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