Stock Shenanigans

When it comes to the business press’ coverage of the stock market, there is one unfortunate truth: there are just too many companies to pay attention to. As a result, while bigger names get plenty of scrutiny–though nowhere near enough, as the Cendant debacle reveals–there are literally thousands of smaller publicly-traded companies that never garner even a mention in the mainstream press. The problem is that this makes it harder for small investors to stay informed about these companies and easier for the companies to indulge in manipulative shenanigans of the worst sort.

Take, as a cardinal example, the recent movements in the stock price of DataWorks Corp. DataWorks is a San Diego-based company in the currently hot business of providing enterprise resource planning (ERP) software for mid-size manufacturers. ERP software allows manufacturers to keep better track of their inventories and production lines, thereby making it easier to pull off just-in-time production strategies and, in general, to maintain a tighter grip on expenses. Companies like PeopleSoft, Oracle, and Germany’s SAP have prospered by providing ERP software to larger corporations, but DataWorks has kept its focus on the mid-size market.

DataWorks has been a solid company in recent years. Not earth-shattering, but profitable, with healthy margins and a meaningful niche position in an ever-growing market, and less than a month ago, its stock rested close to $20 a share. Then, beginning on June 25, it tumbled, falling three points in three days and then, gathering speed, dropping another five points in two days. On July 1 the stock was worth 40 percent less than it had been the week before.

Remarkably, the fall took place without any news from the company. DataWorks issued no release about a possible earnings shortfall, and there was no bad news in the broader ERP market. Outside investors were completely in the dark. The stock then traded in the $12-$13 range for the next two weeks–again with no comment from the company–until, on July 17, the company finally dropped the other shoe. It announced that it would, in fact, fall well short of Wall Street’s expectations for the quarter, and that its profit margins were coming under severe pressure from “steep discounting.” The stock dropped another four points that day, and has remained below $9 a share ever since. In less than a month, DataWorks’ stock lost almost 60 percent of its value.

The Inside Advantage

What’s important about this is that clearly somebody knew about those numbers well in advance–two or three weeks in advance, in fact–of DataWorks’ release, and that information somehow got into the hands of investors who were able to dump their shares and get out before the firestorm. This is the definition of insider trading. The same thing happened on a more massive scale with Cendant, where a large institutional investor dumped a 1,000,000-share block the day before Cendant said that the problems caused by fraudulent accounting went much deeper than previously expected. But where the Cendant situation was so egregious, and the company so well-known, that everyone noticed, DataWorks is so tiny it’s not surprising that all of this happened with nary a comment from anyone who matters.

Insider trading is a notoriously difficult crime to define, since all traders are seeking better information than the rest of the market and since deciding who is hurt by insider trading is harder to do than you might think. (Are you hurt if you sell stock to someone who knows more than you?) But the selective disclosure of material information to certain investors and not others wreaks serious damage on the whole system, for the simple reason that it destroys the confidence of investors in the transparency of markets. On both the upside and the downside, if companies hide from investors, investors have no recourse but to hide from them.