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$10 Million Cost of Bad Ethics in Data Collection

If you are an investment adviser, hedge fund or active trader looking for the edge that good research can give you, you might turn to "alternative data providers" as investment professionals refer to any intelligence that isn't contained in traditional financial reports. There are over 450 vendors in this sector according to Some providers offer satellite photos of parking lots to help predict whether retailers will blow-away Holiday shopping season estimates, others look for weather patterns' impact on commodity prices, or do sentiment analysis on corporate earnings calls, or gather any number of indicators available through big data and the Internet of Things (IoT). It's all fair game to trade smarter and be a step ahead of others in the marketplace.

Or is it really all fair game? Not so fast, Speedy, says the U.S. Securities and Exchange Commission that regulates trading in public companies' stock. In an enforcement action against App Annie, the leading alternative data provider that tracks downloads and usage of mobile apps, the regulator issued a $10 million fine against the company, a $300,000 fine against its CEO and banned him from serving as a company officer for 3 years. Where App Annie went wrong is that it lied to the tech company clients whose apps it tracked by saying it would anonymize and protect their usage data, then sold this information to other clients who were Walls Street investors hoping to profit from insights about which apps were doing well. Since some of the app makers were publicly traded companies, the information gathered under false pretense was deemed to be fraudulently gathered insider information.

It wasn't only App Annie that engaged in criminal conduct by deceiving both sides: those app makers whose information was sold, and those who bought information they were told was derived from a statistical model. By trading while in possession of material non-public information, everyone who used the illegally obtained and shared data was unwittingly guilty of violating U.S. securities law anti-fraud provisions and risked fines, criminal penalties and a regulatory blemish on the public record. As it turned out in this case, none of the traders and investment managers who were clients of App Annie faced sanctions or were targeted for enforcement actions, however, the SEC has announced it will issue a Risk Alert to communicate additional guidance and spell out expectations of regulated firms on the topic of alternative data. The headshot it fired at App Annie will serve as a warning shot to all others.

What will this mean if you are an active trader, hedge fund or investment adviser planning to use alternative data?

It means that you will likely need to take a close look and exercise due diligence on the reputation, policies and internal controls of the companies you source data from to ensure that they are preventing the use and sharing of illegally obtained or material non-public information. You will also want to have an iron-clad contract where your provider promises that they have not done anything that would cause you to breach the laws on insider trading and use of illegally obtained information. As tempting as it is to get ahead of the competition by any means necessary, some of those means entail risk of serious harm to your firm for crossing the line into unethical or illegal behavior.

What will this mean if you are an alternative data provider?

You can expect that your potential financial services clients, at least the ones who aren't clueless knuckleheads, are going to be asking a lot more questions when they are evaluating your service. They will inspect your policies and your terms of service. They may ask for audit reports and to evaluate your internal controls. They will seek contractual terms whereby you attest to high ethical standards and clauses that indemnify them if you breach your agreements, The cost of doing business for your industry will include the cost of building compliance controls, carrying additional liability insurance and generally there will be no free ride, except a very short and bumpy one.

We discussed the above post with James Taylor, Founder/CEO for SEC Reporting Analytics (not affiliated with the Securities and Exchange Commission) and he explained the approach they have taken, which we might see more of from other providers in the space:

"Given the risks involved in any dealing with material non-public information, SEC Reporting Analytics has chosen to limit our offering to only handling data sourced from public sources, such as the SEC’s own published reports, and adding value to that data by analytical means only. We apply various tools such as data scraping, aggregation, and calculation of financial and operational key performance indicators and believe that the format we present to our clients will save them countless hours to get data that would normally be buried in various static PDF reports into a ready-for-analytics purpose state. Our partnership with Snowflake lets us give our clients access to enterprise grade cloud data & analytics tools such as Amazon FinSpace, Python, SQL, and traditional statistical models that can be used to understand the correlation between stock price and various underlying fundamental metrics over time. Our dataset outputs have been reconciled back to SEC filings over that last 5 years and can be customized to add new metrics based on client need. Whether you are a one-person compliance attorney, a large law firm that has a limited technology budget, or a portfolio manager looking for ways your team can quickly develop, test, and validate custom portfolio construction methodologies, SEC Reporting Analytics datasets will allow you and your team to quickly and efficiently identify and capture significant value for your firm."

We welcome comments and questions from readers on this topic and will give an update on this topic when additional regulatory guidance or significant news comes to our attention.


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