Practical analysis for investment professionals
10 February 2012

Ethics Roundup

Unfortunately, stories of unethical behavior by both individuals and financial institutions continue to dominate the business news headlines. Although financial institutions are not “people” in the eyes of the law, they have been charged and fined when it has been difficult for authorities to assign (or even identify) individual responsibility.

Insider trading and the integrity of asset managers’ performance reports have been major themes over the past few months. Here are the key ethics-related stories you might have missed:

  • From New York to London, securities regulators are continuing their proactive and aggressive prosecution of insider trading. The U.S. government’s “get tough stance” has produced a number of high profile cases, in particular, and U.S. judicial authorities are now considering whether to increase the penalties, according to the Dealbook blog on the New York Times site.
  • Successful prosecution of insider trading requires direct evidence that an individual knowingly acted on material nonpublic information, which often poses a difficult task, as Peter J. Henning illustrated in a recent Dealbook post. To obtain this direct evidence, the government has been successful in convincing some of the those individuals involved to “cooperate” with investigators in the hopes of receiving a lighter sentence. The Wall Street Journal recently published an informative article profiling David Makol, an FBI agent who has been successful in “flipping” these individuals.
  • On 11 January, former hedge fund manager Drew K. Brownstein was sentenced to a year and a day in prison after pleading guilty to insider trading charges. In a teachable moment for all investment professionals, Brownstein stated in court: “In a flash, my horrendous judgment has taken everything from me.”
  • On 18 January, with the cooperation of some of the individuals involved, the government charged seven people with using insider information (i.e., material nonpublic information) to trade shares of Dell Corporation.
  • Britain’s Financial Services Authority has fined David Einhorn of Greenlight Capital for selling shares in Punch Taverns after learning that the company was planning to issue additional shares of stock. The case highlights the fact that the Britain has a broader definition of insider trading than the United States. In a related article on Greenlight Capital’s troubles, the Financial Times noted that UK law requires the filing of a “suspicious transaction report” if firms are involved in transactions that appears to be “unusually lucky in its timing.”
  • Now that 2011 has ended, investment firms are reporting annual performance numbers. To ensure that the figures are accurate, the SEC has launched a new initiative, called the Aberrational Performance Inquiry, to combat fraud in the hedge fund space. The SEC is targeting hedge funds because, unlike mutual funds, they are neither required to register under the Investment Company Act nor are their securities registered under U.S. securities law. As a result, hedge funds are not subject to detailed disclosure requirements — and therefore face far less scrutiny.
  • Under the new SEC initiative, the regulator’s Asset Management unit will use proprietary risk analytics to evaluate hedge fund returns, according to the Securities Technology Monitor.
  • A related article in the Wall Street Journal discusses a study that shows that stock valuations reported by hedge funds in SEC filings sometimes differ from actual valuations based on the closing prices at the end of the quarter. In fact, as it turns out, there are a number of academic studies providing evidence that some hedge funds are “smoothing” returns or manipulating security prices, so they can generate higher returns in December and report disproportionally more small positive returns than small negative returns.

For more news and trends, visit the Standards, Ethics, and Regulations Community of Practice.

About the Author(s)
Michael McMillan, CFA

Michael McMillan, CFA, is director of ethics education at CFA Institute, where he is responsible for creating, sourcing, and developing educational content for CFA Institute members and investment professionals in the area of ethics and professional standards. Previously, he was a professor of accounting and finance at Johns Hopkins University’s Carey School of Business and George Washington University’s School of Business. Prior to his career in academia, McMillan was a securities analyst and portfolio manager at Bailard, Biehl, and Kaiser and at Merus Capital Management. He is a certified public accountant (CPA) and a chartered investment counselor (CIC). McMillan holds a BA from the University of Pennsylvania, an MBA from Stanford University, and a PhD in accounting and finance from George Washington University. Topical Expertise: Financial Statement Analysis · Standards, Ethics, and Regulations (SER)

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