Galleon case rests on separation of aggressive research and insider trading

'We at the SEC are committed to pulling back the curtain on hedge fund operations... It would be wise for investment advisers and corporate executives to look closely at today’s case, their own internal operations and the increasing focus and scrutiny on hedge fund trading activity by the SEC and others.’ – SEC enforcement director Robert Khuzami, October 16, 2009, announcing the SEC’s complaint against Galleon hedge fund manager Raj Rajaratnam.

Well, they can’t say they weren’t warned. At that mid-October press conference, Khuzami described Rajaratnam as ‘a master of the Rolodex... embarked on a deliberate and systematic use of inside information to inform his trading decisions... It was, for all practical purposes, his business model.’

SEC chairman Mary Schapiro followed two weeks later in a speech before the Securities Industry and Financial Markets Association, tallying the new aggressive SEC’s activity in the first nine months of 2009 compared with 2008: more than twice as many formal orders (448 vs 181) and emergency actions (62 vs 30) and a doubling of disgorgements and penalties ($1.8 bn vs $865 mn). So have portfolio managers, analysts and IROs heeded Khuzami’s warning?

Some IROs and their counselors are using the Galleon case as an opportunity to review and reinforce formal disclosure policies. One former sell-side analyst and current hedge fund manager – who asks not to be identified – notes a distinct iciness among contacts at technology firms.

After more than two decades on the Street and with contacts throughout the tech industry, he would chat occasionally with contacts to discuss long-term trends and competitive positioning but ‘not next quarter’s earnings.’ In the weeks following the Galleon complaint, he was told by three or four long-time contacts that they couldn’t talk. ‘They got called to an all-hands meeting and were told, You will not talk to anyone on the Street. If you do, you will be fired,’ he recounts.

While the increased conservatism at tech companies may lead to a needed valuation adjustment, this investment pro is concerned that too much caution may backfire. ‘It’s to the firm’s advantage to expose me to different levels of management, marketing, line guys and operations, so I can understand the next six months or a year out,’ he explains. ‘It’s a fine line.’

Self-described as a longer-term investor, he confesses that it’s a style that ‘doesn’t fit with the tech hedge fund world view right now’, which is focused on market-moving news and short-term trades. ‘Not my forte,’ he laments. ‘I feel like a dinosaur.’

Acknowledging that ‘earnings estimates moved stocks’, this former analyst says it was part of what he had to do on the sell side but it also ‘gave the sense of false precision.’ Not trafficking in leaks or inside information could present competitive challenges as well, he adds. ‘Some sell-side guys had moles in companies and were really good at being precise on company earnings,’ he points out.

The game remains the same
While predicting that increased regulation of hedge funds will be a likely outcome of the current scandals, the anonymous hedge fund manager does not see behavior changing much. For proof, look no further than early November, two weeks after the Galleon charges hit the papers. In the hours leading up to HP’s announcement about the acquisition of 3Com, call options on the target company ‘shot way the hell up. It really makes me wonder,’ the fund manager muses. ‘Greed has no boundaries.’

Analysts ‘have been drilled for years to avoid acquiring inside information because if I do, I’m frozen out,’ asserts senior analyst and managing director Mark Kelleher at Boston-based Brigantine Advisors. ‘I want to stay in the game. You’d drop inside information like a hot potato, tell your supervisor and tell the company it has to get it out.’

He also avoids detouring around the IRO to probe inside companies he follows. ‘It will tick off the company if it finds out, and then you’re screwed,’ he explains. But he will seek out sales people from companies he doesn’t cover. ‘I don’t care if I get them mad at me,’ he says.

Agreeing with the anonymous fund manager, Kelleher believes a tightening-up on the flow of inside information will be good for investors and analysts who ‘are getting screwed by hedge funds trading on information that moves the market. It’s pretty hard to compete with that.’

Many people on the Street and beyond view the scandals as ‘inside baseball’, believing them to be a contained mess without broad repercussions. But Kelleher sees ‘far-reaching implications for the buy side, sell side, hedge funds and companies’, and expects increased regulatory oversight of hedge funds, and possibly also of equity research and corporate disclosure.

‘The best defense is greater transparency,’ argues Jim Allen who heads capital market policy at the CFA Centre for Financial Market Integrity. Companies make themselves vulnerable to leaks ‘when they start warehousing information. If the information is in the market, you don’t have to worry about it leaking illegally.’ He cites his own experience as a bank analyst: monthly loan statistics would affect the market outlook for banks on an ongoing basis, deflating the pre-earnings rumor pit.

Allen believes CFA-certified analysts are not the source of insider trading problems: the prohibition against insider trading is emphasized in both CFA testing and recertification, as well as in ongoing member education. ‘I don’t think we need to reemphasize that more strongly,’ he says.

Informal networks
Securities litigation attorney and Dorsey & Whitney partner Peter Carter sees no problem in companies prohibiting employees from ‘consulting’ for expert networks that serve as direct information conduits for hedge funds. A greater and often ignored threat is posed by informal networks ranging from ad hoc executive roundtables and professional associations to social relationships built around school ties or shared ethnic backgrounds, says Carter.

He has had ‘several SEC investigations that flowed from information shared at CEO roundtables’ and non-investor industry conferences. He urges clients to insist those groups impose confidentiality and trading restrictions ‘as part of their organizing principles’.

How can an IRO manage outsized-ego executives who enjoy hobnobbing with powerful Wall Streeters without the IRO around? ‘It’s a huge problem,’ Carter acknowledges. ‘The only way to convince them is to give them a very concrete example of an executive who said too much and was subsequently pursued by the SEC and sanctioned.’

So we come back to using the Galleon case as a cautionary tale. Brad Wilks, NIRI’s new chairman and managing director in the Chicago office of Sard Verbinnen & Co, recommends providing ‘a turnkey document’ that highlights the issues in the Galleon case and points to existing company policy, which can be shared with senior management and the company’s rank and file.

As long as a company has ‘a very robust disclosure policy’ and communicates it clearly, Wilks does not see the need for new policies. ‘I’m not sure a policy is going to prevent a rogue,’ he explains. Equally important is a communication from the CEO that ‘there can’t be sidebar conversations between senior executives and the Street that are not managed through IR,’ he adds.

Wilks urges IROs to think broadly about risk mitigation. ‘Too often in investor relations we box ourselves into a fairly narrow niche,’ he says. ‘This is an opportunity to build some bridges and say, Collectively, the enterprise needs to tackle this issue.’

In particular, employee communications may be a weak spot in a company’s disclosure defenses, with management sometimes going too far in terms of what is and isn’t public. ‘If you’ve got a webcast with 8,000 to 10,000 employees on it, who knows who they’re talking to?’ Wilks asks. He adds that the entire chain of outside PR and IR consultants, bankers, accountants and attorneys should be reminded periodically about the company’s disclosure policy.

Identifying the leaks
Mike Haase, vice president of treasury and IR at VMWare in Palo Alto, California, is an experienced IR pro in the leak-hungry tech industry. He makes sure before analysts or investors meet management that his pre-meeting briefing memo highlights whether a particular individual ‘has a reputation for trying to gain inside information.’

FedEx tries to counter the pressure for an information edge by issuing an extensive 25-plus-page statistical supplement each quarter, according to IR vice president Mickey Foster. That not only feeds the market’s appetite for data beyond what is in the 10Q, but also provides Memphis-based FedEx’s management with a playbook of what is in the public domain.

A member of the FedEx legal team works with Foster’s IR calendar and gives executives scheduled to meet with investors a heads-up call to remind them of the firm’s disclosure policy. ‘It’s better to have a lawyer do the scary talk,’ Foster says.

Channel checks are a ‘constant irritant and difficult to stop completely,’ says Matt Stroud, IRO at Orlando-based Darden Restaurants. Analysts publish their channel checks during the quiet period before earnings, and ‘it moves the stock,’ he says. ‘We’re handcuffed. We just let the revenue and earnings speak for themselves.’

Analysts defend the practice, saying their clients expect it, and they put the onus back on Stroud to stop employees from talking to them. While the policy is reinforced quarterly and a violation is grounds for dismissal, Stroud acknowledges the company can’t eliminate it entirely. ‘The only advantage we have is our size,’ he notes – because it’s impossible for analysts to get statistically meaningful data across all 1,800 restaurants.

Carter sums up the challenge: ‘There’s an entire industry out there that wants to get as close as it can to insider trading rules to get the information before everybody else, in order to make its trading profits.’

It’s a reality Wilks acknowledges. ‘There are bad eggs who want to circumvent the rules and cheat,’ he says. ‘They’re going to find a way to do it, whatever the rules are. That’s why we have enforcement agencies like the SEC.'