Insider Trading at Hedge Funds: A Risk Area that is Difficult to Address

Insider trading is an area of risk that hedge fund management finds very difficult to identify and prevent.  While the problem has become increasingly prevalent, the tools to be able to assist hedge fund managers have not expanded proportionately.  A break-down in personal trust in the industry as a whole may be to blame.

The problem in the area of insider trading at hedge funds is well-known. Recent high profile hedge fund cases are in the press day after day:  the Galleon case,  the expert network cases, followed by the Diamondback/Level Global/SAC case of last week. Assuming the problem doesn't originate from top management, what tools do hedge funds have to combat insider trading by their employees? And, more importantly, are they effective?

To identify and prevent insider trading, hedge funds typically use a variety of methods, including reviewing personal account trading and preclearance of personal account trades, monitoring trading vs. major company events, reviewing communications, requiring conflicts of interest disclosure from employees, and using restricted lists in conjunction with limiting access to non-public information.  If you analyze each of these methods closely, they ultimately primarily depend on full disclosure from the employee. While these sorts of tools have their place, ultimately the problem here is that if an employee is a "bad apple" and is ready, willing and able to engage in insider trading, what can a manager really do short of trailing him/her 24/7?

We link the increasing insider trading problem at hedge funds to the expansion of the industry and the seeming "retailization" of these investments. If you consider the original concept of hedge funds, which was a small pooled investment vehicle offered to investors with whom the manager had a real relationship, it is hard to imagine how a manager would have engaged in insider trading because of the personal nature of the investment and the personal scrutiny he was under from investors.  Similarly, the organizations were small, so that the employees were under the same sort of scrutiny by the manager. It was really a matter of personal trust- by the manager in his few employees, and by the few investors in the manager.  Where this connection has now been diluted, the insider trading problem has expanded.

Go to: http://sec.gov/news/press/2012/2012-16.htm to view the SEC's release on the Diamondback Capital settlement of insider trading charges. 

Read more articles about the hedge fund industry and related legal issues at Hedge Rows, a blog by Judith Gross

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