Insider Trading Scandal: The New Definition of Research

by: Mark McQueen

News about the latest insider trading investigation always comes as a surprise, and it appears as though the FBI is in the process of scaring the entire U.S. hedge fund industry out of their Gucci loafers.

According to the WSJ, the FBI has shown a particular interest in a one technology research shop. According to the Analyst, two FBI Agents came to his house and asked him to wear a wire. When he refused, they eventually left — and haven’t been heard from since:

Broadband Research is one of many boutique research firms that make a business out of talking to manufacturers’ representatives for companies like Broadcom Corp., Marvell Technology Group and Microsoft Corp., Mr. Kinnucan says. The contacts provide him a view into the strength of such tech companies through what are known as “channel checks.”

Channel checks are a view into whether companies are ramping up or slowing down production, or whether they are winning or losing customers for components and parts they supply to other companies.

Mr. Kinnucan says the manufacturer’s representatives he talks to don’t know what a company’s earnings or results will be. But their view is important enough to savvy tech investors that they put it into the mix of items they consider when making investment bets.

Do you think the FBI sees it this way? Do they agree that the traditional research analyst “channel check” isn’t the garnering of insider information? After all, finding out that a smart phone manufacturer stuffed the channel with product, and therefore will give weak guidance for the following quarter, is gold in the world of trading tech stocks. The shares of firms such as Research In Motion (RIMM) or Apple (NASDAQ:AAPL) can be up or down 5% following their quarterly announcements, and that move is usually based upon the forward guidance. Getting that info is the key to making millions on a trade, which draws new investors to hedge funds, which puts people into US$19 million New York City apartments.

According to the Journal, this may be the largest insider trading investigation ever. Which means that much of the FBI’s research into the securities industry may be only that- research:

Authorities say the criminal and civil investigations could eclipse the impact on the financial industry of any previous such probes. Investigators are examining, among other things, the role of consultants and analysts who provide hedge funds and mutual funds with detailed information about the businesses and industries in which they specialize.

Mr. Kinnucan says the service he provides clients “has nothing to do with ‘inside information’ and everything to do with a lot of hard work and insight.” If he’s trafficking in inside information, he says, then so is the rest of Wall Street.

It will be fascinating to see where the FBI, and the U.S. Courts, wind up on the idea that channel checks are just basic, shoe leather research. In the meantime, the definition of what “inside information” actually is, and if it extends to the supply channel of the world’s tech goliaths, may be up for debate.

The Analyst’s long-held argument is the fact that they’ve learned from a supplier that orders are down, which may well mean that earnings will be down for their client, isn’t “inside information” by definition. Just good research. The FBI may be asking itself “but isn’t it material non-public information?”