New York, NY – Many market observers have blamed former SAC portfolio manager Matthew Martoma and his source former University of Michigan neurologist Dr. Sid Gilman for leaking and purportedly trading on inside information regarding drug maker Elan and Wyeth. However, some have also suggested that expert networks, the firms that put Martoma and Gilman together for a fee, are also to blame for this illicit activity. Today’s blog will discuss the roles that the various players may have contributed to this breaking case.
Background of the Case
The government’s indictment alleges that SAC reaped a huge windfall by trading on confidential, nonpublic information about the results of an Alzheimer’s drug trial.
In mid-July 2008, Matthew Martoma, a portfolio manager with CR Intrinsic, a division of hedge fund SAC Capital, allegedly received non-public information from University of Michigan Neurologist Sidney Gilman showing that bapineuzumab failed to halt progression of Alzheimer’s in patients in the clinical test. Gilman, one of the doctors who oversaw the clinical trial, is now cooperating with the government. Martoma then instructed SAC’s senior trader to begin selling Elan, “and do so in a way so as not to alert anyone else.”
Based on the information, the government says SAC quickly sold huge positions it had amassed in two companies, Elan and Wyeth, which were developing the drug – and then shorted the stocks of these two companies’ betting that their share price would go down. These actions allegedly enabled SAC to book “over $276 million in illegal profits or avoided losses” ahead of the negative public announcement of the drug’s clinical trials.
The Role of Expert Networks
According to the government’s indictment, Martoma was introduced to Dr. Gilman, and ongoing conversations were facilitated by an unnamed expert network. Subsequent news aticles have named Gerson Lehrman Group as that network.
“Between 2006 and 2009, Gilman earned nearly $108,000 from fifty-nine consultations with portfolio managers and analysts at CR Intrinsic and Investment Adviser A, including forty-two consultations just with Martoma. Over time, Gilman developed a personal relationship with Martoma, eventually coming to view Martoma as a friend and pupil.”
It appears from the indictment that Gerson Lehrman provided Dr. Gilman training on what he should or should not speak about in his consultations with clients, including the drug “bapi”.
“Gilman also received training on the prohibitions of the federal securities laws from the expert network firm, which repeatedly reminded Gilman not to share nonpublic information with clients. Emails sent to Gilman by the expert network firm also listed bapi as a topic that Gilman was ‘not allowed to discuss.’”
In addition, Gilman and Martoma attempted to hide the true nature of their conversations from GLG, by lying about the topics they planned to discuss.
“Martoma and Gilman also took steps to conceal the true topic of their conversations from the expert network firm. For example, when Martoma scheduled a consultation with Gilman three hours after the March 18, 2008 SMC meeting, Martoma reported to the expert network firm that the purpose of the call was “Follow-up with Dr. Gilman: AAN Abstract Preview” even though Martoma and Gilman had discussed the Phase II Trial during the consultation. Later, in advance of a consultation that Gilman’s personal calendar noted was to discuss side-effects that the Phase II Trial was finding in patients taking bapi, Gilman emailed Martoma and asked him to set up· a consultation with the expert network firm, suggesting that Martoma tell the expert network firm that the consultation was to discuss a drug to treat Parkinson’s disease.”
Why are Expert Networks at Fault?
Despite these facts, some would have you believe that GLG (and more broadly the expert network industry) was partially at fault for the alleged criminal activity between Martoma and Gilman. They argue that:
- Expert networks like GLG make it easy for hedge funds like SAC to find experts who have valuable nuggets of information like Dr. Gilman had.
- The various rules and restrictions that expert networks put in place are easy to circumvent by clients like Martoma who want to obtain confidential information or MNPI.
- Expert networks create a corrupting financial incentive for experts like Dr. Gilman to provide clients with illicit information.
We don’t agree with most of these arguments. Certainly, expert networks streamline the process of finding, managing, and paying for valuable experts. However, today with LinkedIn, Facebook, Monster.com, and numerous trade association websites, an investor like SAC or Matthew Martoma can easily find any expert they want. It is unclear to us that you need an expert network to easily find experts with valuable information today. In fact, a small group of hedge funds have built their own proprietary networks of experts in an effort to keep their views relatively confidential.
The second argument is that expert network’s rules are easy to circumvent if you want illicit information. Clearly, these rules are meant to establish the boundaries of acceptable and legal behavior. They were never created (in fact no rules were ever created) to keep criminal behavior from taking place. This is not too dissimilar from the legal systems in most western nations. Our laws do not stop criminal behavior. Instead, they make it clear where the boundary between acceptable and criminal behavior lies.
Of course, some argue that the expert networks should make it more difficult for experts to share MNPI with clients. Perhaps this could be by monitoring or recording calls between clients and experts. What is interesting is that many expert networks, including GLG, offer clients the ability to record calls between their employees and experts they speak with. Unfortunately, only a small percentage of hedge fund clients take advantage of this feature.
The third argument, and perhaps the hardest issue to address, is the fact that expert networks establish a financial incentive for experts to provide clients with inappropriate information. Certainly, the $108,000 that Dr. Sid Gilman earned over three years for 59 consultations with CR Intrinsic employees via GLG seems to be high. However, we fundamentally believe that every person’s time and knowledge has value and we all should be free to sell those assets that we have spent a lifetime building in the free market, unless doing so infringes on the rights of others (like our employers or other clients we may have). This is the basis of the free-market system.
Others Who Share Responsibility
So, who do we think should share the responsibility of alleged insider trading cases like the Martoma/Gilman case? We think there are four players who we need to consider. These include:
The direct participants: Clearly, if the government can prove its case, no one is more culpable than Martoma who allegedly sought out and traded on the MNPI in question. It is also difficult to comprehend why a successful 80 year old neurologist like Dr. Sid Gilman would want to risk everything he had built up over a lifetime to proactively collect and provide MNPI about bapi to Martoma. However, it looks like did just that.
The Expert Network: As we have discussed above, it looks like GLG did everything it believed it should have done to insure that the participants played by the rules. However, this calls into question whether other expert networks have the right compliance infrastructure in place to protect clients from receiving MNPI. In addition, clients (and the expert networks themselves) need to ask themselves whether there is more that the expert network industry can or should do in the future to limit the possibility of another Martoma / Gilman case from taking place.
The expert’s employers: Typically no one discusses the responsibility that the expert’s employers have in a case like this. While we don’t know what the University of Michigan did to prohibit employees from moonlighting, we do know that Elan stipulated that the information he received as a consultant for the firm was confidential. We are consistently surprised how few public companies contractually prohibit moonlighting from employees, and even fewer communicate these policies to the expert networks. In addition, very few firms provide training to their staff (except for senior executives) about their duties of confidentiality to their employers. Clearly, employers have a responsibility to minimizing insider trading through establishing clear policies and training their staff about their obligations under these policies.
The asset managers: Another important issue which must be addressed is whether the asset manager fulfilled its duties to develop and implement compliance policies to prohibit insider trading within the firm, and whether it appropriately supervised its employees to live by these policies. It is possible that the recent Wells notice issued to SAC is an attempt by the SEC to make a case that SAC (and Steve Cohen as the control person) did not effectively supervise Martoma in this case. Asset managers need to ask themselves whether they have appropriate policies and procedures to manage their use of expert networks, and whether they need to implement additional controls (like monitoring or recording) to their suite of controls. In addition, asset managers need to decide whether they know enough about the basic controls that the expert networks they use have in place so they can supplement these with their own.
Even though we don’t believe that GLG should be blamed for what allegedly took place in the Martoma / Gilman insider trading case, it is clear that expert networks are one of the four parties who do have a responsibility to mitigate potential insider trading, including the participants (experts and users), the expert networks, the expert’s employers, and the user’s employers.
Employers need to ask themselves if they are doing enough to protect their confidential and proprietary information, including establishing policies against moonlighting, communicating these policies to the expert networks, and training their employees about how and what they should communicate with outsiders.
Asset managers also need to determine whether they are using “safe” providers that have adopted best practices as it pertains to compliance, as well as whether they have sufficient compliance policies in place to complement their expert networks’ controls.
Finally, we believe that expert networks need to investigate their own policies to determine whether they are doing enough to protect their clients, or whether there are additional controls they should put in place to restrict the communication of possible MNPI to their clients.