The challenge of cracking down on 'insider trading lite'July 11, 2013: 9:20 AM ET
New York Attorney General Eric Schneiderman must explain why a 5-minute advantage for ordinary Thomson Reuters subscribers to access market-moving data is fine, while a 5-minute, 2-second one for premium subscribers is not.
By Roger Parloff
FORTUNE -- The fuzzy interface between our exception-ridden insider-trading laws, aggressive hedge funds, and resource-starved universities and journalism companies were all on stark display Monday when New York State Attorney General Eric Schneiderman and Thomson Reuters reached an interim standstill agreement while Schneiderman continues probing Thomson's early release of certain market-moving consumer-confidence data to premium-paying customers.
Pending the inquiry's outcome, Thomson agreed to stop letting its premium customers see the results of a biweekly University of Michigan consumer sentiment survey two seconds before it gives the same information to ordinary subscribers -- which is still, by the way, five minutes before the rest of us shnooks get it.
These unusual practices -- or, perhaps not so unusual practices, depending on what Schneiderman finds -- were highlighted in a June 12 story by CNBC's Eamon Javers and then further explored the next day in a front-page Wall Street Journal article by a team of reporters led by Brody Mullins.
The practices were also the subject of a whistleblower suit filed in a New York state court last April, which is what prompted Schneiderman's inquiry, according to a source in his office.
The University of Michigan publicizes its survey findings to the general public at 10 a.m. every other Friday in a press release. Thomson pays the university more than $1 million a year, however, for the exclusive right to distribute those same findings five minutes earlier, at 9:55 a.m., to its subscribers. (At that point the results begin trickling out to the general public through various news outlets that are themselves Thomson Reuters subscribers, including Dow Jones and the New York Times.)
Prior to Monday's announcement, Thomson also released the survey findings two seconds earlier still, at 9:54:58, in machine-readable form to certain premium customers -- hedge funds that specialize in high-speed trading. Such funds are capable of trading millions of shares within that tiny window of a head start. According to the Journal, the premium subscription costs $5,000 a month, plus another $1,025 a month for the connection charge. Thomson Reuters says its practices were fully disclosed.
"Thomson Reuters strongly believes that news and information companies can legally distribute non-governmental data and exclusive news through services provided to fee-paying subscribers," the company said in a statement. "It is widely understood that news and information companies compete for exclusive news and differentiated content to help their customers make better informed trading and investment decisions."
Selective disclosure practices like those involved here do not violate federal insider trading laws, even if they might strike many readers as achingly unfair. (We'll explain why below.) Attorney General Schneiderman is scrutinizing the practices instead under a much broader state law, known as the Martin Act, which can be used to punish or enjoin unfair business practices even without a showing of intent to defraud. (When he was attorney general, former Governor Eliot Spitzer used the Martin Act extensively.)
Neither Schneiderman's Monday announcement nor Thomson Reuters's statement suggested, however, that anyone is contemplating tampering with the five-minute head start that subscribers routinely get on the nonpaying public.
Which leads to two obvious questions. Does Schneiderman acknowledge that there's nothing wrong with selective, early disclosure to subscribers? It would not be surprising if he did because many business news organizations charge a premium to provide potentially market-moving information sooner than non-premium customers can access it. (The WSJ article about Thomson's selective disclosure of the consumer sentiment survey acknowledged that its own publisher, Dow Jones, "does send some exclusive content reported by its news staff to premium subscribers before it is published on general newswires or on its website," for instance.)
If the answer is yes, that leads us to the second obvious question. If there's nothing wrong with that first-tier form of preference (the 300-second head start given to ordinary subscribers) what's wrong with the second-tier preference, the extra two-second jump given to customers who pay even more?
"I wouldn't say the [five-minute advantage for ordinary subscribers] is OK," says the source inside the Attorney General's office. "We're looking into all of these different practices of varying disclosure times." He said he couldn't comment further because it's an ongoing investigation. He added that the probe "may also include instances that are not Thomson Reuters-related."
Though neither party is in a position to say it, one very likely distinction between the status of the first-tier and the second-tier preferences in the Thomson Reuters situation might be just how "fully disclosed" each was. The first-tier advantage given to Reuters subscribers was widely known, and had, in fact, prompted, according to the Journal story, complaints from rival Bloomberg for some time. But the second-tier advantage appears to have been far from common knowledge. It was disclosed only here, in a link that, the CNBC story noted, "could be found on the 'Machine Readable News' product page of its website, under a drop-down menu for 'suite components.' " To the extent subscribers in the first-tier did not know about the existence of the premium-level second-tier, they might justifiably feel misled about the value of what they were receiving.
Why aren't Thomson Reuters and its subscribers all violating the insider trading laws? Isn't Thomson Reuters profiting by disclosing material nonpublic information to people who plan to trade on it before it becomes public?
There are many interrelated answers to that, but a few key ones include these. First, there's no federal "insider trading law" per se, so what constitutes illegal insider trading has been determined by judges on a case-by-case basis interpreting a standard statute forbidding "fraud" in the sale of securities. Fraud requires trickery and deception. Courts have decided that mere trading with a material informational advantage can't amount to "fraud" (because there's no trickery involved) unless the trader owes some special duty of trust or confidence to someone that he is violating by trading without disclosing to that person his informational advantage.
Corporate officers with material inside information about their company owe such a duty to their shareholders, for instance. Similarly, employees who obtain material nonpublic information from their employers -- law firm associates, for instance, who learn about an impending corporate merger in the course of their M&A work -- owe such duties. In fact, if a Thomson Reuters employee gained access to the consumer sentiment survey results before they had been released and traded on that information himself, he would be guilty of insider trading under the federal securities laws!
But Thomson Reuters itself, which paid the University of Michigan $1 million for the consumer sentiment survey result, is certainly violating no duty to the university, from whom it obtained the information, and the university itself violated no duty to anyone by going out and generating that information through its own original research, ingenuity, hard work, and so on.
So the mere fact that someone richer than us can buy market-moving information sooner than we can does not, in itself, mean that any fraud has been committed. It may be terribly unfair, but it's not fraud.
Then why not change the laws to make any sort of trading on material nonpublic information illegal, regardless of whether any arcane "duties" are being violated? The answer seems to be that most legislators -- like the Supreme Court justices who effectively created the existing rules on insider trading -- believe that any attempt to mandate a radical leveling of the informational playing field is neither possible nor desirable. We want to encourage people -- analysts, hedge fund managers, journalists -- to apply time and effort to ferreting out and distributing reliable information about the value of stocks. We therefore also want to incentivize them to do so by allowing them to charge for or benefit from the informational advantages they provide. After all, when a research firm or short-seller or news outlet says, "I think Enron's a house of cards, and here's why," it's performing a valuable service.
So the federal insider trading laws don't forbid what Thomson Reuters was doing here. What Attorney General Schneiderman is up to, then, is a delicate matter. He's trying to use New York's famously malleable Martin Act to plug up some loopholes left by the federal law that are allowing practices that strike him as outrageously unfair -- call it Insider Trading Lite. And he picked a good place to start.
The challenge, though, will be finding a principled basis for distinguishing between what's "fair" and "unfair," and then explaining the distinction to everyone in terms that will be clear enough to enable them to stay on the right side of the line.
That process will begin when he explains why the 300-second head start Thomson Reuters gives to ordinary subscribers is OK, while the 302-second head start given to premium subscribers is forbidden.
I'm not saying it can't be done. I'm just saying it's part of the difficult job ahead of him.