Wednesday, April 27, 2011

A New Twist on Insider Trading: Expert Network Consultant Firms

A little over a week ago, Reuters broke a news story about Joseph "Chip Skowron's arrest on criminal securities fraud and conspiracy charges. Skowron is an Ivy League-educated doctor who left a Harvard University residency program to become a stock picker on Wall Street. Skowron worked for several prominent hedge funds, before he became the manager of FrontPoint Partners' healthcare funds. FrontPoint is a spinoff from Morgan Stanley.

Skowron violated trading restrictions imposed by FrontPoint, in attempting to avoid a loss from adverse hepatitis drug trials conducted at Human Genome Sciences, Inc., a company Skowron's hedge fund invested in. According to the U.S. Attorney's allegations, FrontPoint avoided $30 million in losses by selling their Human Genome holdings prior to Human Genome's public announcement of problems with its hepititis C drug treatment on January 23, 2008. FrontPoint Partners has not been accused of any wrongdoing, but agreed to pay to a $33 million settlement to the Securities and Exchange Commission (SEC), without any admission of guilt.

Where did Skowron's insider tips come from? FrontPoint paid $900,000 to a firm named Guidepoint Global to gain access to that company's network experts or consultants. Guidepoint Global is in the business of matching hedge funds with industry analysts. In this case, Dr. Yves Benhamou, a 51 year old Parisian infectious disease expert, a consultant to both a biotech firm and the expert networking firm (Guidepoint Global), was paired with Skowron and FrontPoint. According to prosecutor's allegations, Skowron, in violation of FrontPoint ethics rules, cut a side deal with Dr. Benhamou beginning in 2007. Dr. Benhamou, the network expert, allegedly provided insider trading tips to Skowron about Human Genome Sciences, Inc.

The facts and allegations brought forward by the SEC read like an international spy novel. to seal their secret arrangment Skowron met Dr. benhamou at a hotel in Barcelona in April 2007 and gave him an evelope with over $7,000 in cash. A few months later, Skowron paid for a lavish stay at a New York hotel for Dr. Benhamou and his wife. Finally, after getting tipped off about Human Genome, Skowron and Dr. Benhamou met in a Milan hotel bar, where Skowron passed an evelope filled with at least $10,000 in cash to Dr. Benhamou in April 2008. Dr. Benhamou has since pled guilty to securities fraud charges, conspiracy charges, and for making false statements to FBI agents. Dr. Benhamou is cooperating with federal investigators and prosecuters according to the terms of his plea agreement.

The lesson learned is that we need to watch the relationships between hedge funds and expert network firms and consultants. Let me be clear--not all of these relationships are inherently wrong nor evil, nor merit oversight and scrutiny. Some bad apples are spoiling the cart. Not all expert networks are bad, most provide legitimate information to hedge fund managers in areas outside the manager's expertise. However, it is clear that the SEC and federal investigators are paying more attention to relationships between hedge funds and expert network firms, and their temptation to engage in insider trading. "Prosecuters say expert network relationships are not inherently wrong but that some consultants have crossed the line by taking fees to leak corporate secrets to hedge fund traders and analysts."

Undoubtedly, expert networks are creating new regulatory challenges for the SEC. The jury is somewhat out on how these organizations will be treated or regulated. In the coming months and years the SEC's approach to expert networks will be interesting to watch. I will try to keep you posted.


  1. Samantha B.- UC

    What is most interesting to me in this case is that Skowron did not trade on his own holdings, but those of FrontPoint. Where did the money he used to pay Benhamou come from? Did Skowron really do this on his own dime or was he using corporate funds? I realize there are multiple reasons that FrontPoint would strike a settlement with the SEC even when they haven't been charged (to clear their name, to make it go away, to handle the situation quietly), but it does strike me that there may be more to the story. At least with the settlement, they got rid of their profit and more, though I wouldn't be surprised it private suits arose later against them or Skowron. Whether the company had a role or not, it is clear that what Skowron did was inappropriate and a fraud. I am not sure how I feel about the relationship between hedge funds and expert network relationships. It can be a slippery slope for those involved, especially when there is a temptation for side deals as we saw in this case.

  2. What strikes me the most about insider trading is the millions that companies spend to avoid losing money, which sounds like a contradiction in itself. Here, the company paid $900,0000 to gain inside information and later paid $33 million to the SEC to settle the charges. Even worse, the heart of the issue is the marketability of a drug to treat hepatitis C, which is a dangerous disease in need of manageable treatment. With another avenue in which companies can gain inside information in these network experts, the bad apples can outskirt the SEC with these on-the-side deals by paying the price. On the other hand, those affected by FrontPoint's attempt to avoid a loss in share value may pay the price with their health and not their wallet.

  3. I do not believe that these expert networks are creating any "new" problems for the SEC other than those already posed by traditional tipper/tippees. The expert networks simply make it easier for investors to be in contact with potential insiders.

    The fact that expert networks are generally legitimate businesses should make it easier for the SEC to regulate the activities of the businesses, and certainly makes it easier for the SEC to discover information leading to potential securities fraud. Since the expert networks will keep track of their employees and the relationships those employees maintain with investors, the SEC can easily scrutinize those relationships.

    For example, if the SEC notices an investor conducting a large amount of trading before a public announcement, the SEC would have the option of investigating relationships that the investor has with expert networks. The business records of both the investor and expert network will lead the SEC to individuals that may have provided tips to the investors. While these relationships provide investors with more opportunity for contact with insiders, they also expose those insiders to more risk because of the paper trail that can connect the investor to the insider, and insider trading is based largely on cost-risk benefit. The SEC does need to scrutinize expert networks more closely, but the problems arising from those networks dont present new difficulties for the SEC.

    Patrick B. UC

  4. I would be very curious to hear how these expert networks arose. I have to agree with Samantha B. that it appears the expert network relationship could become a very slippery slope into insider trading. Surely there are regulations regarding what information expert networks can provide. If not, perhaps the SEC needs to regulate that aspect more closely.

    I too will be very interested to see any potential fallout between FrontPoint and its shareholders. If I were a shareholder of the company I would certainly be alarmed at the $33 million settlement. I in fact would likely want to bring suit for a breach of fiduciary duty.

  5. I do not agree that these expert networks are creating "new" problems for the SEC. I think the fact that many of the expert networks have legitimate business relationships with investors will make it easier for the SEC to regulate these relationships.

    For example, if the SEC notices an investor trading heavily prior to a company's public announcement the SEC will be able to use the business records of both the investor and expert network to determine who the investor had communicated with. Because of this transparency, the SEC will be able to target potential suspects.

    While I do believe that these expert networks do need to be watched closely by the SEC, I do not think they present new problems outside of the traditional tipper/tippee securities fraud.

    Patrick B. UC

  6. A part of me thinks we need a SOX for hedge funds. But I don't know that it is warranted at this point. There has to be some kind of oversight of these kinds of transactions, though.

    Josh L. - UC

  7. I think that more and more people will be tempted to turn to actions like these, skirting the rules in order to realize higher yields. There is no less pressure on hedge funds today to turn a profit than there was five years ago, but now they are operating in a much more difficult market.

    Matt W. / UC

  8. The purpose behind these expert networks seems legitimate enough. They were created to help CEO's better understand complex issues outside of their comfort zone. As this case illustrates however, these relationships are only a hair's width away from becoming nefarious. Because of this very real danger, perhaps it would be appropriate to require exquisite records be kept for those engaged in similar relationships. As here, I presume this instance was in part uncovered because travel plans/itineraries matched up. This should not be too burdensome, as many corporate officers are encouraged to keep meticuluous records in any event for reimbursal from their corporation. This would allow the investigating agency to be one step closer to uncovering any impropriety if suspicious activity is detected in the run up to major corporate announcements.

    Don H. - UC

  9. Is the SEC saying that these experts breached a fiduciary duty to the source of their information and that Skowron breached his own fiduciary duty to FrontPoint? Is this any way different than tipper/tippee liability established under Dirks v. SEC? What if these experts were not affiliated with a specific organization and thus owed no fiduciary duty? To what extent will the SEC go to protect against these experts sharing information in the future? This article said that, “Expert-network firms are a key focus of a three-year probe that people familiar with the matter say could prove as jarring to the financial industry as any past insider-trading investigation.” Sounds like the SEC has been and will continue to watch these situations very closely. Should be an interesting thing to keep an eye on going forward.

    John-Mark Atkinson