by Bruce Carton
Two months ago I declared September 2010 “Insider Trading Month” for the Securities and Exchange Commission’s sudden burst of enforcement activity on that front. Then came November, and boy, did enforcement go off the charts.
The extraordinary activity of prosecutors and regulators that month set Wall Street traders abuzz, but compliance officers and other executives at public companies should also take careful notice. And what’s so different about the latest round of insider-trading cases? Investigators are focusing on the flow of supply-chain information. That includes a lot more people than the gossipy traders working in lower Manhattan.
On November 20, reports circulated that both the Justice Department and the SEC were preparing insider-trading cases against a long list of Wall Street entities: consultants, investment bankers, hedge fund and mutual fund traders, and analysts. According to the Wall Street Journal, the charges would allege “a culture of pervasive insider trading in U.S. financial markets, including new ways non-public information is passed to traders through experts tied to specific industries or companies.” Two days later, the FBI raided the offices of three hedge funds as part of the investigation, with more raids expected.
Portions of the investigation are fairly standard—hedge funds tipped off to pending merger deals, for example; that’s nothing new under the sun. But another wrinkle has equity research analysts on red alert. Regulators are now thought to be probing whether an analyst practice commonly known as “channel checking” constitutes illegal insider trading. If so, the public companies whose information is in play could soon be pulled into the whirlwind.
One company where channel checks have reportedly now become a widely used and highly relied-upon source of information for traders is Apple.
In a channel check, analysts try to glean information about a company’s production via interviews with the company’s suppliers, distributors, contract manufacturers, and sometimes even current company employees. The goal is to piece together a better picture of the company’s performance. Apple, always secretive about its products, is an example of a company where channel checking is reportedly common. Indeed, analyst reports based on channel checks routinely cause Apple stock to dip or surge.
As supply-chain expert Pradheep Sampath of GXS noted on his blog, these interviews typically occur without the target company’s permission or participation. Sampath adds that:
Data collected from these sources is seemingly innocuous when viewed separately. When pieced together however, these data points from a company’s supply chain can deliver startling insights into revenue and future earnings of a company—much in advance of such information becoming publicly available. This practice becomes more pronounced for companies such as Apple that are extremely guarded and secretive about information they make publicly available.
Reasons abound to question whether the Justice Department or the SEC will ever decide to bring a channel-checking case. First, the information gleaned from any one individual in the channel is unlikely to be material by itself. For example, the maker of screens for Apple’s iPhones may reveal that sales of those screens to Apple ticked up in December. But given that Apple has so many revenue streams and just as many channels for those streams, this one detail from our screen-maker is not likely to be material by itself.
Only when that information is pieced together with many other pieces of information to build a “mosaic” does a larger picture emerge that might arguably be material information about the company. This is, in effect, what equity research analysts are paid to do. But as the U.S. Supreme Court stated in the SEC’s ultimately unsuccessful insider-trading case against research analyst Raymond Dirks, analysts play an important role in preserving a healthy market, and imposing “an inhibiting influence” on that role may not be desirable.
Nonetheless, if prosecutors are now scrutinizing analysts’ practices of gathering information from a public company’s supply chain—which have a long, established history—that presents an important opportunity for public companies to re-examine their own policies and procedures concerning how such information is tracked and controlled. Here are some questions that public companies will want to consider:
1. Are analysts interested in, and attempting to obtain, information from our supply-chain?
If not, then channel checks may be more of a back-burner issue for you. If yes, press on.
2. As part of our agreements with suppliers, distributors, and manufacturers, do we have confidentiality or non-disclosure agreements (NDAs) in place?
Implicit in any enforcement action or prosecution that might result from the ongoing channel-check probe is the idea that the information in question is confidential and a company’s suppliers should not be sharing it. Suppliers speaking to Apple analysts, for example, may well be violating NDA agreements with Apple and allowing analysts to access confidential information. That doesn’t differ much from committing insider trading by obtaining information from inside the company itself.
If the SEC and prosecutors now view supply-chain information as material, non-public information that can support an insider-trading case, then companies should take a fresh look at how they try to prevent the misuse of such information.
Jacob Frenkel, a former SEC enforcement attorney now with law firm Shulman, Rogers, Gandal, Pordy & Ecker, says that weak corporate controls over supply chains has been a looming issue and was bound to become a compliance headache sooner or later. Frenkel says companies should adopt rules governing the conduct of their business partners, including what information they may share.
3. If we do have confidentiality agreements or NDAs in place with suppliers, distributors, and manufacturers, are they being violated? And are we seeking to enforce them?
To continue the Apple example: If traders routinely receive and act upon analyst reports based on supply chain interviews about the company, one wonders whether any NDAs with suppliers are in place or enforced. (Regulators would certainly be wondering about it.) For the record, Apple told the Wall Street Journal that the company does not release that type of information about its production, and declined to comment further.
Consider this hypothetical:
- Company X’s supply-chain information is material and non-public, meaning Company X or a “person acting on its behalf” could not selectively disclose it to one analyst under Regulation FD without making a public disclosure of that same information;
- Company X is fully aware that its suppliers are providing supply-chain information regularly to select analysts; and
- Company X either (a) does not impose an NDA on its suppliers, or (b) does impose an NDA but never enforces it.
Is the supplier’s disclosure of information to select analysts, with Company X’s knowledge, a “back door” violation of Regulation FD (or at least the spirit of Regulation FD)?
4. Are we permitting current company employees to hold discussions with analysts or traders as industry “consultants”?
Law professor Peter Henning noted in a recent article that many employees are providing information as consultants do so openly, and “it may even be that these consultants were authorized by corporate employers—or it was at least tolerated as a cost of keeping talented employees.” Given the risk that an employee/consultant may end up talking about the company, however, Henning says it is an “interesting issue” why a company would allow one of its employees to consult in this fashion.
Given the SEC’s intense focus on insider trading, there is certainly more to come on this front, so keep an eye on developments in the coming months. And keep an ear to the ground for those whispers from your suppliers, distributors, and contract manufacturers.
Originally published in Compliance Week. Reprinted with permission. © 2010 Haymarket Media, Inc. All Rights Reserved. Compliance Week can be found at http://www.complianceweek.com. Call (888) 519-9200 for more information.