SAC Insider Trading Case Highlights Role of Compliance Technology

Terry Flanagan

Insider trading, which is currently in the headlines due to the fallout from hedge fund SAC Capital—and which U.S. authorities say is the largest case of insider trading yet—has become easier to detect, and therefore more difficult to perpetrate, thanks to detection systems that scour e-mails, instant messages and other forms of communication for potential red flags.

“There’s a lifecycle to insider trading, and systems can be used to connect the dots at various stages of the lifecycle,” said John Edge, managing director of compliance solutions at Nice Actimize, a provider of compliance and anti-fraud software.

Historically, insider trading detection has focused on isolating abnormal-sized trades taking place before some random news event, such as an earnings release.

To take a hypothetical situation, Mr. Smith, a trader, gets a phone call from Mr. Jones, a hedge fund manager, on Tuesday, telling him that Retailer A are going to announce blowout Black Friday numbers, which is clearly non-public information.

On Wednesday morning, Smith buys a large block of Retailer A and at noon Retailer A’s stock goes up 8% as a result of the announcement. Unbeknownst to Smith, however, the compliance department has been monitoring the news and has been alerted about Smith’s buy prior to the announcement.

“Miss Wright from the compliance office confronts Smith, who denies that he had been tipped off prior to the announcement,” said Edge. “The compliance department proceeds to search all communications involving Smith, and discovers an instant message had been received from Smith by Jones regarding the stock.”

Federal investigators continue to tighten ranks around hedge fund manager Steven Cohen, the founder of SAC Capital—the latest move coming when authorities arrested one of Cohen’s former portfolio managers, Matthew Martoma, in what the U.S. Attorney for New York called “the most lucrative insider trading scheme ever charged”.

Martoma is accused of tipping off associates at SAC Capital about poor clinical trial results of an experimental Alzheimer’s drug jointly developed by Wyeth and Elan. Martoma’s alleged use of material inside information is reported to have netted an SAC subsidiary more than $276 million in illegal profits.

The SAC case illustrates concerns over insider trading among some hedge funds.

“Since the passage of Dodd-Frank [the 2010 Wall Street financial services reform Act], you have more than 1,000 newly registered funds acting as investment advisers,” said Marc Powers, head of the securities litigation and enforcement practice at law firm BakerHostetler.

“Advisers are required to have proper policies and procedures in place to prevent misuse of material non-public information. Failure to have this in place exposes hedge funds to separate charges that can bring substantial penalties and create steep reputational damage among institutional investors.”

More advanced fraud detection systems utilize sentiment analysis, also known as opinion mining, in order to identify and extract subjective information in source materials through natural language processing, computational linguistics and text analytics.

“We use sentiment analysis to power our insider trading algorithm,” said Edge of Nice Actimize. “We get a machine-based data feed of news containing information related to buy and sell recommendations, and cross-reference that with historical trading patterns.”

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