For the past month, I have been telling anyone who is unfortunate enough to sit next to me on a plane that the Galleon investigation will reshape how regulators manage stock markets around the world. Then last week a fellow traveller told me something that made me believe that I am not alone in believing that this insider trading investigation will be a watershed for equity markets.
According to my fellow traveller, Indian regulatory authorities are considering introducing to India the equivalent of what’s called in the US “Reg FD”, a regulation which says that corporates cannot reveal anything to analysts and investors which is not in the public domain.
To understand why Galleon is so special, a bit of context is useful. Conventional insider trading investigations are hard work for regulators and focus on prosecuting employees working inside a corporate or an investment bank who use their privileged position to access sensitive financial information (with regards to earnings, corporate M&A, key Directors’ entry/exit, etc.) and then take trading positions based on this financial information. Such investigations, when successful, result in the errant employee being fined (with the fine being equivalent to the profits made from trading on inside information) and sent to jail (as insider trading is deemed to be a criminal offence).
There are three things that make the Galleon investigation unique and make it likely that it will influence the way stock markets are regulated. (For those who want a detailed account of the investigation so far, a visit to the Financial Times’ or Wall Street Journal’s websites could be worthwhile).
Firstly, much of the data in this investigation has been collected using wire taps. This is a major regulatory first because while the law in most countries does not prohibit regulators from using wire taps, it does say that evidence collected from such taps cannot be used in the court unless the person incriminated has given his permission for such taps. The New York prosecutor seems to have found a way around this legal Catch-22.
Second, while prosecutions regarding insider trading have been successful in the US and elsewhere, what regulators have found is that it is much, much harder to build a coherent case against the broader offence of “market abuse” (which includes but is not restricted to insider trading). If successful, Galleon could be the first high profile prosecution of market abuse.
Third, this investigation offers regulators and newspaper readers around the world a window into the operations of large hedge funds. In particular, the hedge funds at the centre of this investigation are alleged to have built up networks of contacts not just in board rooms of the companies whose stocks they traded in but also more widely in the tech industry.
My understanding is that this is common practice in the world of big ticket investment management in the US and elsewhere (including in India). So, many CIOs of large investment management firms encourage their fund managers and analysts to be on first name terms with not only the CEOs in whose stock they have put money but also with leading management consultants and investment bankers, ex-Board Directors in industry leading companies, politicians, regulators, etc. Indeed this practice is so common that in the US there are now a number of firms earning hundreds of millions of dollars of revenue selling “expert networks” i.e. directories of experts who can give you market leading insights on pretty much every listed stock.
Now, assume I know a leading IT consultant and assume that he and I went to school together. Assume further that my friend is a revered industry figure with the ear of the CEOs of India’s top IT companies. So when I have lunch with my friend, will I just discuss cricket, politics and the weather or will our conversation venture into the domain of sensitive information on listed companies? While I leave it to your imagination to decide what we will discuss over lunch, a glance at the packed lunch rooms of Mumbai hotels suggests such lunches are common place in business circles in India.
By highlighting to regulators around the world, how much “alpha” can be squeezed out of industry networks, Galleon could change the way our industry functions. Lunches could become more boring and the conversation in cocktail parties could remain largely focused on political and cricketing gossip. That’s if (and it is a big “if”) our regulator actually goes ahead and launches Reg FD in India and follows that up with some stringent enforcement.