After causing the collapse of the Galleon Group hedge fund in 2009, insider trading enforcements have once again shaken the hedge fund industry. Late last week, the US Securities and Exchange Commission (SEC) charged Steven A. Cohen, CEO of SAC Capital Advisors LP, one of the world’s largest hedge funds, with failing to supervise two of his managers, Mathew Martoma and Michael Steinberg, who traded on material non-public information concerning three US listed companies in 2008.
As a result of these illegal insider trades, SAC Capital Advisors earned profits and avoided losses of almost $300 million. If the high-profile administrative suit of the SEC proves to be successful on August 26, Cohen could face a permanent bar from the financial services industry, leaving the survival of SAC Capital on the edge and sending shivers through the entire hedge fund industry.
In general, insider trading refers to some investors (e.g. managers and directors of corporations) trading on proprietary information that is not yet available to the rest of the market. In the US, insiders are allowed to trade, as long as they meet two fundamental requirements: they do not trade ahead of information events – for instance, mergers and acquisitions and corporate announcements - where they have access to sensitive information prior to the rest of the market; and they report their trades by filing a Form 4 with the SEC.
In the 2012 fiscal year, the SEC brought 58 insider trading actions against 131 managers and entities accused of gaining profits – or avoiding losses – totalling approximately A$600 million. Between 2010 and 2012, the SEC has filed more insider trading actions — a total of 168 cases against nearly 400 individuals and entities — than in any three-year period in the SEC’s history. “[T]hese illegal practices impose a cost on law-abiding investors and the integrity of the financial markets,” said Robert Khuzami, director of the SEC’s division of enforcement, in a press statement.
Insider trading: costs and benefits
There is much debate among economists and jurists on whether the benefits of insider trading outweigh its costs. On the cost side, insider trading is said to decrease market liquidity due to greater adverse-selection costs of asymmetric information imposed on outside investors, and reduce investors’ confidence in capital markets, hence increasing the cost of capital and lowering firms’ value.
Other academic studies suggest there could be benefits. One view is that insider trading could improve market efficiency by impounding quickly certain strategic non-public information (such as earnings management) into prices, information that would otherwise be withheld by corporations.
Strengthening internal governance
Notwithstanding the uncertainty regarding the balance between informational costs and benefits of insider trading, little is known about how internal governance affects managerial incentives and profitability of insider trading.
Given that better governance could influence strong managerial incentives from performance fees and investors’ flows to engage in insider trading activities, understanding the role of hedge funds’ governance in preventing insider trading is crucial.
It is unsurprising that the Dodd-Frank Act took an important step in this direction by eliminating the previous exemption of advisory registration for hedge funds.
Starting from March 2012, all hedge funds were now required to file form ADV with the SEC. This form requires information on the hedge funds’ organisational structure, compensation, assets under management, clientele, disciplinary history, and governance. As such, not only does it improve the transparency of hedge fund operations, but it could also help better manage potential operational risks.
More importantly, form ADV requires the board of a hedge fund to designate an independent chief compliance officer (CCO) with the aim of strengthening internal governance. The CCO should be responsible for supervising all portfolio transactions and overseeing the implementation of insider trading compliance policy which must include an affirmative statement of prohibition against insider trading. It is also important to remember that US mutual fund advisors have been filing form ADV since the introduction of the Investment Advisers Act of 1940. It might not be a coincidence that many of the targets of the SEC’s insider trading investigations are managers of hedge funds, rather than mutual funds.
What next?
There is no doubt that despite this significant regulatory change, we will continue to see hedge fund managers populating the SEC’s “name and shame” enforcement action policy. Even so, the new provision of the Dodd-Frank Act represents an interesting experiment to study whether the new requirement of designating a CCO within the hedge fund organisation will provide hedge funds with various ex-ante and ex-post mechanisms to prevent their managers from exploiting inside information.
The stakes are high not just for the SEC, which has been pummelled for not always holding Wall Street accountable for misconduct, but also for the hedge fund industry as a whole, given its $1.5 trillion of assets under management.