Litigation

Is ?channel checking? illegal insider trading?

By Tracy Coenen

Bruce Carton of Securities Docket wrote a very interesting article called Who’s Checking Your Channel? The article highlights the practice of “channel checking” which has been something investment analysts have done for a long time. Now it appears that our government is trying to decide whether channel checking is actually illegal insider trading.

I see channel checking as independent research. People are looking into a company, doing things like looking at customer, supplier, employer, and competitor data, in order to find out how the company is really doing. It’s a fact that most of the information about a company comes from the company itself, and that public companies have a vested interested in making things look rosy. It is only through independent research that outsiders have a chance of finding out some of the not-so-rosy things.

The channel checker is out there kicking tires, trying to find out information or trends before they are widely know. The information is reported back to the entity that paid for the research, and they may trade on that independently developed information.

Bruce reports:

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.

What is the government so riled up about? Independent research isn’t the same as material non-public (insider) information (on which trading is illegal). I suppose if the channel checkers gathered enough information from their research, it could become material.

This situation has a similarity to recent FCPA enforcement activities.  The enforcement of FCPA is currently completely unpredictable. Our government has gone about these enforcement actions in somewhat of an arbitrary way, making it so that companies cannot predict which actions will be targeted and what the punishments might be. It seems “insider trading” might be going in the same direction, particularly if activities that have been going on for years (and never before challenged as improper or illegal) are suddenly under scrutiny for possible enforcement action.

Full post as published by The FRAUDfiles Blog on December 10, 2010 (boomark / email).