By Britt Erica Tunick
As soon as news broke of a lawsuit alleging that Harbinger Capital Partners’ January 2007 acquisition of Applica succeeded, at least in part, because of its receipt of “nonpublic information” about a rival bid, Harbinger began damage control. Within hours, it sent a letter to investors insisting that claims in the suit were “wholly unsubstantiated” and that the firm could explain its conduct regarding the acquisition.
The $8 billion Harbinger has since taken pains to remind the public that the firm has not been accused of insider trading, saying that it has received no inquiries from the Securities and Exchange Commission regarding the allegations by NACCO Industries, a holding company whose subsidiaries include small appliance housewares. The facts of the
case notwithstanding, the Harbinger flap is a window into the hysteria that has gripped the hedge fund industry—both managers and investors—ever since the first insider trading case against a hedge fund was lobbed last fall. On October 16, Galleon Group founder Raj Rajaratnam was accused of being at the center of an insider trading ring estimated to have netted as much as $53 million. The investigation’s tentacles continue to grow and have since touched more than 36 people, peripherally reaching some of the industry’s biggest names: A former employee at Steve Cohen’s SAC Capital Advisors and a fund manager seeded by Julian Robertson have also been dragged into the net.
Faced with massive redemption requests, Galleon shut its doors within a week, exacerbating the willingness of investors—still stinging from the losses and gates of 2008 and the Bernard Madoff scandal—to turn tail at the mere hint of impropriety.
“A couple of crooks have given the entire industry a bad name,” says Guy Haselmann, a principal with fund-of-funds firm Gregoire Capital. “Coming out of a crisis, Washington needs a scapegoat, and while they’re certainly picking on investment banks, they’re also skewering hedge funds and making them out to be the bad guys.”
That’s the conventional wisdom of most in the hedge fund industry. In the meantime, the SEC appears to be working overtime to repair its own tarnished image, following its inability to detect Madoff’s Ponzi scheme at his SEC-registered hedge fund. An aggressive reorganization of the SEC is helping to turn up the heat on fund managers that break the law. Robert Khuzami, the regulator’s new director of enforcement, has stepped up oversight of the hedge fund industry and is casting a wide net in the agency’s search for insider trading and other abuses.
While some hedge fund managers say the rules are black and white, others argue that a lack of clarity regarding regulators’ definition of insider trading has created its own share of problems. Fund managers say there can be many instances where analysts receive information from individuals in a company that they assume is public and legitimate as far as regulators are concerned but which might actually be deemed nonpublic in certain scenarios. And fund managers are quick to note that virtually every hedge fund firm lawfully comes across some sort of material nonpublic information on a daily basis. Though hedge fund firms have procedures in place to ensure that they do not improperly trade on such information, and most traders are afraid of unintentionally running afoul of the law, industry participants say that there will always be those who view any gray area as license to cross the line into insider trading.
The most easily detected abuses are found in publicly traded equities, leading some investors to begin shifting their allocations away from long-short equity funds into quant funds, where insider trading is by definition almost impossible. (See “The Quant Answer,” p. 49) But the issue is by no means limited to equities. Regulators are finally taking a close look at the less-transparent world of credit—including the much-maligned credit default swaps industry—and they’re gaining traction. A recent insider trading suit against two traders is expected to give the SEC more authority in the CDS market.
There’s more. Investors are now nervously eyeing lawsuits by former employees, associates or spouses. Anyone with an ax to grind might find today’s environment an extremely lucrative one. No wonder people are spooked.
Gregoire’s Haselmann recently discovered just how much fear exists when he put together a small roundtable of alternative investment professionals to discuss some of the issues plaguing the hedge fund industry—including insider trading. Haselmann was stunned that 63 people showed up. He had invited only 15.
Fund-of-fund firms such as Gregoire have been inundated with calls from investors seeking assurances that their holdings don’t include headline-making names such as Galleon. These fund managers are faced with the need to educate investors about the intricacies of hedge funds, including some of the risks innate in trading where the line between well-sought-out public information on a company and nonmaterial public information can be a fine one.
In this world of uncertainty, image is everything. Galleon was only the latest firm to liquidate while under SEC scrutiny, something that just two years ago hardly caused a ripple of concern among investors. In recent years, when such well-regarded funds as Perry Capital, HBK Investments and Millennium Management alerted investors to either pending SEC investigations or settlements, investors barely blinked.
No more. As the rapid demise of Galleon demonstrated, hedge fund investors today are likely to flee at the first sign of trouble. “There have been too many blow-ups in hedge funds,” says one San Francisco fund-of-funds manager, noting that investors are no longer willing to give fund managers the benefit of the doubt when a firm is touched by scandal. “Look at the history of Pequot [Capital Management]—it was an extremely large fund founded by people highly respected in the industry, and that all went sour because of allegations of insider trading.”
The industry’s biggest hedge fund firm for a brief period in 2000, Pequot announced in late May 2009 that it would shut down due to an SEC investigation into alleged insider trading of shares of Microsoft by the firm’s founder Arthur Samberg. The case had been a political nightmare for the SEC since mid-2006 when former SEC attorney Gary Aguirre accused the agency of nixing its investigation of Pequot under pressure from a major George W. Bush donor, John Mack, then the chairman of Pequot and now chairman of Morgan Stanley. In early 2009 the SEC reopened the case.
“Public disclosures about the continuing investigation have cast a cloud over the firm and have become a source of personal distraction,” wrote Samberg in a May 27 letter to the firm’s investors announcing its liquidation.
That case is a reminder of what loose cannons disgruntled ex-employees can be. After all, it was someone who used to work at Galleon, Roomy Khan, who tipped off regulators about Rajaratnam and the others.
Hedge fund managers have always had to contend with lawsuits from ex-employees who believe they have been ill-treated, frequently over compensation or bonuses. Circumstances of such legal battles differ, but each lawsuit carries the same risk for hedge fund managers: negative headlines that could set off a string of redemptions as investors worry about repercussions down the road.
In a current lawsuit, former DB Zwirn partner Perry Gruss is suing founder Daniel Zwirn and his firm for $9.6 million, alleging that he was denied money owed him when he was pushed out of the firm in 2006. In early 2008 DB Zwirn was shut down after the revelation that an internal investigation had uncovered improper accounting at the firm that led to more than $2 billion in redemptions.
In addition to dealing with the litigation over Harbinger’s acquisition of Applica, Harbinger founder Phil Falcone is fighting a suit by Howard Kagan, a former Harbinger analyst who insists Falcone cheated him out of roughly $62 million when he left the firm. Kagan alleges Harbinger failed to honor his employment contract. Harbinger has denounced the claim as nothing more than differing interpretations of the terms of Kagan’s contract and says the suit is meritless. “This is a disappointing outcome for a former employee who underperformed our expectations,” says a spokeswoman for Harbinger.
Another fund that is dealing with the ire of former employees is Touradji Capital Management, which has been hit by suits from Gentry Beach and Robert Vollero over claims that the pair didn’t get $50 million in bonuses they had earned.
Each of these hedge funds deny that they have done anything illegal, and in Touradji’s case, the outspoken fund manager has actually launched countersuits. A spokesman for Touradji declined to comment on the matter.
Because of the clannish nature of the hedge fund industry, progress of the Galleon case has created an avalanche effect as cooperating witnesses come forth, exposing some bigger names to the bad publicity—if not the charges.
One of the greatest shockers is the recent disclosure that a key SEC witness dubbed “Tipper X” has been identified as Thomas Hardin, a former trader at Lanexa Global Management whom the firm said it fired in January 2009 over performance issues. Hardin’s unmasking brought attention to the fact that Lanexa’s founder Ian Murray was backed by Tiger Management founder Julian Robertson—an individual long viewed within the industry to be somewhat of a choirboy for his insistence on adhering to the straight and narrow. Though Robertson is not alleged to be involved with insider trading, his ties to Hardin hint at the few degrees of separation that exist in the industry. A spokesman for Robertson would not comment on the issue.
SAC Capital Management’s name has also been dragged into the mud, inadvertently at least. Former SAC analyst Jonathan Hollander was recently identified as one of the key informants in an SEC case filed last year against an insider-trading ring including Ramesh Chakrapani, a former managing director at Blackstone Group. SAC hasn’t been accused of wrongdoing in the suit. And if that case wasn’t enough to cause unease for SAC, the ex-wife of founder Steve Cohen ensured that the firm will continue making headlines with her recent filing of a RICO suit alleging that her former husband hid roughly $300 million in assets during their divorce and engaged in various insider trading activities in the 1980s. The case was dropped in mid-December, but Cohen’s former wife has since brought on a new attorney who is expected to refile the suit. A spokesman for SAC declined to comment on the issue.
The SEC is hoping to take advantage of the close ties among hedge funds as it cracks down on insider trading. In the year since taking over the SEC’s division of enforcement, Khuzami, a former prosecutor for the U.S. Attorney’s office for the Southern District of New York, has made some major organizational changes that should make the regulator more effective at policing insider trading.
One of the biggest changes has been the establishment of specialized units dedicated to the hedge fund and private equity communities. Khuzami has also fostered a closer relationship between the SEC and prosecutors in the U.S. Attorney’s office, which has helped move investigations along at a faster pace. And to encourage individuals to voluntarily work with regulators and report activities such as insider trading, he has made it clear that the SEC will reward cooperators with incentives similar to those that are commonplace among criminal prosecutors, where the first person to come forward receives the best deal.
“The SEC seems to be on a very broad fishing expedition of insider trading,” says Richard Morvillo, a partner with Schulte Roth & Zabel. He says the agency has recently been issuing broad subpoenas looking at such issues as relationships between and among hedge funds—a dramatic departure from the past, when subpoenas were directed at specific trading activities.
Before now, the SEC’s ability to prosecute insider trading was somewhat limited, with even the most airtight cases taking years to play out. That reality, coupled with the fact that the regulator ignored cases with a tinge of gray, led to laxity among many hedge fund managers and traders.
“It used to be that the rewards were so great and the risks so small that it encouraged people to take the risk,” says Jay Gould, the head of law firm Pillsbury Winthrop Shaw Pittman’s investment funds and investment management practice team and a former SEC staff attorney. He says many people perceived insider trading as a harmless crime. “But now that may not be the case... This is a new model of enforcement, and they’re able to bring and settle cases quicker,” says Gould.
For all the SEC is doing to crack down, industry participants are quick to note that the regulator has also had a hand in the lack of clarity in the laws regarding insider trading. “Right now public disclosure is so bad that almost anything a company says is new information,” says Andy Redleaf, founder of $3.2 billion hedge fund firm Whitebox Advisors.
Since Whitebox takes a nondirectional approach to investing, the firm does not face the same risks regarding insider trading that those whose investments center around individual companies do. Nonetheless, because the guidelines in some cases are vague, Redleaf says, his firm is extremely cautious.
To highlight the confusion the rules may cause, he outlines a scenario in which a company hoping to raise money in the debt markets asks a fund manager’s opinion as to how much it could expect to raise under prevailing market conditions. Though the fund manager hasn’t actually been provided any information, the mere indication that a deal could be coming down the pipeline at some point might be enough to get a firm in hot water if the fund manager were to, say, short that company’s stock if a deal occurred shortly thereafter. “The laws and regulations are unnecessarily vague,” says Redleaf, noting that it would be unclear in such a situation if a company’s question could be indicated as definitive knowledge of a deal coming to market.
The lack of clarity surrounding insider trading guidelines has made most firms overly cautious. “If we get something about a company we immediately send it to our legal counsel and cc the whole world,” says a fund manager for one Midwest hedge fund, noting that the firm circulates lists of restricted stocks on a weekly basis. One New York multistrategy shop has tried to avoid insider trading not only by setting clear parameters for the firm’s traders but also by requiring them to sign contracts allowing the firm to claw back any compensation based on improper trades, according to a fund manager there.
Industry participants say that insider trading abuses are most rampant in the credit world. That’s something regulators have long suspected, but policing is difficult because of the lack of transparency in many areas, including the arcane world of credit default swaps. “The regulators just don’t understand credit derivatives at all, and there’s no database or clearinghouse for them to look at,” says the head of one quant firm with close ties to the credit market. “If you can’t even track the data, how do you know if somebody’s cheating?” he asks.
The $85 billion bailout of CDS player American International Group in 2008 led to calls for more regulation of CDS, but the financial regulation legislation now being debated won’t mandate exchange trading and full transparency for the entire CDS market, leaving much of the market still in the dark.
Few insiders want to see the lack of transparency in many sectors of the credit market changed. Says one attorney close to the credit market: “The last big area within credit is the municipal market, and that’s a real arcane place where people do business in a very different way. You’ve got the highest rate of defaults and all of these sweetheart deals... Some of it’s not just insider trading but outright fraud.”
Questionable activity in the credit market has been difficult for regulators to identify and document, but industry insiders say it’s a big problem. “We’ll notice when somebody sells big blocks of a certain credit, and then just a few days later some news will come out that the company is issuing a ton of additional debt or being downgraded for one reason or another. So there are definitely people that get information ahead of time, and it doesn’t seem to be something that the regulatory bodies have been focusing on,” says one municipal bond professional.
Hedge funds, of course, are known for exploiting every tiny anomaly, which makes them keen to pay for any information that gives them an edge. At least one of the transactions under scrutiny now involves Blackstone Group’s October 2007 takeover of Hilton Hotels. According to the SEC’s complaint, Hardin has admitted to being tipped off about the deal in early July of that year, saying he shared that knowledge with Gautham Shankar, a proprietary trader at New York trading firm the Schottenfeld Group. Like Hardin, Shankar—who acted on the tip by purchasing 25,000 shares of the hotel chain for a $156,000 profit—has pleaded guilty to insider trading and is cooperating with the SEC’s investigation.
The Hilton deal is notable because CDS spreads spiked in advance of the takeover’s announcement. “It’s not impossible to figure out who purchased contracts before a deal, and there are well-known deals like Hilton where people profited from enormous positions in CDS,” says the quant firm head.
“Regulators have been looking at the CDS market as a place where people have been trying to place insider trading bets,” says Michael Feldschuh, a former trader for FrontPoint Partners who recently launched New York hedge fund firm Aristarc Capital. Feldschuh says that even with the limited data available on the market it is a commonplace occurrence for spreads to move in advance of takeover deals. “People who might be thinking that they’re getting away with this stuff shouldn’t sleep so easy because the government may simply be building its case,” he says.
If a recent judgment in one such case is any indication, the SEC may well start stepping up its enforcement of CDS. In early December, Judge John Koeltl of the U.S. District Court for the Southern District of New York set a precedent when he declined to dismiss insider trading charges against a pair of traders for violating section 10(b) of the Securities Exchange Act of 1934 (the antifraud provision governing the secondary trading of securities) in their trading of credit default swaps.
In this lawsuit, which marks the SEC’s first insider trading case based on CDS, the regulator alleges that Jon-Paul Rorech, a salesman for Deutsche Bank Securities, and Renato Negrin, a former fund manager at Millennium Partners, violated insider trading laws by acting on privileged information regarding a bond offering by Netherlands-based publishing company VNU, whose holdings include Nielsen Media. After learning about a change to VNU’s July 2006 bond offering that would increase the price of CDS on the company’s bonds, Rorech allegedly tipped off Negrin, who is said to have reaped a $1.2 million profit for Millennium by trading on the information. Millennium was not named in the suit.
A motion on behalf of Rorech and Negrin argued that “10(b) does not provide the SEC with the authority to regulate the CDS at issue in this case because they are not ‘securities-based swap agreements.’?” But Koeltl allowed the SEC to proceed with its case. “Judge Koeltl concluded that it was a factual question he couldn’t resolve on a motion to dismiss, and I think that gives the SEC a little traction to try go garner facts suggesting that, in certain circumstances, debt and other hybrid instruments can be securities,” says Schulte Roth’s Morvillo. He also says that a recent budget increase at the SEC will allow the regulator to hire more people to bolster its scrutiny.
The SEC says the Galleon and VNU cases are simply examples of the regulator’s new priorities in its enforcement division. “The lack of transparency in the derivatives markets adds a new and more dangerous dimension to misconduct such as insider trading,” said Khuzami in a December 8 speech at the AICPA National Conference on Current SEC and PCAOB Developments. “Together, these two sets of cases [Galleon and VNU] illustrate the concerns that we have with respect to both hedge funds and the derivatives markets, and in particular the intersection of both.”
Despite all the extra attention by regulators and the gray areas, is it really that hard to avoid doing something wrong? “Doing good work leads to an information edge that is legally able to help your risk reward in a trade,” says Gregoire’s Haselmann. “If you do your homework you should be rewarded for doing more fundamental analysis than other people, and most people in the business know the difference between information that they should and should not have.”
Still, when egos get so inflated, and the payoff for crossing the line is big, it is unlikely that insider trading will become a thing of the past anytime soon, if ever. “There’s always going to be crime, and you’re never going to prevent every fraud,” says one fund manager. “And with the egos in the business there will always be the guys who want to be the biggest guys in the room.”
Even with the ramped-up regulator surveillance, insider trading could get even easier over time, or so some think. “Insider trading is more sophisticated now, and there are more ways to potentially engage in insider trading or illegal conduct without really fully realizing what you’ve done,” says Pillsbury Winthrop’s Gould. “And there are more ways to go about it when you know exactly what you’re doing.”
As for Harbinger, even though the firm has not been accused of insider trading, it continues to try to head off investors’ worries. “We firmly believe that we will prevail in this lawsuit when our side of the story is told,” the firm said in its letter to investors regarding the Applica lawsuit. But with Harbinger remaining relatively quiet on the matter, it remains to be seen whether Harbinger’s efforts to preempt investors’ anxiety has been successful or if the damage has already been done—something that will most likely become clear during the firm’s next redemption period.
The quant answer
With the regulatory spotlight on insider trading, some investors have begun to shift their attention to quant funds—which use computer algorithms to analyze specific market sectors—and away from long/short strategies that rely on analysis of individual companies. “Quants are becoming much more attractive again because they are cleaner—they’re actually playing by the rules,” says Michael Feldschuh, founder of hedge fund firm Aristarc Capital. He says there is a newfound awareness in the investor community that if a fund’s returns seem too good to be true, they likely are. “All of the sudden people are going back to quants, where we can make a 15% or 20% return but will never make 80%, and they are saying that those returns are now looking attractive,” says Feldschuh.
The benefits of regulators’ crackdown have been twofold for quants. The ramped-up policing has caused a resurgence of interest in quant managers’ strategy, plus it has curtailed the trading abuses that often have a detrimental impact on quants. Because insider trading can lead to unexpected movement in a stock’s price, quant funds reliant solely on public information can wind up on the wrong side of a trade. “Quants will look at public information and think a stock is overvalued, not knowing what the insiders know—which is that there’s going to be a premium bid for the stock,” says Feldschuh.
— Britt Erica Tunick
