The insider trading challenge

As insider trading continues to be a high priority for the Securities Exchange Commission in the US and the Financial Conduct Authority in the UK, hedge funds have to find ways of managing this particular risk.  


High profile cases like the Galleon case, expert network cases or Diamondback have shown that the prevention of insider trading is an area that every hedge fund needs to focus on.  

In 2012 alone the SEC brought 58 insider trading actions against 131 individuals and entities. Over the last three years the agency has filed 168 insider trading actions, more than in any three-year period. These insider trading actions were filed against nearly 400 individuals and entities with illicit profits or losses avoided totalling approximately $600 million. 

In the UK, 50 insider dealing cases have been brought since 2007. While the first cases were “small beer” according to David Kirk, chief criminal counsel of the Financial Conduct Authority, cases now include large insider dealing rings.  

The tougher stance had a significant effect on market integrity, according to Kirk, as “dubious trading activity” around earnings announcement and other news impacting the market has fallen by 50 per cent in three years. However, this does not mean that the problem is disappearing; it rather morphs into more sophisticated practices, he said. 

Speaking at GaimOps conference at The Ritz-Carlton in April, Kirk drew attention to the FCA investigation of David Einhorn and Greenlight Capital. The case was settled last year on the basis that Einhorn did not admit that he had dealt on inside information, but he was still fined $11.1 million for engaging in market abuse regarding an anticipated significant equity fundraising by Punch Taverns Plc.  

Einhorn, who explicitly refused to receive information in confidence in a conference call with the company, liquidated Greenlight’s holdings of the Punch Taverns stock immediately upon hearing about the company’s intentions. Although he was not guilty of insider trading, he should have appreciated that he traded on insider information, argued Kirk. 

John Nathanson, a partner at law firm Shearman & Sterling said under US law Einhorn’s actions would not have constituted insider trading. He added the case indicates that the British regime appears to go further in terms of what is appropriate conduct, as opposed to lawful conduct, and that the UK imposes higher penalties. “In some ways [the UK] has gone beyond US law.” In contrast, the US government expends larger resources investigating insider trading, he said. “The pace [of new investigations] continues to be extremely brisk.” 

Patrick Sinclair, a prosecutor in the US attorney’s office, said Einhorn should have consulted Greenlight’s legal and compliance team before trading on the information. “If a company is approaching an announcement situation, the minute a portfolio manager hears there is something wrong, they should involve their compliance team,” he said. “If a company provides you with information in trust, involve the compliance and legal people immediately. Don’t just sell out the position,” he advised. 

Nathanson agreed that because in certain cases it is very difficult to determine what constitutes insider trading, it is important to involve legal and compliance teams. In the Einhorn case that was one of the key failings, he said. 

Kirk added, the cases most in danger of prosecution are the ones “where the senior person in an organisation tends to think they don’t need to take advice from anybody”.  

To identify and prevent insider trading, hedge funds typically use a variety of methods. Funds review and preapprove personal account trading. 

In some cases they even prohibit personal trading. Andrew Kandel, chief compliance officer and co-general counsel, at Cerberus Capital Management, LP said personal trading is only allowed in certain assets, such as ETFs or onshore funds. He acknowledged that initially this was considered extremely conservative but he said the industry has caught-up. 

Hedge funds also monitor trading versus major company events and review email communications. 

They require conflict of interest disclosures from employees and they use restricted lists to limit access to non-public information and prevent personal trading.  


Use of expert networks  

Nathanson noted a significant change in culture since 2009, especially around the use of expert networks and the question who hedge funds can talk to. The resulting fear has meant that many communication avenues have shut down.  

“And this is not good. It is the job of an analyst to ferret out information and how do you do that if no one talks?” Expert networks are a legitimate means of how hedge funds do research, he said. 

To continue the use of expert networks hedge funds had to develop new processes. For instance they should confirm that the expert they are speaking to is not breaching a fiduciary duty, that the expert network has compliance policies and procedures of its own, they should review communications between the expert and the firm for red flags and ensure that the expert only discusses topics preapproved by the fund manager and the expert network.  

Sinclair disagreed with the notion that there has been “a chilling effect” on the industry, as result of SEC investigations. In terms of best practice, he said it is necessary to instil an instinct in staff that if they don’t want to see something in an email or Bloomberg, there is something wrong. They should ask themselves “do I want to see this in a courtroom one day?”  

Nathanson called on funds to have robust compliance procedures and training around insider training. He asked: “Do you encourage people to come to your compliance personnel? Is there a sense that your compliance personnel are part of the team or are a drag on the team? Does the compliance officer have access to the head of the firm? How often does the compliance officer talk to the portfolio managers? Is there a robust restricted list?”  

Addressing these questions is necessary not only to ensure that problems can be prevented but also so that in case a problem arises, the fund can point to the compliance measures it has taken. Whether a fund gets charged can depend on factors such as the actual effectiveness of the compliance programme and self-reporting, he noted.  

Sinclair concurred and said the notion that firms that have come forward were being prosecuted is false: “They just don’t make it into the press.” 

He said the focus of insider trading investigations is now “expert networks 2.0” – political consulting networks and lobbying firms and how they obtain information from political circles. 


David Einhorn was fined $11.1 million for engaging in market abuse regarding an anticipated significant equity fundraising by Punch Taverns Plc.