The Consequences of Insider Trading: A Cautionary Tale
Who says that one bad apple doesn’t spoil the whole bunch? Just ask FrontPoint Partners who saw its assets under management decline with breathtaking speed—dropping by $6 billion in eight months—after one of the firm’s portfolio managers was caught in an insider trading scandal.
FrontPoint was one of the first cases prosecuted in a multiyear crackdown on insider trading by the SEC. Since that case broke, a number of other high-profile investment professionals have been swept up in the crackdown, notably Raj Rajaratnam and Drew K. Brownstein. But revisiting the FrontPoint case is illustrative for both practitioners, who risk their professional reputation (and freedom) when they flout regulations, and for their managers, who can see the entire organization take a hit when they fail to reinforce the importance of ethics among their employees.
Our cautionary tale begins in the fall of 2007, with Dr. Yves M. Benhamou. Benhamou was not only overseeing the clinical trials of a hepatitis C drug that was being developed by Human Genome Sciences (HGSI), but also was a consultant for an expert-networking firm. According to the SEC filing, in November 2007, Benhamou divulged “material nonpublic information” about the clinical trials to Joseph F. “Chip” Skowron III, a portfolio manager who oversaw healthcare funds at FrontPoint. Before HGSI publicly announced the negative news concerning its clinical trials in January 2008, Skowron sold all of the firm’s holdings of HGSI (6 million shares), thus saving his firm approximately $30 million.
On October 30, 2010, the SEC filed formal charges against Benhamou and he was arrested. Days later, when Skowron was implicated, investors began pulling their money from FrontPoint, even though neither the firm nor its executives were accused of any wrongdoing. All told, FrontPoint went from $10 billion in assets under management in 2008 to $1.5 billion by June 2011. As a result, the firm was forced to close its flagship hedge fund as well as nine other funds.
So what is the take-away from this?
- Make sure you know to whom you owe a duty: Benhamou had a fiduciary duty to keep all information connected with the clinical trial confidential and to use this information only for the benefit of HGSI. Passing on or receiving material nonpublic information is a violation of not only SEC rules but also the CFA Institute Standards of Professional Conduct: “Members and Candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.”
- Know the source and role of the information provider: As investment professionals we must consider the specificity, nature, and reliability of the information we are provided—as well as the source of the information. According to the SEC complaint against Skowron, he either knew or should have known that Benhamou was an insider who owed a duty of confidentiality to HGSI.
- Know what is considered material nonpublic information: Information is “material” if its disclosure would probably have an impact on the price of a security or if reasonable investors would want to know the information before making a decision. Information is “nonpublic” until it has been disseminated to the marketplace in general.
- Instill an ethical environment at your firm: It may take only one bad apple to spoil the bushel, but it takes more than a code of ethics to instill ethical behavior. FrontPoint was partially owned by Morgan Stanley. Both organizations had a code of conduct, an employee trading policy, and a code of ethics which prohibited insider trading.
Investors have become hypersensitive to scandal and are apt to flee at even a whiff of wrongdoing. Consequently, firm managers need to take an active role in establishing and supporting an ethical environment in the workplace, ensuring that their codes of ethics are living documents rather than just pieces of paper.