An investment expert witness advises on a case involving a capital market investment firm who allegedly acted on inside information. The Securities and Exchange Commission (SEC) alleges that prior to an announcement of a merger agreement between two companies, one defendant directed the purchase of 287,500 shares of one of the companies, based on a tip that he had received from one of the research analysts he employed at his hedge fund management company. The SEC alleges that employee, located in North Dakota, who is also a defendant, tipped his boss after receiving a tip from a loan underwriter.
The defendants deny the allegations. They claim their owner and hedge fund company closely followed the merging company for more than 10 years. They say that the decision to purchase more shares was based on his knowledge of the company and the fundamental research conducted by his firm, and was not based on any tip.
Question(s) For Expert Witness
- 1. What is involved in following a small-cap company such as the one at issue in this case?
- 2. Did the defendants’ research materials substantiate their defense?
Expert Witness Response
It is my opinion that there is a reasonable basis to conclude that the hedge fund company defendant conducted exhaustive research into the merging company over an extended period of time. The research of the company is consistent with its approach as a small-cap value investor. That research process led the hedge fund company to conclude that the merging company had attractive long-term prospects and was considerably undervalued at the time of each of the defendants’ investments.
The hedge fund company’s research on the merging company contains almost 200 individual items amounting to approximately 1,000 pages compiled over a 14-year period. It consists of brokerage reports, press releases, company presentations to investors, various company filings, internal memos, handwritten notes from selected conversations, and a variety of other documents. The merging company’s CEO testified that he had spoken with the hedge fund owner 20 or more times.
In my experience this volume of research reflects exhaustive coverage for the size of the merging company. The quantity of research reflects the hedge fund’s mindset of a long-term oriented investor, willing to buy out-of-favor and potentially under-valued stocks and hold them over time so as to reap above-average gains for the investors in the funds. The CEO testified that the defendant was focused on the strategy of the company and where it was going. Further, the hedge fund owner was a big supporter of the merging company and had faith in it and its management. The hedge fund bought stock on many occasions throughout the CEO’s tenure.
In contrast to the long-term oriented investor who bases investment decisions on fundamentals, a trader would look for a quick hit without doing extensive research, disregard capital gains preferential tax rates, and move on to the next case. He might base his decision on a news item, a technical pattern on a chart, earnings surprise, brokerage recommendation, or some other market perception. This was not typical of the hedge fund’s investment style.
The expert is the president of an investment advisor and litigation consulting firm with more than 30 years in the investment management industry with major banks, trust companies, investment advisors, and a broker dealer.