United States

FBI shares the inside story on insider trading


FBI Supervisory Special Agent David Chaves was the featured speaker at a recent event hosted by 100 Women in Hedge Funds and sponsored by RSM. Chaves shared his experience investigating securities fraud, specifically during Operation Perfect Hedge, the FBI's investigation into insider trading in the hedge fund industry.

Investigating insider trading in the hedge fund industry was no easy task. Chaves said that the FBI had been hearing allegations of insider trading in the hedge fund industry for years, but that it was difficult to gain the information necessary to build cases. He pointed to a number of challenges:

  • Exponential growth
  • Relatively light regulation
  • Lack of transparency
  • Gaps in the FBI's intelligence regarding alleged cases
  • Difficultly placing undercover agents because the industry was closed to outsiders

Can I get a witness?

Chaves said that, because of its insular and interconnected relationships, the challenges of penetrating the hedge fund industry were similar to those confronted when investigating organized crime - and they called for the same solution. The FBI needed to develop cooperating witnesses with inside knowledge of the insider trading schemes.

The FBI began with a detailed analysis of the telephone records of suspected individuals, comparing them with the phone records of insiders at the companies they were trading. They found the same pattern time and again – a phone call from an insider at a company would be followed immediately by a trade in that company's stock.

With likely targets identified, the FBI undertook months of intensive surveillance, gathering a wealth of information about their targets. Finally, they shared the case they had against those targets and offered them the opportunity to cooperate. And cooperate they did. So far, Operation Perfect Hedge has led to 85 convictions, including major figures such as Raj Rajaratnam, CRO of Galleon Hedge Fund, and Rajat Gupta, former managing director of McKinsey & Company and board member at Goldman Sachs. The federal government has not lost a single case in this effort. Chaves emphasized that the perfect conviction record reflects the FBI's focus on only the most serious violations.

Chaves also noted that, in every case, defendants raised a mosaic defense, claiming that any insider information they may have had was only a small part of a vast research effort and, therefore, was not really instrumental in their investment decisions. That defense has not worked yet. Chaves set a clear line for hedge funds to consider. If you have a troubling piece of information, call the general counsel at the company in question and ask if that information should be considered nonpublic. If the answer is yes, then you need to sequester that data and hold off on any trades in that stock until that information becomes public.

Trouble at expert networks

Expert networks were one area where the FBI found serious abuses. These networks are supposed to offer traders legitimate access to experts in key industries to assist traders in researching industry trends. However, the FBI found that some of these networks were crossing the line, connecting hedge funds with insiders who were willing to share nonpublic information. Chaves pointed to Primary Global Research (PGR) as a prime example. While their compliance policy clearly forbids the sharing of nonpublic information, that policy was not enforced, and the FBI uncovered numerous incidents of hedge funds gaining illegal access to confidential information through PGR's experts. During his sentencing hearing, a cooperating witness from PGR described the firm's goal as "to recruit experts who would disclose confidential information to its hedge fund clients."

Chaves pointed out that expert networks can be legitimate and valuable tools for hedge funds. He encouraged funds to protect themselves by:

  • Carefully reviewing the expert network's compliance policies
  • Ensuring that the experts participating in the network have permission from their employers to do so
  • Ensuring that the fund's employees understand appropriate boundaries for discussions with expert networks
  • Pre-approving and occasionally monitoring expert network conversations

Chaves notes that not all insider trading schemes were hard to crack. In one case, the executive secretary of Disney's CEO, who had access to the company's earnings in advance of their release, teamed up with her boyfriend to send a letter to hedge funds across the country offering that information for sale. Chaves was pleased to report that not a single hedge fund bit on the offer, but several forwarded the email to the FBI. The duo was promptly arrested.

Chaves concluded by saying that the hedge fund industry is a great industry staffed by intelligent and hard working people. Hedge funds that are playing by the rules have no need to be paranoid. He encouraged professionals in the industry to reach out to him or his fellow agents at any time.

RSM Financial Services Director Matt Reynolds notes, "Strong enforcement actions by the FBI is crucial to the protection of investors and capital markets, which are key economic drivers of growth. The prosecution of corporate insiders who leverage non public information for personal gain helps establish market integrity and engender investor confidence. As Chaves notes, the hedge fund industry is made up of intelligent and hard-working individuals. We counsel clients that well thought through policies and procedures support good corporate hygiene and help prevent non compliant behavior by bad actors."

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