New York, NY – Last November, buy-side analysts were shocked as the growing insider trading investigation seemed to call into question their use of expert networks and channel checks. In recent months, SEC officials have tried to clarify that they are not trying to eliminate these types of legitimate research. Instead, they are trying to eliminate the collection and profiting from clearly illegal insider information. Today’s blog discusses the issues surrounding the appropriate use of channel checks.
Background on Channel Checking
Traditionally, channel checks are the practice of conducting research on a company’s business by collecting information from a variety of sources in the supply chain or distribution channels of a company. Channel checks can provide analysts with insights on topics such as distributor and retailer attitudes towards a product and its competitors, inventory levels, the success of marketing initiatives, pricing trends, local sales trends, and so on.
Many analysts at sell-side investment banks, hedge funds or mutual funds, and independent research providers conduct channel checks as an input to their investment research process as this type of research provides an insight which is impossible to get from purely public information such as financial statements, management presentations, or other regular industry releases. Typically, analysts either conduct channel checks themselves (using their own rolodex or leveraging an expert network) or they use third-party providers to conduct the channel checks for them.
Questions Arise About Channel Checks
However, in recent months the industry has been shaken by reports that federal investigators were interested in channel check providers like John Kinnucan of Broadband Research. Another development — the Big Lots civil lawsuit of research provider Retail Intelligence Group for its channel checks on the firm — also caught the market’s attention. These developments created a widespread concern among institutional investors that channel checks might somehow be “out of bounds”.
Ultimately, at issue in these two circumstances was 1) did the researcher collect and disseminate material nonpublic information in their channel checks, and 2) did the researcher induce an employee to breach a fiduciary duty of confidentiality to his / her employer when conducting its channel checks.
Regulators Hint Channel Checks OK
Federal authorities realized that a great deal of uncertainty existed in the marketplace about the use of expert networks and channel checks. Consequently, on February 8th, 2011 Preet Bharara, US Attorney for the Southern District of New York, tried to allay these concerns during a press conference discussing a new round of insider trading charges against hedge fund professionals Samir Barai, Donald Longueuil, Noah Freeman, and Jason Pflaum.
Bharara said, “Now let me begin by making something crystal clear. There is nothing inherently wrong with or bad about hedge funds or expert networking firms or aggressive market research for that matter. Nothing at all. But if you have galloped over the line, if you have repeatedly made a mockery of market rules, if you have converted a legitimate enterprise into an illegal racket then you have done something wrong and you will not get a pass.”
Bharara was clear that nothing was inherently wrong with aggressive market research. We believe that this comment meant that he feels channel checking is inherently OK.
Unfortunately, the industry did not receive the kind of additional clarity we had hoped for on the appropriate use of channel checks from the Big Lots lawsuit against Retail Intelligence Group. The settlement of this case in mid-February left some rather important questions unanswered, including what obligation do research providers have to discover if Big Lots store managers had signed a confidentiality agreement with their employer, what kind of questions are appropriate or not appropriate to ask, etc.
Risks with Channel Checks
While we believe the federal authorities do not think channel checking is a problem as a general research practice, we do think some approaches create more risk for the analyst than others. Some of these areas for concern include:
- Inducement: One of the first issues we always warn buy-side clients about when they conduct channel checks is the issue of inducement. Are they (or their suppliers) providing some sort of reward or incentive to an employee to encourage them to provide information they should not be providing. This is one reason we suggest that clients not use expert networks to pay employees they want to do channel checks with. It is also important to note that inducement doesn’t always have to be monetary. Providing an employee anything of value to provide information could increase the risk for the analyst.
- Duty of Confidentiality: Another important issue is whether the employee you are interviewing has a confidentiality agreement with their employer (or with a customer) prohibiting them from sharing certain types of information with you. Typically, most analysts rely on the person they survey to refuse to speak if they have a confidentiality agreement with their employer or client. However, it is unclear whether a company might take the position that the analyst “should have known” that their employees had a duty of confidentiality not to share information with the analyst. Consequently, some buy-side clients are requiring their analysts (or their channel check vendors) to ask all employees they want to survey if they have confidentiality agreements with their employers or clients that prohibit them from speaking with them about the topic they wish to discuss.
- Surveying employees about their own companies: While there is no hard and fast rule prohibiting an analyst from surveying an employee about their own company, we have always felt that the risk of an employee breaching a duty of confidentiality is lower if they are surveyed about other companies (competitors, suppliers, distributors) or about other firm’s products than about their own. For example, we think there is greater risk of getting into legal trouble if you survey GAP Store managers about their own store sales, versus surveying them about the sales trends of various brands they carry like Levis jeans.
- Types of questions asked: Analysts also need to be careful about the types of questions they ask as some questions are more likely to generate answers that could be considered either confidential or material. Certainly, we believe the risk increases significantly if analysts ask employees for quantitative data like actual sales, earnings, or profits (even if this data is only at the store level) rather than ask for more qualitative information. Of course, many analysts believe that actual “store-level” sales are not a material piece of information – particularly if a firm has a large number of stores.
- Unfiltered data: We also believe that analysts need to be careful to screen and filter the data that they have collected during their channel checks to make sure that no individual pieces of information that they collected could be construed to be either confidential or material. For example, an analyst needs to quarantine information from a store manager who mentioned receiving an internal memo about a potential acquisition or significant strategic development with the company.
It is clear to the team at Integrity Research Associates that federal authorities are not trying to eliminate analysts’ use of channel checks as a part of their investment research process nor are they trying to change the definition of the “mosaic theory”. We also strongly believe that channel checks provide an extremely valuable input to investors’ mosaic that is not available from any public sources, including management conference calls or companys’ quarterly financial reporting. However, today’s market envionment has created a concern for some clients that channel checks may be too risky. We believe users of channel checks can reduce the risk for their firms if they think through a number of legal and compliance issues before they conduct (or engage other parties to conduct) channel checks.