Mosaic theory (investments)

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The mosaic theory in finance involves the use of security analyst personnel to gather information about a company or corporation to evaluate and determine its financial stability. [1] In addition to public information available to all investors, securities analysts also have access to non-public information which the vast majority of investors do not possess. Trading based on such non-public information can be considered illegal if the information is also material, as defined by insider trading law. However, by gathering various non-material information, often from sources at or close to the issuing corporation, an analyst can draw useful conclusions about the current and future health of the company, allowing them to profit from transacting in shares of its stock and related derivative contracts. However, extrapolating conclusions from a "mosiac" of such bits of non-public information can be vague, sometimes leading analysts to false conclusions about the corporation. [2] Security analysts then have to sort through the data collected and make recommendations to their clients or keep the information to themselves to use later for personal profit based on determining the underlying value of a company's securities. [1]

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Seal of the United States Securities and Exchange Commission Seal of the United States Securities and Exchange Commission.jpg
Seal of the United States Securities and Exchange Commission

Since the Commission's Fair Disclosure rule (Reg FD) was enacted, the viability of the mosaic theory has been retained within the United States under the Securities and Exchange Commission [2]. Broadly speaking, the SEC requires public corporations to register their stock sales and protects investors in the municipal securities markets. [3] Though it was not created by the Securities and Exchange Commission, it has placed a judicially imposed limitation on the information gathered by insider trading. [4] If the U.S. Securities and Exchange Commission deems that there is illegal insider trading, they can freeze assets tied to the company's shares. The Securities and Exchange Commission explains that this nonpublic information, known as research to the security analysts, isn't banned 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”[3]. The SEC constantly are evaluating trends and when unknown traders purchase equity call options that are millions of dollars. [3] The SEC can also freeze accounts on suspicion of illegal insider trading when the accuracy and validity of information may be incorrect within the marketplace [2] . This had led to the legality of insider trading laws to be under intense scrutiny. Though it is legal under the United States Federal insider laws to utilize the mosaic information that is obtained by a securities analyst, it must be within the guidelines of the confidentiality that the company or corporation created. [4] For most companies within the United States and do business with the United States, these guidelines of confidentiality are required. Some of the controls that have mitigated the potential of illegal trading within the mosaic theory include the interactions between a company and consultants, notification in connection with approved consultants, remaining alert to potential issues, compliance oversight, information barriers, and being within the SEC guidelines. [4] These guidelines have made companies more transparent with their financial stability to the general public.

Under insider trading laws, analysts may not use material non-public information to help select their trades. But traders might be able to piece together non-material non-public information and material public information into a mosaic, which may increase in value when properly compiled and documented. The theory is also referred to more colloquially as the scuttlebutt method by Philip Fisher in Common Stocks and Uncommon Profits .

Mosaic theory involves collecting information from different sources, public and private, to calculate the value of security. Applying the mosaic theory is as much art as it is science. [1] An analyst gleans as many pieces of information as possible, determines if they tell a story that makes sense, and decides whether to recommend a trade.

It is also a legal theory used to uphold the classification of information, holding that a collection of unclassified information might add up into a classified whole.[7] [8] The theory has also been applied to legal reasoning in the context of the Fourth Amendment where the continuous use of GPS surveillance was found to violate the subject's "reasonable expectation of privacy". [3]

Legality of the Mosaic Theory

Though the Supreme Court recognized the legality of the Mosaic Theory in Dirks v. SEC, the concerns have arisen with the potential of illegal insider trading happening within analysts. [2] Analysts can take advantage of vague insider trading laws and this brings of the legality of it. Securities analysts can obtain non disclosed information from company insiders that an average investor cannot. [2] Under insider trading law, this advantage is an unlawful method. [2] To combat this issue, confidentiality agreements as well as operating under internal policy guidelines are in place. [2] Section 10(b) of the Securities Exchange Act of 1934 and Exchange Act Rule 10b-5 falls under the category when unknown traders purchase equity call options that are millions of dollars. [2]

The mosaic theory relies heavily on the U.S. economy's fluctuation and stock market. [3] Without public corporations being transparent, the mosaic theory would be ineffective and the stock market would be vulnerable to sudden shifts as hidden information comes out. [3] Thus, it is illegal for Unites States public companies to not be transparent with their corporate profitability. [3]

Court Cases

In May 2011, US District Judge Richard J. Howell sentenced Raj Rajaratnam, the founder of the Galleon Group hedge fund, to eleven years in prison who was found guilty of fourteen counts of insider trading. [5] During the high-profile trial of investor Raj Rajaratnam, defense attorneys used the mosaic theory to argue against allegations of insider trading. [3] These arguments were ultimately unsuccessful. Though it was ten years shorter than the requested amount of time, it constitutes as the longest prison sentence given to an insider trading case. [5] Under the Securities Exchange Acts15 USC §78j(b) and 17 CFR §240.10b-5, Rajaratnam and other Galleon traders were convicted with fraud and conspiracy. [5] They profited tens of millions of dollars of insider trading and based their arguments off of the mosaic theory. [5] So far, this is the only court case that has used the mosaic theory in court to validate insider trading in the court of law.

See also

Related Research Articles

Insider trading is the trading of a public company's stock or other securities based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider information is illegal. This is because it is seen as unfair to other investors who do not have access to the information, as the investor with insider information could potentially make larger profits than a typical investor could make. The rules governing insider trading are complex and vary significantly from country to country. The extent of enforcement also varies from one country to another. The definition of insider in one jurisdiction can be broad, and may cover not only insiders themselves but also any persons related to them, such as brokers, associates, and even family members. A person who becomes aware of non-public information and trades on that basis may be guilty of a crime.

U.S. Securities and Exchange Commission Government agency overseeing stock exchanges

The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government. The SEC holds primary responsibility for enforcing the federal securities laws, proposing securities rules, and regulating the securities industry, which is the nation's stock and options exchanges, and other activities and organizations, including the electronic securities markets in the United States.

Securities Act of 1933

The Securities Act of 1933, also known as the 1933 Act, the Securities Act, the Truth in Securities Act, the Federal Securities Act, and the '33 Act, was enacted by the United States Congress on May 27, 1933, during the Great Depression and after the stock market crash of 1929. Legislated pursuant to the Interstate Commerce Clause of the Constitution, it requires every offer or sale of securities that uses the means and instrumentalities of interstate commerce to be registered with the SEC pursuant to the 1933 Act, unless an exemption from registration exists under the law. The term "means and instrumentalities of interstate commerce" is extremely broad and it is virtually impossible to avoid the operation of the statute by attempting to offer or sell a security without using an "instrumentality" of interstate commerce. Any use of a telephone, for example, or the mails would probably be enough to subject the transaction to the statute.

The mutual fund scandal of 2003 was the result of the discovery of illegal late trading and market timing practices on the part of certain hedge fund and mutual fund companies.

Goldman Sachs U.S. multinational investment bank

The Goldman Sachs Group, Inc., is an American multinational investment bank and financial services company headquartered in New York City. It offers services in investment management, securities, asset management, prime brokerage, and securities underwriting.

Regulation FD , ordinarily referred to as Regulation FD or Reg FD, is a regulation that was promulgated by the U.S. Securities and Exchange Commission (SEC) in August 2000. The regulation is codified as 17 C.F.R. 243. Although "FD" stands for "fair disclosure," as can be learned from the adopting release, the regulation was and is codified in the Code of Federal Regulations simply as Regulation FD. Subject to certain limited exceptions, the rules generally prohibit public companies from disclosing previously nonpublic, material information to certain parties unless the information is distributed to the public first or simultaneously.

SEC Rule 10b-5, codified at 17 C.F.R. 240.10b-5, is one of the most important rules targeting securities fraud promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934. The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. The issue of insider trading is given further definition in SEC Rule 10b5-1.

Front running, also known as tailgating, is the prohibited practice of entering into an equity (stock) trade, option, futures contract, derivative, or security-based swap to capitalize on advance, nonpublic knowledge of a large ("block") pending transaction that will influence the price of the underlying security. In essence, it means the practice of engaging in a Personal Securities Transaction in advance of a transaction in the same security for a client's account. Front running is considered a form of market manipulation in many markets. Cases typically involve individual brokers or brokerage firms trading stock in and out of undisclosed, unmonitored accounts of relatives or confederates. Institutional and individual investors may also commit a front running violation when they are privy to inside information. A front running firm either buys for its own account before filling customer buy orders that drive up the price, or sells for its own account before filling customer sell orders that drive down the price. Front running is prohibited since the front-runner profits from nonpublic information, at the expense of its own customers, the block trade, or the public market.

Securities regulation in the United States is the field of U.S. law that covers transactions and other dealings with securities. The term is usually understood to include both federal- and state-level regulation by purely governmental regulatory agencies, but sometimes may also encompass listing requirements of exchanges like the New York Stock Exchange and rules of self-regulatory organizations like the Financial Industry Regulatory Authority (FINRA).

Stock trader a person or company involved in trading equity securities (share stock in companies)

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Securities fraud, also known as stock fraud and investment fraud, is a deceptive practice in the stock or commodities markets that induces investors to make purchase or sale decisions on the basis of false information, frequently resulting in losses, in violation of securities laws.

SEC Rule 10b5-1, codified at 17 C.F.R. 240.10b5-1, is a regulation enacted by the United States Securities and Exchange Commission (SEC) in 2000. The SEC states that Rule 10b5-1 was enacted in order to resolve an unsettled issue over the definition of insider trading, which is prohibited by SEC Rule 10b-5.

Stock all of the shares into which ownership of the corporation is divided

Stock of a corporation, is all of the shares into which ownership of the corporation is divided. In American English, the shares are collectively known as "stock". A single share of the stock represents fractional ownership of the corporation in proportion to the total number of shares. This typically entitles the stockholder to that fraction of the company's earnings, proceeds from liquidation of assets, or voting power, often dividing these up in proportion to the amount of money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may be issued for example without voting rights, with enhanced voting rights, or with a certain priority to receive profits or liquidation proceeds before or after other classes of shareholders.

Raj Rajaratnam is a Sri Lankan-American former hedge fund manager and founder of the Galleon Group, a New York-based hedge fund management firm. On October 16, 2009, he was arrested by the FBI for insider trading, which also caused the Galleon Group to fold. He stood trial in U.S. v Rajaratnam in the United States District Court for the Southern District of New York, and on May 11, 2011, was found guilty on all 14 counts of conspiracy and securities fraud. On October 13, 2011, Rajaratnam was sentenced to 11 years in prison and fined a criminal and civil penalty of over $150 million combined.

Galleon Group

The Galleon Group was one of the largest hedge fund management firms in the world, managing over $7 billion, before closing in October 2009. The firm was the center of a 2009 insider trading scandal which subsequently led to its fall.

Anil Kumar was a senior partner and director at management consulting firm McKinsey & Company, where he co-founded McKinsey's offices in Silicon Valley and India and created its Internet practice among others. Kumar is additionally the co-founder of the Indian School of Business with Rajat Gupta and the creator of two different kinds of outsourcing. He graduated from IIT Bombay in India, Imperial College in the UK, and The Wharton School in the US.

<i>SEC v. Rajaratnam</i>

SEC v. Rajaratnam, 622 F.3d 159, is a United States Court of Appeals for the Second Circuit case in which defendants Raj Rajaratnam and Danielle Chiesi appealed a discovery order issued by a district court during a civil trial against them for insider trading filed by the Securities and Exchange Commission (SEC). The district court compelled the defendants to disclose to the SEC the contents of thousands of wiretapped conversations that were originally obtained by the United States Attorney's Office (USAO) and were turned over to the defendants during a separate criminal trial.

The Raj Rajaratnam/Galleon Group, Anil Kumar, and Rajat Gupta insider trading cases are parallel and related civil and criminal actions by the United States Securities and Exchange Commission and the United States Department of Justice against three friends and business partners: Galleon hedge fund founder-owner Raj Rajaratnam and former McKinsey & Company senior executives Anil Kumar and Rajat Gupta. In these proceedings, the men were confronted with insider trading charges: Rajaratnam was convicted, Kumar pleaded guilty and testified as key witness in the criminal trials of Rajaratnam and Gupta, and Gupta was convicted in Federal district court in Manhattan in June 2012.

S.A.C. Capital Advisors

SAC Capital Advisors was a group of hedge funds founded by Steven A. Cohen in 1992. The firm employed approximately 800 people in 2010 across its offices located in Stamford, Connecticut and New York City, and various international satellite offices. It reportedly lost many of its traders in the wake of various investigations by the Securities and Exchange Commission (SEC). In 2010, the SEC opened an insider trading investigation of SAC and in 2013 several former employees were indicted by the U.S. Department of Justice. In November 2013, the firm itself pleaded guilty to insider trading charges and paid $1.2 billion in penalties, although no formal charges have been filed against Cohen himself. The firm shrunk after returning the vast majority of its outside investor capital. Point72 Asset Management was established as a separate family office in 2014. SAC ceased to exist as a separate entity in 2016.

References

  1. 1 2 3 Davidowitz, A. S. (2019). "Abandoning the 'Mosaic Theory' of Securities Analysis Constitutes Illegal insider Trading and What to do about it". 6 Wash. U. J. L. & Pol’y281.
  2. 1 2 3 4 5 6 7 Fisch, Jill (2013). "Regulation FD: An Alternative Approach to Addressing Information Asymmetry".
  3. 1 2 3 4 5 6 7 "UBS Global Asset Management Insider Trading Policies and Procedures". SEC. 2012.
  4. 1 2 3 Becker, D. M. (2000). "Speech by SEC Staff: New Rules, Old Principles". SEC.
  5. 1 2 3 4 Hautekiet J. (2011). "The Galleon Insider Trading Case: How To Sentence a Seemingly Victimless Crime?". Berkeley University of California.