In what has been termed the biggest insider trading ring in a generation, the SEC recently brought cases against the founder of the Galleon Group hedge fund and former directors at a Bear Stearns hedge fund. In a series of interviews, Senior Editor Melanie Rodier spoke with Larry Tabb, founder and CEO of TABB Group, and Yvonne Pytlik, managing partner, Global Compliance Risk Management Corp., about what processes and technology financial firms can use to stop insider trading. (Watch the complete video interview now.)
WS&T: Can financial firms stop insider trading?
Tabb: It is a very difficult thing to catch. [Perpetrators] are not using corporate telephones, they're not using e-mail. They're working with a surreptitious group of folks to do things they know they're not supposed to do.
The issue really is trying to understand who is involved in [corporate] actions, especially on the M&A side and the banking side, and to try to keep them cordoned off [from trading professionals] as much as possible. But the challenge is trying to understand the trading activities and the names you're focused on on the corporate side and surveilling them.
As well as ensuring the folks on the banking team are cordoned off and isolated from trading folks, you have to make sure you've got strong agreements with all of your vendors, that everyone knows that everything is sensitive information. And it's also about following traditional compliance policies. The problem with catching some of this stuff is that people know they're doing something wrong, and they do go pretty far to hide it.
Pytlik: The recent cases of insider trading and other compliance violations have had a tremendous impact on the industry. A serious compliance violation impacts investors and shareholders and is self-destructive to companies themselves. No one is immune to those trends. Banks and hedge funds and asset managers have to take much more proactive actions to address those issues.
There are [several] areas where they can address this issue: First, having a single view across the organization and truly identifying in a systematic and methodological way the highest risk across the organization. One of these [risks] is insider trading. It should be on the agenda on boards and senior management and executive committees. And companies should be looking at their own environments and understanding how insider trading can be prevented, how they monitor and identify those cases, and finally, the escalation process and remediation. From that perspective, [firms need] strong methodologies and standards.
The second area to be evaluated in light of insider trading is companies' compliance programs across the organization. What types of policies are in place to address insider trading? What kinds of procedures and infrastructure are in place on the business side, and what supervision is there to effectively identify insider trading?
WS&T: Is the line between information and insider information different at hedge funds, such as Galleon Group, which are known for their secrecy, and other financial firms?
Tabb: No, there's no difference. Insider trading is insider trading. The issue has more to do with compliance. Do they take it seriously? Does the organization have pressure from the top to gather that type of information and take advantage of it? Compliance starts at the top. If there's significant pressure at the top to find and take advantage of inappropriate information, no matter how many compliance people are in the organization, you're going to have a problem.
WS&T: There's been a lot of talk in the Galleon case about Raj Rajaratnam, founder of Galleon Group, and others using expert networks to get inside information. What are these networks, and how do they work?
Tabb: Expert networks are an issue for a lot of firms. They are a group of unlinked individuals who have information on certain aspects of a company or business, industry, or economy. I'm a member of the GLG [Gerson Lehrman Group] expert network. People call me about different things. There are all sorts of reminders the firm gives about what [its experts] can talk about. I'm not allowed to provide sensitive information. There are all sorts of warnings on the GLG site.
What a hedge fund asks me is up to the hedge fund, and it's up to me to stay within the guidelines of what I can say and can't say. For a hedge fund, it's an invaluable tool. There's no mechanism to record a conversation. As an industry analyst, I have access to some sensitive information -- but not much. But if I'm a programmer at Microsoft and someone is asking me about the next Windows release, there's probably a bunch of stuff I can't say. Expert networks have come to strength in the last eight to 10 years. They're a function of the social media business model, channeling requests to the right set of people who have information that funds are looking for.
WS&T: Has the number of insider trading cases risen recently because of the economic downturn?
Tabb: Insider trading has always gone on. The ability to spot it and capture it has gotten better with the ability to analyze more data. The SEC is under tremendous pressure because of its failure with [Bernard] Madoff. So it's very important for them to get a couple of wings in their hat -- to make a high-profile arrest and prove they're on the case. We'll be seeing more fines and more criminal proceedings as the SEC tries to reestablish its reputation.
WS&T: How can technology help stop insider trading?
Pytlik: Technology is very critical, especially right now as regulations and the complexity of the business are increasing. IT is the tool that will help identify a number of violations. Insider trading is probably one of the most complex areas to identify and detect. There are bigger companies that offer tools, such as Actimize and [Oracle] Mantas. And there are also more boutique firms [that offer solutions]. But we have to remember that information technology needs to be much more sophisticated. Companies need to do real-time monitoring and really focus on preventive controls as a first measure. They [also need to] monitor on the back end and identify compliance violations.
Tabb: Generally it's going to be surveillance-type tools [for] monitoring the names you're working with and [checking] for abnormal activity that's going on -- especially on the options side if it's a specific company -- and monitoring e-mail and all types of communications. It's a very hard thing to catch.