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News January 10, 2011 Issue

When A Rumor May Be Something More – Fleshing Out The Fine Lines Of Insider Trading

When are you receiving material, non-public information (MNPI) and when are you not?

Sometimes the lines are bright – quarterly performance results in advance of public announcement, for example. Other situations can be murkier.

As more and more experts, analysts and portfolio managers are being charged with the misuse of MNPI for profit, some of those lines get reinforced and lessons can be drawn.

In the recent arrests of half a dozen experts, analysts and traders, several examples have been offered of the information that was allegedly illegally passed.

Often, the information has involved the technology sector. Charges allege that corporate secrets have been divulged about companies such as Apple, Dell, Marvell Technology, AMD and Research In Motion, among others.

In the case of Apple MNPI, the government has charged Walter Shimoon, a business development official for Apple supplier Flextronics, with passing sensitive information about the iPad in advance of its public release. Shimoon speculated on an expert basis that Apple was developing some sort of reader. About four months ahead of the iPad’s debut, Shimoon told an undercover government witness that he believed Apple’s secret new product was called "K-48," and that "at Apple you can get fired for saying K-48… that’s how crazy they are about it."

Many months in advance of that taped conversation, technology bloggers had surfaced the name K48 in relation to a coming product that would be similar to the iPod Touch, but on a larger scale.

If Shimoon was just repeating gossip in the public domain, what’s the problem?

Bloggers speculate and spread rumors on a daily basis, and raw guessing is often exactly what that activity represents, said one industry observer. If a company executive or access person says it, however, then there’s substantiation, or at least the information has more credibility.

The gray areas in the business of information gathering, i.e. the expert matching services so prominently involved in recent insider trading charges, have sent asset managers running for the exits in droves. That doesn’t have to be the case, however. Expert matching services can still play a valuable role for portfolio managers who can mind the lines.

The rise of expert matching services has been credited to Regulation FD ("Full Disclosure"). Statements in the August 2000 adopting release reinforced support for the "mosaic theory." That theory promotes the idea that an analyst, in the course of doing his or her research, can piece together various bits of non-material information, public or non-public, to come to a potentially material conclusion about an issuer.

In the release, the SEC noted that an issuer is not prohibited from disclosing a non-material piece of information to an analyst, "even if, unbeknownst to the issuer, that piece helps the analyst complete a ‘mosaic’ of information that, taken together, is material." Analysts "provide a valuable service in sifting through and extracting information that would not be significant to the ordinary investor to reach material conclusions," said the SEC. "We do not intend, by Regulation FD, to discourage this sort of activity."

The focus of Reg FD, is said, is on whether an issuer discloses material non-public information, "not on whether an analyst, through some combination of persistence, knowledge, and insight, regards as material information whose significance is not apparent to the reasonable investor."

The government also alleged that Shimoon provided sales figures and sales forecasts for Apple products in advance of the public release of that information. The MNPI lines appear to be a little brighter there.