The inside view on insider trading

Hedge fund Galleon has been charged but how many other people are in the same boat 

I usually write this monthly column about a topic that everyone in the City is talking about. This month I'm writing about something very few people are talking about, precisely because few people are talking about it.  In fact not only are people not talking about it but I was advised by one of my contacts, a corporate finance director,that I shouldn't even write about this subject. I felt like the naïve tourist in An American Werewolf in London being told not to go on to the moors at night, even though no one would admit to the existence of werewolves.  Interestingly, the local pub in that movie was called The Slaughtered Lamb, and although in real life the pointers aren't usually so obvious, in the case of insider trading there are plenty of them.

So why is everyone avoiding talking about insider trading?

Well, over the last few weeks almost every single day has brought new revelations in the case of the US hedge fund manager Galleon where the top officials were recently charged by the SEC. The initial allegations were that the Galleon had a number of sources in key organisations who would supply Galleon with inside information on an
ongoing basis. These organisations included reputable names such as Intel, McKinsey, and IBM. Since then it has
emerged that there were a vast number of feeders of information to Galleon including staff at investment banks,
corporate finance boutiques and investor relations firms. This episode has caused the blue-chip firms involved to react rapidly in suspending the alleged people, and has tested their commitment to business ethics in how
they treat and discipline those employees. 

Closer to home, another recent case has highlighted the insider dealing issue. Last month, the FSA concluded a case against Mark Lockwood, an Investment Adviser, who had executed a trade for a client knowing that the trade was as a result of inside information. He was fined but the fine was mitigated by the fact that, as the FSA noted, he made no personal gain from the transaction. The FSA seems to have overlooked the fact that the trade enabled him to continue serving his client and charging the client fees and commissions.

Information Seepage

In my discussions with City folk this month, there seems to be broad agreement that insider dealing goes on but they would rather not talk about it. I was told of numerous cases where corporate transactions have been underway but information has seeped out leading to a movement in the share price.

One private equity fund manager described how his firm had spent weeks and incurred hefty adviser fees on preparing for a large equity stake in an AIM-quoted company only to see the share price jump by 35% a few days before the announcement. This has scuppered the investment and the company is now unable to obtain the funds it needs to invest in accelerating its growth.

Another corporate finance director described the dilemma of when to bring an investor inside in a case where his
firm was acting for a bidder and needed to establish the likelihood of winning over major shareholders. The discussion with the investor almost can't be had without having a discussion about the discussion as the investor may not want to be tied down by being an insider. This highlights the grey line when accusations of insider dealing arise and it also highlights why they can be notoriously difficult to prosecute.

New Formats

New communications formats such as bulletin boards, live chat and SMS bring a new angle to insider
dealing especially as some forms don't leave a trail. One contact told me of a market maker who was made redundant from his City job last year and began trading from home in North London. He benefits from not commuting at 6am everyday and yet he doesn't feel removed from the City because on Bloomberg chat he gets all the information he needs without the regulatory monitoring of his chats that he used to suffer working for an institution. The casual format of such chat tools means that rumours abound and some may be founded or apparently founded and some not and of course the big question is "When does a rumour become inside information?" . He describes his Bloomberg chat facility as the best investment he's ever made and I suspect it's not because he's discussing last night's football.

A lawyer contact told me that the complexity of modern communications has made the passing of inside information (or misinformation) all the easier and that the challenges presented have yet to be fully addressed by the regulators. I was also told that what we see reported or prosecuted isn't even the tip of the iceberg but the flag on the tip of the iceberg.

So, how many other people are in the same boat as Galleon? The consensus seems to be that insider dealing is widespread but it tends to be opportunistic and unstructured. What makes Galleon different is the extent to which
formal structures were developed specifically to gather inside information with the aim of helping a hedge fund deliver the elusive alpha.

Extensive Grey Area

Why won't people talk about it? It sounds as if they'd rather not acknowledge that it's a problem and more frankly because they don't want to lose business from jeopardising their City relationships. Moreover, with an extensive grey area about what insider dealing is, they are probably concerned that they may get inadvertently caught in the regulators net, and in general it seems to be something that is just part of the City game that needs to be managed and they are resigned to it.

As usual, my final question is "What can you as a private investor do about it?" and this month I'm afraid there's no answer to that. When you invest in markets, you are taking all sorts of risks and that includes the risk of being the victim of an apparently victimless crime. As investors or advisers or companies, we're all in the
same boat and we have to deal with the City as it is.