Is the Securities and Exchange Commission redefining what constitutes insider trading? Many think it is.
The SEC is focusing its latest string of insider-trading investigations on technology employees who moonlight as consultants in expert networks and the hedge funds and analyst they provide with tips. The charges have caught some companies off guard and mean they will need to get a tighter grip on confidential information.
“These cases have a number of relatively unusual features a lot of people will want to look at,” says Thomas Gorman, a partner in the law firm Dorsey & Whitney. Those include wiretaps, cooperating witnesses, and expert networks, to name a few.
On Feb.8, the U.S. Attorney for the Southern District of New York and the FBI's New York office charged Samir Barai, a former portfolio manager at two hedge funds, Donald Longueuil, a former research analyst and portfolio manager, and two others with conspiracy to commit securities and wire fraud.
The charges came on the heels of Feb. 3 SEC charges filed against six technology company employees who allegedly pocketed hundreds of thousands of dollars in consulting fees for illegally tipping hedge funds and other investors with material non-public information about their companies. The six insiders were expert network consultants to the firm Primary Global Research LLC.
The charges may serve as a wakeup call for companies to put more stringent controls on non-public information and to crack down on employees who speak out of school, like those who participate in expert networks. Many are now reviewing their policies on what employees are privy to sensitive sales and customer information.
Companies should consider extending prohibitions to cover disclosure of the company's own information and disclosure of information on customers and suppliers, particularly any relationships covered by a confidentiality agreement, says Russ Ryan, a partner in the law firm King & Spalding.
Finally, Ryan and others say companies might consider explicit and detailed guidance — or outright prohibition— on employee affiliations with expert networks. “Many insider-trading policies, even good ones, may not explicitly cover that type of thing,” says Ryan.
The cases have cast a harsh spotlight on those networks, which match institutional investors, often hedge funds and money managers, with consultants who get paid fees to provide research and analysis. Expert networks aren't new. “Especially among companies in the tech sector and areas where there's active trading, it's fairly common for senior and mid-level employees to be part of expert networks,” says Robert Heim, an attorney at Meyers & Heim.
Such networks emerged “in large part as a response to the SEC's [Regulation Fair Disclosure] rule as a new way for Wall Street to get a leg up,” says Peter Henning, a law professor at Wayne State University. Reg. FD prohibits executives and spokespeople from selectively disclosing material non-public information. “This is a new source of inside information. Before this latest round, most insider-trading cases had been episodic. It appears from the pleas and charges so far that this was a much more organized system for dispensing information.”
KHUZAMI ON PRG
The following excerpt is from remarks made by SEC Enforcement Director Robert Khuzami about PGR:
PGR was a so-called “expert networking” firm in the “matchmaking” business — matching people who had information with people who wanted it. They claimed to run a clean operation. Today we pull back the curtain and reveal that the only matching that was going on here was to match theft with greed.
The theft and greed started with people who worked at companies well-known to all of us: AMD, Dell, Flextronics, and others. These trusted employees chose to steal information that belonged not to them, but to the company and its shareholders. They lined their pockets with tens of thousands of dollars by trafficking in that stolen information in a manner that is not unlike an employee who drives to the loading dock late at night and fills the trunk of his car with valuable office equipment and sells it to his neighbor.
They attempted to cover their tracks in some cases by making sure that the calls with PGR clients were not taped, their names were not used, and they were referred to by pseudonyms. They did this to avoid getting caught by their employers.
Hedge Funds
The greed continued with the hedge funds and their principals who corruptly arranged to receive this stolen information and to trade using that information for profit. They were looking for detailed, company-specific information about earnings, sales, top-line revenue, product orders and other similar material information with which they could make, in the words of one defendant, “fast money.” And they paid cold, hard cash for that information.
Today's actions are not a condemnation of all expert networking firms or the consultants who are associated with them who provide legitimate expertise and experience to assist investors in making investment decisions. But that is not what occurred in the events that underlie today's charges. Today's charges reveal thoroughly corrupt conduct, through and through.
Broad Theme
These corrupt arrangements violate a basic principle that lies at the heart of our capital markets system. Everyone is expected to play by a single, uniform set of rules. That basic principle gives investors confidence that the markets are fair and the playing field is level.
Insider trading corrodes that investor confidence. It undermines the integrity of the markets by tilting, unacceptably, the playing field in favor of those whose greed drives them to betray the duties and confidences they owe others. And it shortchanges every other investor who executes trades, with all the attendant risks, on the basis of trading decisions made by dint of hard work and genuine analysis. Today's actions should make it clear that the price one will pay for providing or receiving such corrupt services is ultimately too high. All of us here today are sending that message in the strongest possible terms.
There can be no exceptions. And none will be tolerated.
Source: SEC's Robert Khuzami Remarks. (Feb. 8, 2011).
Many companies are barring employees from engaging in expert consulting services that relate to their own employer, says Heim. “The new [insider trading] cases have highlighted the need for companies to look not just at their insider-trading policies, but also at their policies related to outside employment activities,” he says. Specifically, companies should consider whether to place restrictions on the type of consulting employees can do. For example, Heim says it may be okay for employees to consult on general industry trends and developments, but not to have any discussions about their employer or related companies. Henning expects many firms to simply prohibit employees from participating in expert networks completely.
Those using expert networks should also make sure they have policies in place that make it clear that the experts it works with shouldn't reveal information they have a duty to keep confidential. “Many hedge funds I work with require expert consultants to acknowledge and sign off on specific policies saying they won't pass inside info to the fund,” says Heim.
The cases present a major challenge for compliance officers, says Henning. That's because some of the insider-trading investigations center on information that employees provide to analysts and hedge funds that alone might appear harmless, but when put together with other pieces information, form a picture that goes beyond what is publically available—known as the mosaic theory. “You might not always know insider information right away when you see it,” he says. “That it is a compliance officer's worst nightmare.”
Hedge funds in particular should expect more scrutiny. “The SEC is sending them the message, ‘we're watching you,'” says Henning. “That whole slice of the industry is coming under the microscope.”
While the legal theory in the cases isn't new, observers says the tactics used are. Until recently, most insider-trading cases weren't investigated until after the trading occurs. “The use of wiretaps and cooperating witnesses makes these different from the usual insider-trading cases,” says Gorman. “These are more forward-looking.” In other words, “These investigations were done in real-time,” Henning says.
Another major concern is the impact the government's focus on information flow could have on price discovery in the market, says Gorman. “The latest cases are broadening the definition of insider trading,” he says. “If they broaden it too far, it will undermine price discovery.”
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