Gerson Lehrman Group (GLG), the leading expert network provider, recently rebranded its social media experiment which connects business professionals at no charge.  The previous name, G+, created confusion with Google’s brand, so GLG changed the name to ‘High Table’.  The move illustrates how difficult it is for GLG to transition itself into a social media company.

Gerson Lehrman introduced the G+ brand last year, in an apparent move into social media.  The core services which connect professionals for a fee were rebranded as ‘GLG Research’, and the new product was available for free to anyone who registered.  Now G+ has become High Table, connoting a slightly elitist image.  The term ‘high table’ alludes to the tradition in universities such as Oxford to place professors and distinguished guests at a raised table at the end of a dining hall.

Here’s how GLG describes the service: “HighTable provides active and influential professionals, academics and entrepreneurs a place to collaborate around new business ideas by asking and answering questions and conducting meetings online and in-person.”

Don’t be confused by High Table’s claim of “conducting meetings online and in-person.”  If you want to go beyond online Q&A, you will need to trade up to the premium services of GLG Research.  High Table does feature some GLG Research webinars, allowing High Table members to sign up for the webinars for free.

What’s the purpose behind High Table?  The business rationale is to drive more traffic to GLG Research.  High Table showcases experts and events that can be paid for through GLG Research.  Also, High Table helps position GLG as a social media firm if it ever goes public.

An obvious concern is cannibalization of the hundreds of millions that GLG Research earns in fees.  As High Table says about itself, “The best, first-hand expertise on any business issue should be more accessible and inexpensive than ever…”  However, there is a big difference between the value of High Table’s online Q&A and GLG Research consultations where you can get nuanced responses, ask follow-on questions, and gauge an expert’s credibility.  Plus GLG Research consultations are private.

The bigger question is whether High Table can attract enough traffic to make cannibalization a concern.   High Table competes against Quora, which has a large following and very active discussions.  Although the bulk of Quora’s topics are not business related, it has discussions relating to stocks and other finance topics.  The answers are often high quality.  For example, many of the questions about Amazon are answered by current or former Amazon employees, an aspect that is becoming increasingly rare in expert networks because of compliance concerns.

High Table has the advantage of GLG’s network of experts, plus many GLG employees are active on the site.  GLG acquired a Chinese social media start-up last fall to add an international dimension.  However, High Table has queries numbering in the hundreds whereas Quora has queries in the tens of thousands.

Another competitor is Quewey.com, a recent attempt to create a business-oriented version of Quora leveraging LinkedIn connections.  However, Quewey seems to have less traffic than High Table.

Remaking GLG into a social media company is not an easy task.  It takes more than a free website to generate traffic.  As the rebranding of G+ to High Table illustrates, it is hard to get it right.  But give GLG credit for trying.

The Wall Street Journal‘s Best on the Street Analysts Survey, published last week, graphically illustrates the long tail of investment research.  Awards were given to over 60 research firms, and the most awards garnered by any firm was 9 by Goldman Sachs.  Talent (or luck) is distributed broadly and there is no go-to firm for research, at least by the WSJ’s metrics.

This is an important caveat, especially for institutional investors.  The survey measures the performance of BUY and SELL recommendations, which generally ranks low on the list of attributes that are important to institutional investors.  However, recommendations are valuable for retail investors, so it not surprising to see retail-oriented providers such as S&P Capital IQ, Morningstar, and Argus garnering multiple awards.

In the past, the WSJ has ranked firms by the percentage of analysts receiving awards.  Since they neglected to do this, we have done it below.

This data raises the question of whether independent firms do a better job, at least on recommendations, than larger brokers.  Although  independents as a group have an average ratio of 1 award for every 4 analysts (compared to 1.2 awards per 10 analysts for investment banks), this doesn’t necessarily mean that performance is better with IRPs.  Smaller firms have higher ratios when they garner awards, and independents tend to be small.

Similarly, the fact that IRPs represent 30% of the awards is difficult to interpret, since it depends on how extensive FactSet’s coverage is of independents.  If they are not highly represented in the database, then it is a respectable showing.  30% is significantly higher than the portion of research dollars generally allocated to independents, which tends to be in the 15-20% range.

This raises the question of where the big boys, who are paid the big bucks, rank.  Pretty low and some are missing altogether (Citi, Credit Suisse, Deutsche).  Goldman does best with 9 awards (14% of total analysts included), followed by BofA / Merrill with 7 awards (11%) and JP Morgan Chase with 5 awards (7%).  Barclays, UBS and Morgan Stanley have the worst ratios (2-3%) among firms that received awards.

Granted, performance of BUY/SELL recommendations is not the highest priority for institutional investors, but you would think that given their resources, and the large payments they receive, that bulge firm research would do better.  Viewed through the lens of the WSJ rankings, there is a big disparity between the payments made for research and the performance of that research.  This reinforces the belief that the large investment banks and broker-dealers are being paid for other things.  Certainly not performance, and perhaps not even related to research at all.

Stanley Ng, a former Marvell Technology Group Ltd. accountant, was sentenced to two years’ probation for his role in an insider-trading scheme involving the failed expert network Primary Global Research (PGR).

Ng was recruited by Winifred Jiau, a $10,000 per month expert affiliated with PGR.  Jiau was retained on an exclusive basis by Noah Freeman, a former SAC Capital Advisors LP portfolio manager, and Samir Barai, founder of New York-based Barai Capital Management LP, both of whom have pleaded guilty.

Ng, who was the Securities and Exchanges Commission reporting manager for Hamilton, Bermuda-based Marvell, pleaded guilty in December, admitting that he passed information about the chipmaker’s earnings in 2007 and 2008 to Jiau.

“Everyone agrees that this defendant is at the very low end of insider trading, a very, very limited offense brought about in large part by his relation to Ms. Jiau,” U.S. District Judge Jed S. Rakoff said.  In addition to probation, Ng must perform 400 hours of community service, pay a $2,000 fine and forfeit $6,464.

In contrast, Jiau was sentenced to four years in prison.  Since being arrested in December 2010, she was denied bail and held in maximum security facilities for the majority of her time in prison.  Subjected to being handcuffed, shackled and caged in a locked cell, Jiau was finally transferred to a federal prison camp in Dublin, CA after a year of incarceration where she will serve the remainder of her 48 month prison term.

Ng’s lawyer, Silvia Serpe, emphasized her client didn’t make any money or trade on any inside information.  Jiau allegedly made $200,000 between September 2006 and November 2008 through consultations arranged by PGR.   However her sentencing was based on profits made by Freeman and Barai.

New York, NY – Financial information services company Markit today announced an agreement to acquire New York-based provider of enterprise data management services, Cadis.

Markit, based in London, said the acquisition will help position the company at a time when financial institutions are becoming increasingly reliant on enterprise data management (EDM) platforms to manage their big data challenges, reduce risk and comply with new regulations including Dodd-Frank, Basel III and Solvency II.

Cadis’ EDM platform consolidates data from multiple sources within a centralized hub, and provides data management needs including front-to-back office integration and data frameworks for trading, pricing, risk and compliance management.  The Cadis platform is used by investment banks, insurance companies, regulators, asset managers and hedge funds.

“Data management is top of just about every financial institution’s agenda; the scale and complexity of the data they are managing have never been greater,” said Lance Uggla, CEO of Markit. “Following this acquisition, we will be able to provide our customers with Cadis’ market-leading data management solution which comes with a fantastic track record in successful implementation. The EDM space is large, global and growing and Cadis fits well with Markit’s entrepreneurial growth-oriented culture.”

Cadis, established in 2007, has offices in London, New York, Boston, Hong Kong, Luxembourg, Manchester, Paris, Sydney and Tokyo.  The firm will operate as a business unit alongside Markit’s other enterprise solutions including Markit Analytics, Markit Portfolio Management and Markit on Demand. Daniel Simpson, Cadis CEO, will join Markit’s executive management team.

Cadis is owned by employees and private investors.  Financial details of the transaction were not disclosed.

Recent sanctions by FINRA highlight risks associated with outsourcing compliance.  However, outsourcing compliance functions makes sense for some firms, provided it is done conscientiously.

The principal of a small broker dealer was sanctioned by the Financial Industry Regulatory Authority (FINRA) earlier this year for delegating supervisory responsibility in an ineffective manner.  FINRA alleged that the principal of Lane Capital Markets LLC delegated compliance responsibilities to a part-time Financial and Operations Principal (“FINOP”) who had similar responsibilities at multiple firms.  Lane Capital then hired two employees with significant disciplinary histories.

The part-time FINOP expressed concerns about being able to adequately supervise these employees, particularly since they were in a separate office.  According to FINRA, the principal did not address these concerns.

The situation was compounded by Lane Capital’s alleged failure to prepare an annual certification of the firm’s processes to establish, maintain, review, test and modify written compliance policies and written supervisory procedures.  Further, there was no certification that the principal had conducted one or more meetings with the FINOP in the preceding twelve months to discuss the firm’s compliance/supervisory processes.

It would be a mistake to draw the conclusion that FINRA frowns on outsourcing compliance.  Many smaller broker dealers use outsourced FINOPs, and there is nothing inherently wrong with this.

The moral of the story is that certain compliance responsibilities cannot be outsourced.  Senior management has the ultimate responsibility for ensuring that compliance policies and practices are effective.  As illustrated in this case, senior management can’t delegate overall responsibility for compliance:

• Senior management needs to keep policies up-to-date, which is particularly important in this regulatory environment;
• Senior management needs to make sure that the compliance function, whether internal or outsourced, is adequately staffed for the requirements of the firm;
• Effective compliance requires the ongoing involvement and support from senior management to ensure that all employees understand that compliance is an important component of their jobs.

Too often the approach to compliance is ‘tick the box’.  Given the regulatory environment, and the evolving nature of insider trading litigation, it is dangerous to assume that compliance risks are static.  Further, firms evolve.  New employees are added.  New locations opened.  New products launched.  Each has different compliance implications.

The biggest risk with outsourcing is the assumption that it can be fully outsourced.  It can’t.  Outsourcing can be a viable option to ensure that you have appropriate expertise and staffing to help administer policies.  But to be effective, it still requires a significant ongoing commitment from the leadership of the firm.

New York, NY – According to a report recently published by Colorado-based consulting group, the Compliance Department, the number of U.S. broker-dealers that shut their doors during the first quarter of 2012 was less than the number that closed down in the first quarter of 2011.  Despite this slowdown, the overall number of B-Ds in the US continues to decline as sliding commissions and increased legal and regulatory requirements puts enormous pressure on smaller firms.

B-Ds Continue to Close

During the first quarter of 2012, 93 broker-dealers are reported to have closed, compared to 137 firms during the same period in the prior year.  However, only 44 new B-Ds opened during the first quarter of 2012, whereas 57 broker-dealers started up in the first quarter of 2011.

This slowdown in closings doesn’t dramatically alter the negative trend in the industry.  FINRA reports that the number of registered broker-dealers has dropped by 11% over the past five years – from 5,005 broker-dealers in 2007 to 4,428 in March of this year.

Factors Driving B-D Weakness

A number of factors have contributed to this decline.  Certainly, increased regulatory requirements have been one factor which has led smaller broker-dealers to shutter their operations.  David Alsup, national director of business development with the Compliance Department explained, “You just can’t be a two-man shop and hire a $70,000-per-year compliance officer and stay in business.”

Rising legal costs have also squeezed a number of B-Ds.  Almost 50 broker-dealers that sold failed private placements of firms like DBSI, Medical Capital Holdings, and Provident Royalties are reported to have closed down due to the high cost of litigation and potential arbitration judgments.

Another factor which has prompted a number of B-Ds to shut their doors has been weak commission revenue caused by falling equity commission rates and declining trading volume.  In 2011, Greenwich Associates reported that the average “all-in” commission rate paid by U.S. institutional investors was 3.7 cents per share – down from 3.8 cents from 2010′s study. This was due to a drop in the average commission rate for normal, high-tough agency trades.  Equity trading volume also remains weak.  In fact, in April 2012, the average daily trading volume of US equities was at its lowest level since December 2007.

“I don’t see an end to the steady downtick” of broker-dealers’ closing, explained the Compliance Department’s Alsup. “And I don’t see an uptick for a while.”

Impact on Research Biz

While most of the 93 broker-dealers that shut their doors during the first quarter of 2012 were either agency brokers or small retail oriented B-Ds and did not publish research, some of the closed firms clearly did.  As we have mentioned in the past, Royal Bank of Scotland shut down its equities research earlier this year.  Firms like Ticonderoga Securities, WJB Capital and Kaufman Brothers also recently shut down, while in the UK Evolution Securities was bought by Investec, and Collins Stewart Hawkpoint was absorbed by Canaccord.

Ultimately, this trend means there are fewer firms producing brokerage research, and fewer job opportunities for sell-side analysts.  However, we are unlikely to hear a great deal of grumbling from the buy-side about this shakeout.  Part of this is because declining commission pools have made it difficult for buy-side firms to maintain what they pay their sell-side firms for the research they provide.

In fact, one broker liaison we spoke with recently explained that his firm was likely to eliminate half of the large brokers they used due to the duplication of execution and research services they provide.  They just don’t generate enough in equity commissions to keep all of their sell-side broker-dealers fed.

Could this trend benefit independent research firms?  It is possible.  However, most buy-side firms explain that the tight market conditions over the past few years have taught them that they don’t need to pay their research providers as much as they thought.  Consequently, we doubt that any savings buy-side firms generate from reducing the number of sell-side firms they use will go to boosting payments to independent research firms.

Who are you going to believe?  A mid-cap company ranked fourth in its industry globally, operating on 3 continents, followed by a dozen sell side analysts two-thirds of whom with buy recommendations? Or Anonymous Analytics, affiliated with hackers, and almost certainly seeking to benefit from short sales?  Since trading has been suspended in Huabao International subsequent to the release of Anonymous Analytics’ report last week, the verdict seems to go to the rogue research firm.

The U.S. ADRs of Huabao (each ADR represents 25 shares of underlying common traded in Hong Kong) traded from $31 the prior week to $18 when trading was halted.

Huabao issued a press release a day after trading was suspended, saying they are preparing “a clarification in response to certain recent incorrect and misleading allegations.” The company also said it has dispatched “delegates to the respective local offices of the State Administration for Industry & Commerce of the People’s Republic of China (“SAIC”) to verify the financial information for the year of 2010 (i.e. for the 12 months ended 31 December 2010) of some domestic subsidiaries of the Company filed thereat, so as to be supporting documents for the clarification announcement about to be published by the Company later” and it is working with its auditor, PricewaterhouseCoopers, to prepare financial statements for its fiscal year ending March 31, 2012 by the end of June.

All this commotion was caused by one 44-page report from a group that is purposely obscure.   Perhaps because the source lacks credibility, the report is very good—well researched, well written, and quite devastating.

The people behind Anonymous Analytics did their homework.  They pulled 23 sets of State Administration for Industry & Commerce (SAIC) documents covering all of Huabao’s relevant subsidiaries. They did extensive channel checks including over 150 phone calls to all the major cigarette manufacturers, as well as contacting Huabao customers, competitors, and industry experts. They sent teams to multiple locations spanning three continents, including a trip to Botswana to check out a dodgy subsidiary.

This raises a few questions.  What exactly were the sell side analysts from firms such as Citigroup, Credit Suisse, Deutsche Bank and JP Morgan doing since Huabao went public in a backdoor listing in 2004?  Why didn’t the red flags that caught the attention of Anonymous Analytics raise concerns among the sell side analysts following the stock?

There seems to be no lack of red flags.  These include a backdoor listing, an auditor resignation, executive resignations, “absurd related party transactions, and a company founder who can’t sell off her shares fast enough.” Indeed, it was the company founder, Chu Lam Yiu, 36 years old when she first took over Huabao, who first drew Anonymous Analytics to the stock.  From an interview in Foreign Policy, the pivotal question for Anonymous Analytics was “How did this 36-year-old female who no one had ever heard of manage to become a billionaire overnight, particularly in a notoriously government-controlled and patriarchal industry?”

Last year Ms. Chu was ranked the 8th richest woman in China on Hurun’s list of Self-Made Women Billionaires. Notably, Hurun also published a “Cashout List”, which lists billionaires who have been cashing out of their own companies. The list places Ms. Chu at No. 2, having cashed out of US$549 million last year alone.  The Anonymous Analytics report alleges that Chu is a proxy for unnamed people who are actually pulling the strings.

This brings us to the question of whether Anonymous Analytics uses hacking to supplement its analysis.   The report itself is an excellent example old fashioned equity research, incorporating financial analysis (why are Huabao’s margins at 70% when the rest of the flavoring industry is at 40-50%?), industry analysis (is Huaboa’s market share credible given the size of the Chinese cigarette industry?), channel checks (revealing phantom customers), on site visits (showing suspect R&D facilities and mysterious subsidiaries), and forensic research (the numerous red flags mentioned above.)

The report shows no evidence that the firm used (or needed) hacking.  However, to prevent retribution, the report holds back information: “…we have an immense interest in the safety and well-being of our people. This is why all the information withheld from this report has been encrypted and stored online. This information pertains to Huabao’s business, along with the personal information of the individuals who run Huabao behind the scenes and their associated proxies (you didn’t actually think a 36 year old woman was the true running force behind one of China’s largest public tobacco enterprises, did you?)”  Hacking, or the threat of hacking, is another (unstated) deterrent.

However, the group says it doesn’t hack, sort of:  “We don’t hack for information since that would attract all kinds of horrible attention we don’t need. … But then again, if we were hacking, chances are we wouldn’t go around talking about it.”

Who are the people behind Anonymous Analytics?  In the interview with Foreign Policy, they acknowledge links to Anonymous: “Our members grew up within the Internet subculture and cesspool that is 4chan [an English-language bulletin board copied from one of the most popular forums in Japan, Futaba Channel]. We have been active in the Anon community over the last several years in some capacity. Some of us eventually grew up and got jobs in industry and government but we retained the dark humor that is Anonymous. More importantly, we retained the skill to source information and social-engineering capabilities that we honed through our work with Anonymous.”

How does the firm make money?  The report’s disclaimer mentions that the firm has clients, and perhaps the clients pay to receive the group’s research before it is publicly released.  The disclaimer also mentions contributors, which are most likely hedge funds which had already taken a short position in Huabao.  Although Anonymous Analytics says it “holds no direct or indirect interest or position in any of the securities profiled in this report,” you have to assume that the report has a vested interest, which is driving down the price of the stock.

So how are we supposed to react to an outlaw research firm, that may or may not use illegal methods, and which at the very least is associated with short sellers intent on launching a bear raid on the stock in question?  Ambivalent, just as we feel about Muddy Waters, which makes no secret of its short positions.

What this graphically illustrates is the sorry state of sell side research.  The Huaboa website lists 12 sell side firms covering its stock, including JP Morgan, Deutsche Bank, Citigroup, Credit Suisse, Nomura, Jeffries and DBS Vickers.  An article in the Financial Times mentions 9 covering firms, of which 6 had buys/outperforms and 3 had holds.  One analyst was quoted as saying that she plans to review the stock based on the information to be released by the company (whenever that will be).

Anonymous Analytics has the tagline “Acquiring information through unconventional means.”  If they are not hacking, then they must be referring to channel checks, onsite visits, forensic analysis and the other due diligence they performed.  But these are all tried and true techniques used in securities analysis, so in what sense are they unconventional?  Perhaps the firm is making a statement about conventional sell side research.

Reading the Anonymous Analytics report makes one incredulous that other analysts did not pick up on any of the clues.  As the report puts it, “It’s almost like management is playing a game of chicken with analysts, like they’re trying to see how many red flags they can raise and still get ‘buy’ recommendations.”  Sadly, it wasn’t the sell side analysts who ultimately called the bluff.

FOR IMMEDIATE RELEASE

Montreal, QC—April 30, 2012 – In response to industry demand, respected independent global research provider, BCA Research, will launch a Geopolitical Strategy service on May 8, 2012.  This new service, believed to be the first of its kind, will be headed up by BCA Senior Geopolitical Strategist, Marko Papic.

“While the BCA tradition of rigorous macroeconomic analysis has always incorporated geopolitical analysis, this new service – led by the experienced Marko Papic, will encompass the knowledge and expertise of BCA’s existing 60+ research staff – combining first class macroeconomic research and geopolitical risk analysis into a single framework”,  says BCA Director of Research, David Abramson.  “The resources committed to the GPS service have been structured to evaluate the risks posed and opportunities presented by geopolitical developments and their impact on longer term investment trends”.

In a world menaced by uncertainty and rising geopolitical risks, this new BCA Research service will provide actionable investment strategy against the backdrop of current geopolitical themes including unique and custom strategies adapted to specific tail-risk scenarios.   With a background in private intelligence and academia, Senior Strategist, Marko Papic, will avoid bias – instead relying on the fundamental analysis based on constraints and necessity.

“Our market research has determined there is tremendous potential for this service.  While 80% of clients surveyed responded that the impact of Geopolitics on their general investment decisions was “important” or “very important”,  over 65% confirmed “investment implications” were missing from their current source of Geopolitical analysis”,  states Nanci Murdock, BCA’s Marketing Manager.  “The feedback from March and April beta reports has been overwhelmingly positive – we are delighted to officially launch this product into the marketplace.”

For more information on BCA Research or the BCA Geopolitical Strategy, contact Nanci Murdock at 514.499.9550 or e-mail marketing@bcaresearch.com.

About BCA:

Founded in 1949, BCA Research has developed an enviable reputation as a world leader in the provision of independent global investment research.  The firm produces leading-edge analysis and forecasts of all major asset classes, along with clear and focused investment strategy recommendations.  Research is provided to financial professionals in more than 90 countries through a wide range of products, services and meetings.

Contact:  Nanci K. Murdock, CFA
Company name: BCA Research Inc.
Phone: 514.499.9550 ext. 254
Web Site: http://bcaresearch.com
E-mail: marketing@bcaresearch.com

# # #

Equity research morale has sunk to new depths as commissions continue to shrink.  “Equities teams face shakeout” reads the headline of a recent Reuters’ article.   The Financial Times speculates that investment banks might begin closing their equity research.

The mood among veterans is no better.  There are rumors that JP Morgan and Deutsche Bank will be announcing significant cuts.  Cheuvreux, the well-regarded equities subsidiary of Credit Agricole, is said to be closing after a deal with Citic Securities fell through.   Royal Bank of Scotland shut down its equities research earlier this year.

As we reported previously, Ticonderoga Securities, WJB Capital and Kaufman Brothers shut down last quarter.  In the UK, Evolution Securities was bought by Investec, and Collins Stewart Hawkpoint was absorbed by Canaccord.

“If the lower volumes of the last five years continue, the industry will inevitably see further withdrawals and reductions that will change the competitive landscape in the equities market,” said Sam Ruiz, who heads Nomura’s equity unit in the Europe, Middle East and Africa region, as quoted by Reuters.

Shrinking Commissions

Commission volumes shrank another 20 percent in the first quarter of the year, according to the World Federation of Exchanges.  After 5 years of declines, they are looking structural not cyclical.  Active management is losing assets to passive vehicles.  “When I tell a client to buy a housing stock, they grab a homebuilder ETF instead,” complained a sales veteran recently.  “It is hard to make a living as a stock picker.”

As we have reported before, the IBM Institute for Business Value has predicted that 85-90% of total worldwide assets under management will move toward indexing or repackaged types of beta instruments over the next decade.  Although we are a long way from this number, the reality is that many active managers act passively, especially during times of uncertainly.  Market participants say that turnover declines as portfolio managers trade fewer names and hug the indices.

Another secular cause of commission declines is the shift to electronic trading.  Full service commissions are becoming extinct.  Although clients will pay a premium for advisory, that premium is declining creating commission compression.  Industry sources say that Goldman Sachs is automating as much as its cash equities as it can, relying on the strength of its banking (and the expectation of IPO allocations) for relationships rather than high cost advisory services.

Conclusion

Investment banks are creatures of boom and bust, hiring heavily during fat times and laying off employees during the lean.  Layoffs are nothing new, but industry participants are wondering if this time is different.  Instead of the usual cycles, are we beginning to see structural change?

The answer is yes, but don’t expect investment banks to suddenly exit equity research.  What we are seeing are gradual, incremental changes.  Death by a thousand cuts.  Although there is extreme overcapacity in equity research, no bank wants to forgo their commission streams, declining though they are.  So employees will get smaller bonuses, the businesses will be automated and downsized, and bank research will keep hollowing out, replaced by more robust buy side research and boutique firms.

New York, NY – Last week, Rajat Gupta’s lead attorney in his insider trading investigation said federal prosecutors informed him they were investigating an unnamed Goldman employee in California for passing inside information about two public companies to Raj Rajaratnam.  Including Mr. Gupta, this would make the fourth Goldman Sachs employee who is being investigated for insider trading.

Another Insider Trading Source for Raj

The new investigation of another Goldman Sachs employee was made known to Gary Naftalis, Gupta’s lawyer, during a hearing last week involving the insider trading case against former Goldman board member Rajat Gupta.  Gupta, a former director of Goldman Sachs, has been charged with illegally tipping his former friend Raj Rajaratnam.  Naftalis, acknowledged that Assistant US Attorney Reed Brodsky asked him not divulge the details of the newly disclosed investigation.

This new information could prove important to Mr. Gupta’s case as this would be a fourth Goldman Sachs source who is being investigated for allegedly providing inside information to Mr. Rajaratnam.  This could create doubt about the ultimate source of the inside information that Rajaratnam traded on.  Gupta has denied any wrongdoing in the case.  Gupta’s trial is scheduled to begin on May 21.

In March, newspapers published that prosecutors were investigating a Goldman Sachs Managing Director named David Loeb. Loeb is an institutional salesperson who works with technology hedge-funds.  Loeb also introduced Goldman Sachs technology analyst based in Asia, Henry King, to a number of hedge funds, including to Galleon.  King is also under investigation for providing insider information.  Neither Loeb nor King has been accused of any wrongdoing in this matter.

According to people familiar with the matter, the new Goldman Sachs source is different from Loeb or King whose names became publicly associated with the investigation last month.

Unintended Consequences of Investigation

Since Rajaratnam’s arrest, federal authorities have charged 64 people with crimes related to insider trading, of which 59 have pleaded guilty or been convicted. The FBI says that it currently has enough informants to keep prosecutions going for another five years.

Despite the obvious success the government is having prosecuting insider trading, some argue that the current investigation is having significant unintended consequences — including a negative impact on both the hedge fund and independent research industry.

In fact, some have linked hedge funds’ poor performance in 2011 to the effort by the FBI and federal prosecutors to catch investors, company managers, and consultants who traffic in inside information.  These market participants contend that the poor performance seen in 2011 was not the result of hundreds of hedge funds suddenly stopping to engage in insider trading.  Instead, they believe that legitimate analysts at hedge funds have become fearful of engaging in legal research efforts.  This fear has led to subpar industry performance.

Certainly, the team at Integrity Research has spoken with a number of buy-side compliance officers and research directors who have expressed these concerns.  They have noted that many of the controls and restrictions they have put in place will reduce their analysts’ ability to conduct high quality research.  However, they admit that these controls are necessary to protect the firm from potential legal liability.

This development has also had a negative impact on independent research providers who have historically sold their primary research, proprietary data points, and unique insights to hedge funds seeking a legitimate informational advantage over their peers.  In fact, many research providers have acknowledged that a majority of hedge funds were unwilling to bring on board new research firms in 2011 for fear of inadvertently obtaining questionable information.

As we have mentioned in the past, some buy-side firms even decided to rely on sell-side research in 2011 to mitigate their concerns of getting inside information from unregulated independent research providers.  However, we think asset managers will find this a difficult strategy to defend given the growing evidence that tipping has been taking place with well-established regulated firms like Goldman Sachs.

Summary

It will be interesting to find out who the fourth person from Goldman Sachs is who allegedly provided insider information to Raj Rajaratnam.  It will also be compelling to see how the legal case against Rajat Gupta unfolds, as the defense tries to prove that others provided Rajaratnam the tips that led to his illicit gains.  However, whatever the results of the courtroom battle, it is clear to the team at Integrity Research that legitimate hedge funds, and the independent research firms that have traditionally served them have become collateral damage in the government’s current war against insider trading.