PE Prompts Insider Trading

The top news item on yesterday’s PE Week Wire was that federal regulators had charged several unnamed individuals with insider trading related to the $45 billion buyout offer for energy company TXU. Specifically, it alleged that the culprits stood to gain $5.3 million after having used inside knowledge to trade TXU stock options just days before the deal was publicly announced.

Why are the defendants unnamed? Because they purchased the options via foreign brokerages, so it’s taking the SEC a bit of time to work through the diplomatic paperwork – but they are expected to be identified shortly. They also might identify themselves – per a court order – but I might consider shorting that option.

Anyway, a number of you took offense at this story being yesterday’s top item, because “it is inconceivable that the illegal trades were made by private equity professionals at [TXU bidders] KKR, TPG or Goldman Sachs.” The general explanation here is that such folks get paid way too much to risk it all on a few million dollars (i.e., lunch money at Goldman Sachs). This ignores the unfortunate reality that smart people do dumb things – particularly when greed is at work – but I certainly agree that the web of potential bad actors should be expanded to include: Bankers, attorneys, accountants, private equiteers at other firms, financial printers, environmental group staffers and assorted lackeys at all of the above. We’ll know soon enough.

In the meantime, there are two reasons I put this story up top. First, belated kudos to the SEC for finally filing charges related to unusual options trading in advance of an LBO announcement. Such volatility has become commonplace, and commonsense dictates that some of this must be promoted by inside information. In other words, this particular situation is not an anomaly because there was insider trading – it’s an anomaly because the traders got caught.

Second, and more importantly, it should serve as a wakeup call to private equity firms that they must dust off – and perhaps strengthen — their internal controls. Again, I have no idea if any of the defendants work for PE firms, but there also is no credible reason to assume they don’t.

I spoke yesterday with a variety of PE attorneys and firm CFO/CAO types, and learned that there are not standard industry controls to protect against insider trading by employees. The largest firms are likely registered investment advisors, which means they are legally required to follow formal SEC procedures – but most firms can bypass such restrictions if they have fewer than 15 funds under management. Some firms nonetheless follow the stringent regs, but far more seem to play such scenarios by ear. Sure they all have official policies, but more than one PE pro I spoke with yesterday admitted that he/she was unaware as to how their firm guards against insider trading.

This might have been (sorta) acceptable a few years back when most buyouts were of private companies, but no longer. Attorneys recommend that firm compliance officers (usually the CFO or controller) dust off the old regs and consult counsel as to whether or not they should be updated. Then, there should be training sessions with all firm employees – but just investment pros. Both partners and their EAs need to be reminded that casual shoptalk outside the shop can lead to dire consequences. One attorney also recommended that individual equity portfolios should be made transparent to firm compliance officers, in order to help prevent malfeasance. He admitted that it would be an administrative nightmare, but that not doing do could be far worse…