Friday, November 26, 2010

Extrapolating from the scrutiny of channel checks

Louis Gray linked to AppleInsider, who linked to a Wall Street Journal article on SEC investigations of channel checks.

Small research outfits such as Mr. [John] Kinnucan's often rely on information from manufacturers' representatives to technology companies to gauge how a business is performing. Such information is referred to broadly as a channel check.

Such channel-check information has become crucial to Apple traders, who have come to expect a weekly dose of information from channel checks about Apple's iPad and iPod businesses.

Analysts relay the information—known in the business as "build plans"—weekly to savvy technology investors, who often dart in and out of heavily-traded Apple shares. Such information has grown to be almost as important as Apple earnings, able to move shares throughout the quarter.

The issue is that Federal prosecutors from the U.S. Securities and Exchange Commission (SEC) have been investigating such activities, raising the possibility that these people may be cited for insider trading.

Louis Gray worries about the consequences of this trend:

Assuming the new guide to insider trading is to be adopted, the suggestion essentially means that financial analysts should not be briefed by company employees during the quarter, should not survey those selling the products, their partners or maybe even the customers themselves. The rarified times an analyst can talk with the execs would be limited to the short conference call Q&A periods that occur after each briefing. This would make the already imperfect industry one further removed from real data.

Gray further notes:

What I worry about is not that Apple investors (or others like them) are suddenly going to be in the dark because 1 or 2 guys get slapped on the wrist for chatting up resellers. What this leads to is a company running unchecked with no communication to the outside world, except for every 90 days when they emerge from their corporate offices and tell you how they actually did.

Perhaps Gray is exaggerating, but what if he isn't? In a sense, this could potentially harm the companies themselves. For example, consider these two examples:

  • One of Apple's suppliers is the Taiwanese company Wintek. As a public company, it regularly reports earnings information. The particular example that I cited does not contain detailed information, but public companies (at least in the United States) have an obligation to reveal who their major customers are. If Wintek's monthly revenue happens to fall dramatically, and if it is publicly known that Apple is a major customer of Wintek, then does Wintek's monthly sales statement reveal inside information about Apple?

  • In Gray's scenario, official corporate communications would be limited to the quarterly reports. Obviously, companies communicate a lot in between quarters, although those communications generally include a multitude of disclaimers. Generally. Will more disclaimers be needed? If Steve is on stage and says that a new product will be the most insanely great product ever, will people from corporate wrestle him to the ground and cover his mouth before he reveals even more potentially damaging information?

A more worrisome aspect of this is the possibility that the rules have changed without notification. If the Wall Street Journal is to be believed, then the SEC has not previously prohibited the practice of channel checks. Now it would certainly be understandable if the SEC prosecuted a firm for giving an expensive product (such as an iPad) to a mail clerk, because that would be a violation under existing rules. But if a supplier voluntarily reveals that his plant has cut production on some supplies for Apple, and a channel checker reports this, then does the channel checker deserve prosecution?

In a sense it's too early to tell, since the SEC hasn't officially charged anyone yet. But for understandable reasons, a lot of Wall Street reporters are really anxious right now.
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