By Ronald D. Orol
WASHINGTON--A blockbuster insider-trading scheme allegedly
unearthed by regulators is putting a spotlight on a trend of
so-called "expert networks," which pass specialized information to
hedge funds.
These expert-network firms provide specialized information about
companies and industries to hedge funds, mutual funds and other
investment firms in exchange for large fees.
However, a number of managers of these firms or the consultants
they hire have become subject to insider-trading charges because
they provided confidential information to investors or traded on
it.
"I"m not saying there aren"t legitimate expert networking firms,
but they are a little bit like putting a group of teenagers
together in one room with a lot of booze " something is going to
happen," said Columbia Law School Professor John Coffee.
"The expert network says there shall be no exchange of material
non-public information, but why is the hedge fund paying $30,000 or
$40,000 to meet those people""
The SEC on Tuesday alleged that $276 million in illegal profits
or avoided losses were made by hedge funds trading ahead of
negative news in July 2008 on a clinical trial involving an
Alzheimer"s drug.
In the case, the SEC alleges that hedge fund portfolio manager
Mathew Martoma traded on confidential information about a drug
trial provided by Dr. Sidney Gilman, chairman of a
safety-monitoring committee overseeing the clinical trial and a
paid consultant to an expert networking firm.
According to the SEC complaint, Gilman met Martoma through paid
consultations arranged by the networking firm and Gilman received
more than $1,000 an hour for his advice. Martoma, portfolio manager
at CR Intrinsic Investors, is owned by S.A.C. Capital, the hedge
fund founded by Steven A. Cohen.
The SEC said the expert networking firm provided training about
federal securities laws to Gilman, reminding him not to share
non-public information with clients.
Nevertheless, the insider-trading alleged in the charges stem
from connections made through the expert networking group, a trend
in many insider trading cases brought by the SEC.
In the spring of 2009, the SEC launched an expert networks
investigation, seeking to identify more insider trading related to
these intermediary firms.
Thomas Gorman, a former SEC enforcement attorney, noted that the
SEC"s expert network investigation was launched following the
agency"s review of Primary Global Research, a expert networking
firm tied to the insider-trading case involving convicted
billionaire and Galleon Group chief Raj Rajaratnam.
"The SEC has brought a whole series of cases that really began
out of the Galleon investigation and branched into Primary Global,"
Gorman said.
Since then, in February, 2011, the SEC charged four technology
company employees who the agency said "moonlighted" as consultants
to Primary Global Research.
So far, the agency has charged 25 defendants as part of its
expert-network firm investigation, with alleged illicit profits of
about $120 million. (If Tuesday"s action were to be included,
because an expert networking firm was involved but not charged,
that number would be increased to 28 defendants and $400 million of
alleged illicit profits).
Overall SEC insider-trading cases are up, with the agency filing
58 actions in 2012 and 57 last year, according to a Nov. 14
commission report. The agency has filed 168 insider trading actions
since 2009, the most ever in a three-year period in the SEC"s
history.
Insider-trading and expert networkers
And beyond Tuesday"s charges, there are numerous other cases of
insider trading involving people consulting for or managing expert
networking firms.
In January, SEC Enforcement Director Robert Khuzami said that
"an organized network of analysts and fund traders" was involved in
charges brought against investment analyst Sandeep Goyal and two
big hedge funds.
In February, the SEC charged John Kinnucan and his Portland,
Ore.-based expert consulting firm Broadband Research Corp. with
insider trading.
Following that, in June, the SEC charged Tai Nguyen, owner of
California-based equity research firm Insight Research, with
insider trading in charges stemming from the commission"s expert
networking firm investigation.
According to the SEC, Nguyen allegedly traded on confidential
information he obtained in advance of earnings announcements by
Abaxis. He also passed the same information to Insight"s hedge fund
clients, the SEC said, "who used the inside information to make
millions of dollars in profits."
Gorman, a former SEC enforcement attorney, said the trend of
some expert networking firms crossing the line has scared hedge
funds and other investors from seeking out information from these
firms.
"What is happening now is people are reluctant to deal with
these organizations because of the potential for liability," Gorman
said. "The expert network group industry itself is taking a hard
look at how they can conduct their business because of significant
questions being raised."
-Write to Ronald D. Orol at rorol@marketwatch.com