When the Securities and Exchange Commission announced its massive insider-trading bust against Galleon Management last month, SEC Enforcement Director Robert Khuzami gave a warning: “It would be wise for investment advisers and corporate executives to closely look at today’s case, their own internal operations, and the increasing focus and scrutiny on hedge fund trading by the SEC and others.”
Sobering words, certainly. Since at least 2006, the SEC has declared hedge fund insider trading to be a “top priority,” but it had never brought a case that really drove that message home—until now.
The SEC’s Galleon case and the parallel criminal prosecution by the Department of Justice have captured Wall Street’s attention like few others cases in recent memory. Hedge funds, issuers, and their compliance departments are scurrying to see how they can firm up their policies and internal procedures now that people may be headed off to prison for conduct that many once saw as “minor trading floor indiscretions.”
What lessons can issuers and hedge funds draw from these most recent hedge fund cases? Clearly, the quantity and quality of information that Galleon CEO Raj Rajaratnam and others are alleged to have received, and how easily they received it, are not comforting. Looking at the actual allegations in the Galleon case, and where the non-public information allegedly came from in each instance, it seems quite evident that traders who work relentlessly to position themselves as hubs for gathering and spreading information can repeatedly gain access to market-moving information.
Consider the SEC’s allegations about just a few of the corporations ensnared in the Galleon case:
Polycom Inc.: A senior executive at Polycom provided information on Polycom’s Q4 2005 and Q1 2006 earnings.
Hilton Hotels Corp.: A Moody’s rating agency analyst provided information about the imminent takeover of Hilton by the Blackstone Group. Moody’s was evaluating Hilton’s debt in connection with the takeover.
Google: An employee at Market Street Partners, a consulting firm, provided information about Google’s Q2 2007 earnings. Market Street did public relations work for Google and had access to non-public information concerning Google’s earnings announcements.
Intel: A managing director employed by Intel Capital, a subsidiary of Intel, provided information about Intel’s Q4 2006, Q1 2007, and Q3 2007 earnings.
Advanced Micro Devices: A director at global consulting firm McKinsey provided information about AMD’s pending transactions with two Abu Dhabi sovereign entities. McKinsey and this director, Anil Kumar, were then advising AMD in connection with its negotiations with the two Abu Dhabi sovereign entities.
Akamai Technologies: An Akamai executive provided information about Akamai’s Q2 2008 earnings.
PeopleSupport: In 2008, Galleon had regular access to inside information about PeopleSupport because Galleon owned 25 percent of the company, and because a managing director at Galleon served on PeopleSupport’s board.
All these allegations show how difficult it is for companies to keep material information a secret until the news is finally made public. They also demonstrate just how many different parties and individuals are involved in every significant transaction, as well as the countless relationships in play, and the huge potential value of non-public information to traders such as hedge funds. Given all that, it’s no surprise that people are tempted to share the news and profit from it. Indeed, it seems so easy for well-connected professionals to obtain information that perhaps the only way to end it is via stiff deterrence against its use—for example, the criminal charges Rajaratnam and others now face.
Preet Bharara, the new U.S. attorney for the Southern District of New York, has tried to emphasize that point. He stated that the Galleon case should be a “wake-up call for every hedge fund manager and every Wall Street trader and every corporate executive who is even thinking about engaging in insider trading.” Noting the wiretaps prosecutors used to help break the case—a tactic never before used in insider-trading cases—Bharara added that “as the defendants in this case have now learned the hard way, they may have been privy to a lot of confidential corporate information, but there was one secret they did not know: We were listening. Today, tomorrow, next week, the week after, privileged Wall Street insiders who are considering breaking the law will have to ask themselves one important question: Is law enforcement listening?”
Galleon could have taken a few steps to mitigate some of the problems here. For instance, at most big hedge funds, managers are not allowed to sit on corporate boards so that the hedge fund will not have its trading limited due to access to confidential information. This was reportedly the case at Galleon, too, but apparently that didn’t stop the relationship noted above between a Galleon managing director and PeopleSupport.
For the most part, however, the allegations are simply that insiders surreptitiously passed along inside information to trusted traders, who quickly profited from it. It is hard to see how any kind of compliance program could have stopped that.
Similarly, while training programs at corporate issuers can help protect against accidental or unknowing disclosures of inside information, nothing suggests that any of the disclosures listed above were accidental in nature. To the contrary, the Justice Department alleges that the Akamai executive can actually be heard on a wiretap saying, “I have a major present for you … information.”
Although not currently a part of either the SEC or DoJ allegations, Galleon also reportedly obtained a trading “edge” for itself in another way. As part of its normal operations, Galleon reportedly paid hundreds of millions of dollars a year in commissions to its Wall Street banks, and used that as leverage to demand market information that would not have been disclosed to most investors. For instance, Galleon was known for pushing its banks to divulge information or “color” about big buy-and-sell orders, which is often prohibited by bank policies.
This “color” isn’t insider information from corporate executives like what has been detailed in the Galleon charges, but it’s highly valuable material nonetheless. As Babson College business professor Peter Cohan explained in a recent article, if Galleon knows that the average daily trading volume of a particular stock is 2 million shares, and it learns from its broker that Fidelity had orders to sell 3 million shares that day, it then knows that the price of this stock is likely to fall unless other brokers had even bigger buy orders. Galleon could then sell that stock short and profit from the expected dip from Fidelity’s sell order. No wonder experts like Cohan say this kind of information may be the “most useful form of information of all.”
Assuming that the leaking of this “color” to Galleon and, no doubt, other investors is not insider trading (my guess: It probably isn’t), the new spotlight on this practice raises critical questions for regulators and compliance departments: Is this illegal as “front-running?” Are brokers violating industry or internal rules by sharing this information? Are big-ticket sellers like Fidelity in the example above disclosing confidential information at their clients’ expense? It is unclear what steps, if any, the SEC is prepared to take in this area, although it has been saying for years that it is concerned with “informational controls within broker-dealers” as relates to hedge funds.
The situation is quite clear, however, with respect to insider trading. Hedge funds and corporate issuers now know that both the SEC and the Justice Department have them squarely in their sites. The SEC has promised that more such cases are on the way, and delivered one on Oct. 30 when it charged the former CFO of a San Francisco hedge fund and six of his relatives and friends with insider trading leading to profits of more than $8 million. It may be the case that the free flow of confidential information between executives at public companies and their allies at hedge funds will only be shut down when prosecutors and regulators persuade hedge funds that the benefits of trading on such information no longer outweigh the potential costs.
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