Too early for post-traumatic “insider” stress?


New York – The Galleon case continues to advance, today with testimony from ex-Galleon portfolio manager Adam Smith.  Adam Smith has pled guilty of providing Mr. Rajaratnam insider information over a 6 year timeframe. Mr. Smith indicated that he had formed a relationship with an Intersil executive which eventually produced a number of insider tips that Mr. Smith shared with Mr. Rajaratnam. So far the evidence against Mr. Rajaratnam has been pretty convincing, since many of the witnesses had pled guilty prior to the start of the trial.

Whenever there is an action, there are always the intended results and the unintended results. We know that the intended results revolve around the prosecution of Raj Rajaratnam and insider trading. The unintended collateral damage of the investigation seems to have been the alternative research providers. We have heard anecdotally that the buy-side appetite for alternative research, which was picking up in the third quarter of last year, ground to a standstill in the fourth quarter and was stagnant for much of Q1 2011.

So far, the defense seems to be hinged on whether the information exchanged was insider information based on its interpretation of the legal definition. They seem to be implying that material non-public information is not insider information unless it is traded on and those trades resulted in profit. They may feel that it will be difficult for the prosecution to identify trading activity. If one believes the defenses interpretation of the rules, the prosecution would have to show that the receipt of information preceded the trading tickets and that positions were taken after the non-material information was received and before the information was a matter of public record.

Outside of the courtroom, investors, having been tentative to use third party research for the last several months, are slowly beginning to warm to the use of these services. Initially, it appeared that the insider case painted the entire alternative research process with the broad brush of suspicion. Over the holiday season in particular, there was little active use of new primary research services in particular and/or third party research in general.

Over the past few weeks, though, the regulatory officials have weighed in on the support of the mosaic theory and have affirmed that expert networks as a business model are not being targeted. It is only the transfer of insider information that is problematic.

Until today, it seemed that the major investigations into insider trading might be limited to the Galleon case.  However, news that an FDA chemist and his son have been involved in insider trading to the tune of $3.6 million in illegal profits indicates that the investigations continue to be a priority. Both father and son face criminal conspiracy and fraud charges.

At least for the galleon case, the verdict will be specifically about the guilt or innocence of Mr. Rajaratnam and not a further indictment against third party research.

Yet, despite the apparent exoneration of alternative research, investors will demand a higher standard of compliance in the research space going forward. Those research providers that have explicit and demonstrable compliance policies and practices, will be better placed to capitalize on the post-traumatic insider stress caused by the Galleon case in the future.



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