SEC Promises Scrutiny Will Continue

Sanjay Wadhwa

Designation: Deputy Chief, Enforcement Division (Market Abuse Unit), and Associate Regional Director for Enforcement, New York Regional Office, U.S. Securities and Exchange Commission
 
Education: LLM in Taxation, New York University School of Law; JD from South Texas College of Law; BBA in Accounting, Florida Atlantic University
 
Career: Associate at Cahill Gordon & Reindel LLP; Skadden, Arps, Slate, Meagher & Flom LLP

Boards of directors at hedge funds also sit on the boards of large corporations, and are therefore privy to information. What kind of ramifications will the growing number of insider trading investigations into this nexus have on the hedge fund industry?
Hedge funds are constantly seeking information that gives them an edge in the marketplace relative to their competitors. The SEC’s recent insider trading actions against several hedge funds, including Galleon Management and its founder Raj Rajaratnam, should not be viewed as an attack on the ability of hedge funds to develop market insight by gathering information from different public and private sources. [Rajaratnam was found guilty on all 14 counts of securities fraud and conspiracy.]

Instead, it is the nature of that information that can make a resulting trade legal or illegal. There is nothing inherently wrong with a board member of a public company also being affiliated with a hedge fund, whether in the capacity of an investor, a consultant, an employee, or a board member (at the fund). However, if that person shares confidential information belonging to the public company with the hedge fund, and he or she knows or should have known that the hedge fund will trade on such information, then a violation of the insider trading laws may well have occurred.  
 
Hedge fund managers depend on moneymaking tips clubbed under the vague and broad non-material information category. Does this make compliance difficult?
Hedge funds depend on information that gives them a competitive edge. Toward that end, it is perfectly legitimate for hedge fund managers to consult sources such as academics or analysts about the future performance of any company in the industry that is in their area of research expertise. However, that is quite different from a scenario where a trader pays cash to employees of public companies to steal and sell confidential information, which the trader then uses to trade profitably. The SEC’s recent insider trading actions in the expert networks arena, which include charges against Barai Capital Management and its founder Samir Barai, allege exactly this kind of illegal conduct.

What mechanisms should hedge funds have in place so that they don’t end up in the same situation as Barai Capital?
Hedge funds should ensure that the information they gather is legitimate. Executives can enable compliance by setting up a robust compliance group empowered by the senior management. The group should set clear guidelines that inform traders what constitutes legitimate information gathering, and take proactive steps to prevent illegal information gathering. This could include instituting ‘chaperoned’ conversations, whereby compliance officials silently monitor random phone calls between hedge fund employees and consultants.

In addition, the hedge fund might evaluate the controls that are in place at the expert network firm with which the hedge fund does business and prohibit conversations with an expert who is an employee of a public company. Compliance personnel should also have the ability to ask traders hard questions concerning suspiciously well-timed, profitable trades. These measures, among others, could help a hedge fund root out illegal information gathering before the SEC comes calling.
 
Will the industry see an aggressive crackdown on expert networks, going forward?
The SEC is actively investigating expert network firms and their consulting arrangements with those who provide information and the traders who pay to receive this information. The expert networks industry should expect the SEC’s scrutiny to continue. However, it should be noted that only conduct that crosses the line has resulted in SEC enforcement action. Individuals and entities charged by the SEC include corporate employees who stole and sold confidential information, directly or indirectly through an expert network firm’s employees.

The SEC has also charged a hedge fund and several hedge fund employees who arranged cash payments to receive this stolen information and trade profitably using that information. The corporate employees, the tippers, lined their pockets with tens of thousands of dollars in ‘consulting’ fees while the hedge fund tippees made millions of dollars in illicit gains from trading on the information. The information itself was detailed, company-specific information about earnings, sales, top-line revenue, product orders and other similar material information. Given these egregious facts, the SEC’s actions cannot and should not be read as a condemnation of all expert networking firms or the consultants who are associated with them. That said, the SEC’s investigation into the practices of various expert networks is continuing and, if the facts warrant it, it will bring additional charges.
 
There are genuine and honest executives who are found not guilty of insider trading allegations. But the mere suspicion of such activity can tarnish their credibility. What are some common mistakes that well-meaning executives make that can put them in trouble?
There are instances where people charged by the SEC are found not liable for the securities law violations that were alleged. However, the decision to charge someone is not based on common mistakes made by the defendant but rather on the totality of the facts gathered in the investigation. SEC investigations are fact-finding investigations, meaning that the staff seeks to learn the facts through witness testimony, document production and other means. The staff expects truthful and complete responses to its testimony questions and its requests for documents, and anything less raises red flags for the staff.

It is also important to note that the agency is mindful of the impact that an SEC action can have on a defendant’s reputation and future livelihood, and its processes are designed to ensure that any charges recommended by the staff and any defenses available to the defendant receive close and careful deliberation by the Commission before an action is authorized.
 
In India, where the hedge fund industry is still nascent and poised for growth, what tips from the SEC can you share with SEBI to prevent fund managers from obtaining non-public information?
For any regulator to effectively oversee an industry, it must actively engage industry participants. The key is to encourage them to collaborate with the regulator to develop a common vision regarding generally accepted industry practices, and to take action aimed at curbing conduct that undermines that vision. In the U.S., such a relationship exists between the SEC and the securities industry. The SEC’s recent enforcement actions, apart from having their own deterrent effect, have underscored the need for investment advisers to have policies and procedures reasonably designed to prevent insider trading. To that end, senior SEC staff members have publicly articulated appropriate front-end and back-end controls that could be built around information obtained from expert networks that would minimize the risk arising from consulting with such firms.

(Sujata Srinivasan is a freelance journalist based in Connecticut, USA. She contributes regularly for Forbes India)