The Types of Rules Imposed on Investment Banking

By Matt Krantz, Robert R. Johnson

Investment banks are subject to many rules that govern their activities, but the primary focus of regulation is on information flow — ensuring that all investors have equal access to information and one group is not disadvantaged relative to another.

Illegal insider trading

Under certain limitations, insiders are allowed to trade in the securities of the firm that they’re involved in. The SEC defines illegal insider trading as “buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.”

Information is material if its disclosure would likely have an impact on the price of a security; that is, if investors would like the information before making an investment decision. Information is nonpublic if the investing public has not been made aware of it. For instance, potential mergers and acquisitions, unreleased company earnings numbers, changes in management, and any regulatory approval or rejection of a patent is considered material information.

In addition to trading for one’s own benefit, it is illegal to pass along that information to others who trade on it. Investment bankers have access to much more and better information than the typical investor. Those individuals in possession of inside information are strictly prohibited from trading on that information until it is released to the public through proper channels.

A recent focus of the SEC on insider trading has been on so-called expert network firms. These firms often access the knowledge of company insiders and pass along specialized information to hedge funds and other institutional investors. Although it is certainly legal to consult experts including company insiders on developments that affect the company, if the information obtained is not public, it cannot be traded upon.

Market manipulation

Market manipulation occurs when market participants conspire to distort prices and trading volumes in order to mislead the markets. A classic example is a pump-and-dump strategy in which someone acquires a position in a company, releases positive information about that company, and then dumps the stock at a profit. Pump-and-dump occurrences tend to be concentrated in the micro-cap or penny stock market because these markets are easier to manipulate.

The traditional image of pump-and-dump purveyors was that of the so-called boiler room where individuals would cold-call unsuspecting investors and promote a specific stock or stocks. The advent of the Internet and social media made it much easier to accomplish a pump-and-dump strategy. All it takes is a few strategically placed comments or false rumors to get gullible investors to fall prey to unscrupulous operators.

Market manipulation can also be done by people who take a short position in a security — that is, bet on the stock price falling by short-selling or buying put options — and then denigrate the stock by spreading information. Once the stock price falls, these “stock bashers” close out their positions at a profit.

Although it certainly isn’t illegal for market participants to point out the weaknesses of particular stocks, it is illegal to spread false and misleading rumors. As you may suspect, cases of stock bashing are very difficult to prove.

Not all market manipulation is meant to distort prices. Another form of market manipulation is churning, in which market makers collude to make it appear that the buying and selling in a security is much more active than it actually is. A market maker is a firm that is a dealer in a particular security, standing ready to buy and sell, hoping to profit on the bid-ask spread.

For instance, a market maker may quote a buy price of $20.25 per share and be willing to sell the security for $20.50 per share. A successful market maker doesn’t care as much if the price of the securities that it makes a market in rises. The market maker is concerned with the ability to match buyers and sellers and profit on the spread between the prices.

Investors prefer to invest in securities that have a deep and liquid market and often look to the volume of shares traded in a day or a week as an indication of how deep the market is. Market-making firms could manipulate volume by simultaneously buying and selling the stock or colluding with others to do so.

Information flow

Because information is the lifeblood of the investment banking industry, regulations govern what information is required and how that information is released.

One prominent regulatory change adopted by the SEC in 2000 targeted companies and their disclosure of information — a regulation that had a large impact on the investment banking profession. Regulation Fair Disclosure (Reg FD) requires that companies disclose material information to investors at the same time.

Before the adoption of Reg FD, companies often practiced selective disclosure — alerting professional analysts covering the company to developments prior to disseminating the information to the larger public. Oftentimes, these disclosures took place on quarterly conference calls between the company and firm analysts.

Because information is the valuable commodity in the investment business, providing information to one group prior to more widespread dissemination was viewed as creating an un-level playing field.

Reg FD has taken an interesting turn in the era of social media. The case that really brought attention to this issue was that of Netflix CEO Reed Hastings, who posted on his Facebook page in July 2012 that Netflix monthly viewing hours had exceeded one billion for the first time. Netflix did not simultaneously release the information in the more standard press release or Form 8-K filing.

Despite the page having over 200,000 followers, including analysts and reporters, the SEC originally charged Hastings with a violation of Reg FD. The SEC has subsequently changed its stance and said that companies can use social media to disseminate information if certain requirements are met. It doesn’t strain credulity to believe that many more people saw the Facebook posting than would have seen the standard disclosure.