How to avoid the insider trading net
Four different hedge funds were implicated in the insider trading ring involving Dell Computer shares, a case that brought down Anthony Chiasson and shuttered his firm Level Global. But only one of those hedge funds, Diamondback Capital Management, was able to emerge from the three-year investigation still in business. The turmoil and uncertainty caused by the FBI raids drove investors out of the other funds. Diamondback, however, managed to hold onto half of its $5 billion in assets under management, even though it paid a $9 million penalty and signed a non-prosecution agreement with the government that admitted guilt.
For hedge funds, Diamondback offers an object lesson: Principals urgently need to protect themselves from business-destroying risks like insider trading. And though Diamondback responded to the raid better than Level Global and other firms, such as Frontpoint, which had to close most of its funds after a similar case emerged, there are a number of defensive measures hedge funds can implement well before law enforcement gets involved. Sadly, too few firms seem to know what these steps are or how to take them.
What did Diamondback do right? Where most firms circle the wagons, Diamondback brought in its own investigators from the outside. That move clearly played a decisive role. The U.S. attorney was specific about the factors that led to Diamondback’s non-prosecution agreement, including “Diamondback’s representation [...] that the misconduct [...] did not [...] extend beyond that described in the Statement of Facts, and was not known by the firm’s co-founders.”
By contrast, most internal compliance officers don’t have the ability to demonstrate a knowledge of their employees’ business contacts and social connections. But the soul of insider trading lies in friendships that elide into criminal behavior. In the indictment of Chiasson and the two traders at Diamondback, the government referred to these informal social and work contacts as part of a “criminal club of fund managers and analysts who swapped illegal tips.”
Over the past couple of years the way the government investigates and prosecutes insider trading has changed dramatically. Law enforcement now focuses on aggressively identifying and building insider trading cases around relationships – personal, social and professional – in a way that is unprecedented. For lack of a better term regulators are now “mapping” trader relationships, using both technology and human sources, to triangulate outlier trades against any personal contacts that may have been the source of non-public information.
To protect itself, a fund should have — and maintain — its own map. At K2 Global, we use proprietary software to help funds sift through the enormous amount of data — email, phone traffic, instant messaging — a fund produces. Then we follow up on that information with intensive investigation. Analysis by experienced professionals, including former securities lawyers, law enforcement personnel and journalists, can spot social ties that present a risk before there’s a problem.
There are two important stages to this process. The first is to conduct thorough due diligence on potential and existing employees. This is essential, even though some funds view this as invasive or a sign that they don’t trust their own employees.
The reality is that a quick scroll through LinkedIn or your run-of-the-mill background check won’t provide enough information in the event you need to conduct a deeper investigation later on. General counsels and compliance departments are not equipped to identify deeper social relationships; nor can they evaluate the extent of an employee’s contacts. This is important. The financial markets are an incestuous place where overlapping work histories create opportunities for former colleagues to share — and profit from — information. When that opportunity will come is not always easy to foresee.
Once an employee is hired, the information gathered during vetting might prove essential if suspicious trading later emerges. For example, a portfolio manager makes a purchase of a stock outside his or her normal buy pattern. That portfolio manager may have the due diligence and research to support it, but does the fund know that his best friend from business school works at the company whose stock he just decided to trade? Does the fund know there was a spike in IMs between the two before and after the trade?
A hedge fund’s second line of defense is having the capacity to overlay this internal map on top of suspicious trades and then be able to transform the map into a coherent “story.” In the vast majority of cases, the outlier trades have a legitimate explanation.
When they don’t, the best response to a government investigation is to be able to show that the fund has been monitoring its staff in a responsible manner. That includes having the capacity to identify problematic players, outline questionable relationships and draw boundaries around the extent of any suspicious activity. Above all else, having proactive due diligence on hand allows funds to respond to regulators in the brief window before investors look to redeem their money.
Some funds might think they are protected by the secrecy and complexity of their own data. However, the weak point in the system remains the human beings. They are the point of entry for risk — and for the government. Analysts and traders caught up in illegal activity are now cooperating with regulators to an extraordinary degree. “Cooperating witnesses are crucial in insider trading cases,” Peter Henning recently wrote on DealBook. “The prosecution of Mr. Chiasson hinges in large part on information provided by others in the chain of information, including a former analyst at Level Global.”
In the new prosecutorial climate, the government expects firms to respond, cooperate and mitigate wrongdoing proactively if the firm, not just the individual, expects to avoid prosecution.
Too many trading firms have the attitude that it is not worth the cost and nuisance of developing the kind of “first to know” capacity that thorough vetting and triangulation would create. As we have seen with Diamondback, that might be the best investment a hedge fund ever makes.