As part of its widespread ongoing investigation focusing on expert networks, on February 8, 2011, the SEC charged a New York-based hedge fund and four hedge fund portfolio managers and analysts with trading on illegal tips received from expert network consultants in SEC v. Longoria et al., brought in the Southern District of New York.

Focus on Insider Trading

The case involves insider trading by ten individuals and one investment adviser entity, all of whom are consultants, employees or clients of the California-based expert network firm Primary Global Research LLC (PGR).  The complaint alleges that PGR’s employees sought experts who had access to and were willing to share inside information in exchange for fees of $150 to $1,000 per hour.  In some cases, the so-called experts willingly shared sales forecasts, earnings, performance data, revenues and other detailed information about their own companies with clients of PGR.

The complaint further alleges that managers and analysts at the hedge fund Barai Capital Management illegally traded in securities of AMD, Seagate Technology, Western Digital, Fairchild Semiconductor and Marvell, among others, on the basis of material, nonpublic information obtained from employees moonlighting as expert network consultants for PGR, netting more than $30 million in illicit gains.

This case is an example of joint criminal and civil investigations by the SEC, the FBI and the U.S. Attorney’s Office for the Southern District of New York targeting allegedly pervasive practices of financial industry professionals eliciting material, nonpublic information from firms that match industry specialists with money managers, and trading on such information.  The fallout from PGR’s conduct has resulted in criminal charges against a number of technology company employees, traders (including former employees of SAC Capital, a $12 billion hedge fund group) and consultants for PGR.

Widespread Investigations; Civil and Criminal Charges Pending

These charges come on the heels of other investigations into insider trading and at least two SEC enforcement actions, SEC v. Galleon Management, LP et al. and SEC v. Cutillo et al.  According to the SEC, the insider trading rings identified in these enforcement actions include several prominent hedge funds and high-profile hedge fund managers, as well as Wall Street professionals such as attorneys, professional traders and senior corporate executives.

Most recently, the SEC announced civil insider trading charges against Rajat K. Gupta, a former member of the Boards of Directors of Goldman Sachs and Procter & Gamble, for allegedly disclosing material, nonpublic information about these companies to Raj Rajaratnam, who is the founder and managing partner of Galleon Management, LP.  Among other things, Gupta, a former managing director of McKinsey & Co., is alleged to have disclosed to Rajaratnam material, nonpublic information concerning Berkshire Hathaway Inc.’s $5 billion investment in Goldman Sachs before it was publicly announced on September 23, 2008, as well as information about the investment bank’s financial results for both the second and fourth quarters of 2008.

Key Takeaways

These insider trading cases raise several pertinent issues to be examined by public companies and their employees as well as research analysts, hedge funds and other money managers.  Public companies should have clear insider trading and shareholder communication policies.  Only designated individuals should be permitted to speak on behalf of a company. Problems with rogue employees may persist, but well-documented policies and ongoing training programs for Regulation FD compliance for public company executives, boards of directors and investor relations departments are critical to minimizing the release of material, nonpublic information.  Moreover, companies should review their relationships with third-party consultants and vendors to ensure that their contracts are designed to guard against the distribution or misappropriation of confidential information.  Third parties should have access to such information only as needed to perform their duties.

Analysts and traders should be mindful of the fine line between channel checks (i.e., procuring manufacturing and sales data from third-party suppliers, vendors and retailers), which traditionally factor into fundamental investment research, and trading on material, nonpublic information.  No doubt investors may be wary of research practices such as channel checks after the SEC’s most recent aggressive insider trading investigations.

It is important to note that the SEC’s current activity should not eliminate established research practices, but it highlights the importance of sound compliance programs.  Similar to operating companies, investment companies should have well-documented insider trading policies, which promote practices that (1) educate analysts, traders and other employees, (2) encourage communication with legal and compliance personnel regarding research practices, (3) seek thorough due diligence and supervision of any third-party expert network firm or consultant and (4) facilitate the isolation of suspected material, nonpublic information and prevent trading on such information.