I think it is hard to argue that insider trading doesn’t enhance the smooth functioning of the markets. More high-quality information is out in the marketplace being incorporated into stock prices. News of material events would leak out and be factored into trading activity prior to its release, limiting the potential shock that would arise were the information to be released into the market all at once. Therefore, stock prices would better reflect all the relevant information that is available, more closely representing the true intrinsic value of public companies. What is a boon for market efficiency, however, does not necessarily promote fairness. But that then begs the question - what exactly is fair?
As it relates to the research process, I think fairness should be judged by whether a motivated investor could learn the information through resourcefulness and hard work. If an investor was focused on better understanding the prospects for a particular product, could they read published research, explore primary sources and perform surveys? Sure. Would it be difficult? Absolutely. But it could be done if the individual was sufficiently motivated. Alternatively, they could obtain this information by paying money for it via an expert network. Is it “fair” that someone has the resources to pay for access to experts where another might not? I think so. Those who have built careers around investing and are willing and able to spend money to streamline their investment process are ok with me - provided that the information to which they have access could be obtained by a highly motivated person. What isn’t fair, however, is when experts provide information that couldn’t be obtained through any amount of hard work, e.g., if an official at the FDA was on an expert network panel and had non-public information about the likelihood of a drug making it through clinical trials, sharing this information with a subscriber would unquestionably be unfair. Another example would be a company executive handicapping the prospects of an M&A deal. In these circumstances the recipient of the information would have the ability to trade on it, capturing the benefit between the current stock price and the target stock price reflecting the information they have received. Does this promote efficient markets? Yes. Does it support fair markets? Clearly not.
I believe the current set of cases being brought by the SEC will create a further stratification of the expert network marketplace. The behemoth - Gerson Lehrman Group - will consolidate and enhance their position due to their strong compliance culture and the time they’ve invested with the SEC in figuring out the appropriate business model. Smaller players, however, will be driven out by the costs associated with building and supporting the necessary compliance infrastructure, almost like a Sarbanes-Oxley standard for the expert industry. This will create a brighter line between what constitutes hard-to-obtain information and material non-public information.
Market efficiency is an important goal to which we should always be aspiring, but not at the expense of fairness. But let’s be clear: fairness does not mean equal. It means equal opportunity. And the sharing of material non-public information does not permit equal opportunity.