Kaufman Bros. LP, a minority-owned investment bank, ceased operations as of the end of January, according to a notice posted on its website.  The firm had a small equity research team focused mostly on technology.

Kaufman was founded in 1995 and billed itself as “the country’s largest minority-owned and operated investment banking and advisory firm” focused on technology, media, telecommunications, green technology and health care.

The firm added 6 equity analysts beginning in 2010.  Analysts were seasoned technology analysts averaging over 10 years experience.  The roster of analysts and coverage can be found at http://www.kbro.com/EquityResearch/Overview/tabid/74/Default.aspx.

Kaufman Brothers joins Ticonderoga Securities and WJB Capital in closing during January.  Combined, they have put 20 senior analysts out on the street.  The failures underscore the pressure on all cash equity participants brought on by low commission volumes.  If January is a harbinger for 2012, we have a rough year ahead.

The FSA’s insider trading case against David Einhorn and his fund, Greenlight Capital, highlights the differences in insider trading regulations between the U.S. and the U.K.  Many of the compliance controls used by U.S. asset managers and research firms are triggered by confidential information, but the Greenlight case illustrates that confidentiality protections are not effective in the U.K.

Interactions with Company Management

As we noted last week, one important distinction between U.S. and U.K. laws is the fiduciary duty placed on U.S. publicly traded companies and their advisers by Regulation Fair Disclosure (Reg FD).  A U.S. issuer would be unlikely to tell Einhorn about a pending offering because Reg FD prohibits issuers from selectively disclosing market-moving information.   The broker involved, Bank of America Merrill Lynch, would be viewed as a “temporary insider” under Reg FD, and also precluded from selective disclosure.

The case highlights the role of ‘corporate brokers’, a function unknown in the U.S.  Corporate brokers are  investment bankers who serve as a liaison between public companies and their institutional investors.  As illustrated by the Greenlight case, corporate brokers in the U.K. can legally provide material non-public information to investors who agree not to trade on it in order to gauge the sentiment of their investors ahead of important corporate actions.  The U.K.’s Financial Services Authority is reportedly planning to fine the broker involved in the Greenlight case £350,000 pounds ($549,674), presumably for disclosing confidential information even though Greenlight expressly did not want to receive it.

As some commentators have pointed out, even offering an investor the opportunity to “cross the wall” could provide tradeable information, especially in cases such as Punch’s, in which an action such as the rights issue has been long speculated in the market.

Confidentiality

U.S. lawyers also question whether the Greenlight case would hold under U.S. insider trading law.  The U.S. rules on insider trading say that a trade is illegal if it is based on information that is not only market-moving but also obtained or leaked in violation of a duty to keep it confidential.  Einhorn’s refusal to “cross the wall” and receive confidential information would have gone a long way to protecting him under U.S. law.  However, in the U.K. insider trading rules are broader, allowing regulators to bring actions even where inside information has been received unintentionally or inadvertently.  The FSA claims that Einhorn should have known that he was no longer able to trade once he received the information from the corporate broker, even though he had not requested it.

Compliance officers at U.S. asset managers were shocked by the FSA’s action, while U.K.market participants were wondering why Greenlight had not been criminally prosecuted since to them Einhorn’s actions were so clearly a violation of U.K. market abuse rules.  However, criminal insider dealing requires deliberate intent, whereas the FSA has successfully brought civil cases involving “inadvertent” or “unintentional” violations and successfully defended them on appeal.

Implications

U.S. asset managers have gone to great lengths to implement protections against receiving confidential information.  Analysts and portfolio managers are trained to be alert to confidential information and to ensure that sources of information are not violating fiduciary duties of confidentiality.  U.S. research firms have implemented similar safeguards.  Expert networks have extensive protections against experts passing confidential information to clients.  Channel checking firms try to ensure that its sources are not violating duties of confidentiality.  The Greenlight case highlights that these compliance procedures offer no protection under U.K. insider trading law.   U.S. asset managers and research firms will need to make adjustments to their compliance practices if they are operating in the U.K.

The Greenlight case also highlights the grey area of corporate brokering.  Although corporate broking is unknown in the U.S., it does have a related activity — corporate access.  Corporate access, which is a common practice in U.S., differs from corporate broking in that investment banks facilitate meetings between investors and company management, which the bankers may or may not attend.  Nevertheless, it is clear that regulators on both sides of the Atlantic are taking a closer look at all activities which can potentially generate insider information.

New York, NY – An article published last week in the Financial Times indicates that US financial regulators are planning to issue new rules in the next few weeks requiring that the conflicts of interest associated with sell-side fixed-income research be addressed in a similar manner as the conflicts inherent in investment bank’s equity research.

Proposed FINRA Rule

According to the FT article, “The staff at the Financial Industry Regulatory Authority, at the urging of the US Securities and Exchange Commission, are set to file new rules with the SEC in the coming weeks that would also bind analysts who cover bonds by some of the same rules.”

This follows an initial rule proposal by FINRA last April where the US regulator said it “observed increased retail investment risk in complex debt securities.”  Click here for our previous discussion on FINRA’s preliminary proposal.

Earlier this month, the Government Accounting Office published a report to Congress called “Additional Actions Could Improve Regulatory Oversight of Analyst Conflicts of Interest”.  In this report, the GAO explained:

“FINRA also has been working to finalize another rule proposal that would address conflicts faced by debt research analysts. The current SRO research rules do not cover debt research analysts, although these analysts face conflicts of interests similar to those faced by their equity analyst counterparts. In the absence of an SRO debt research rule, the SROs have relied on antifraud statutes and SRO rules requiring ethical conduct. They also have encouraged firms—with limited success—to comply voluntarily with industry-developed principles designed to address debt analyst conflicts. FINRA plans to package its two rule proposals together and submit them to SEC in the first half of 2012.”

The final FINRA rule is likely to require that fixed-income analysts who publish research read by retail investors abide by the same rules addressing conflicts of interest that publishing equity analysts are required to follow. There are expected to be exceptions for swaps research, as well research discussing company creditworthiness.  Research targeted to institutional investors is expected to be exempt from these rules, though some form of additional warnings are probably going to be required.

Market Opposition

A number of financial market participants oppose FINRA’s proposed rule for a variety of reasons, including the existence of voluntary guidelines for fixed-income research, and the lack of reported harm to investors.  The Bond Market Association established voluntary rules for fixed-income research in 2004.

However, the GAO reported that as a result of the NASD and NYSE joint interpretive guidance on better managing conflicts of interest in fixed-income research in July 2006, they found that many firms had failed to adhere to BMA’s standards.  The examinations also found several cases where firms failed to establish, maintain, and enforce written supervisory procedures in the fixed-income research area — a fundamental obligation under their rules.

In its January 2012 report, the GAO also discussed one example where conflicts of interest in fixed-income research could have harmed investors.  In this case, a sell-side fixed-income analyst who covered Enron’s debt securities testified in 2001 that she perceived pressure from her superiors not to issue negative public comments on Enron because of Enron’s importance as an investment banking client of the broker-dealer.

Integrity’s View

We are a little surprised that everyone is so worked up about extending equity research rules regarding conflicts of interest to the fixed-income markets.  First, the new FINRA rules are expected to apply only to fixed-income research that is published and distributed to retail investors.  It is our understanding that very few retail investors actually receive fixed-income research.  Consequently, the new rule probably should not apply to most fixed-income research.

Secondly, feedback we have received from market participants suggest that very little fixed-income research is being published today.  Instead, most fixed-income research is provided by “desk analysts” who provide their insights verbally to institutional customers rather than through traditional research reports.  This is unlikely to fall under the new rules as it is not considered actual “research”.

However, any new FINRA rules regarding fixed-income research will mean that regulated firms that produce it will have additional compliance rules and regulations that they will need to comply with – an issue that will cost these firms additional compliance time and money.

According to a study recently conducted by The Wall Street Transcript group, close to half of all asset managers they spoke with still conduct their regular broker voting process using spreadsheets, despite the development of more sophisticated broker voting systems over the past decade.

Broker Vote Survey Results

A white paper, recently published by The Wall Street Transcript’s EasyBrokerVote group reviews a survey conducted last year of asset managers on the current state of the broker voting process. The survey suggested that spreadsheets are widely used by asset managers to complete a vote.   Some key findings from the survey include:

1. 48% of respondents use spreadsheets to conduct a broker vote
2. One quarter of firms have a system to track corporate access and research provided
3. 40% of respondents provide feedback to the sell side on request with 15% providing no feedback

EasyBrokerVote

Last year The Wall Street Transcript group launched a low priced web-based application to help asset managers conduct a broker vote called EasyBrokerVote.  The Wall Street Transcript’s MeetMax software division has been providing corporate access and sell-side event registration, scheduling and reporting software since 2003.

The installed base of broker vote applications among asset managers is still relatively limited despite the fact that at least two products have been available for some time (Cogent and Markit WSOD).

The EasyBrokerVote product is targeted at asset managers who require an application to enable a broker vote process to be completed quickly but require greater functionality that spreadsheets. Specifically asset managers who want to vote easily beyond the firm level to capture different services such as corporate access and research.

For more details on the survey and the product offering please contact easybrokervote@twst.com.

New York, NY – Earlier this week, David Einhorn and his US hedge fund, Greenlight Capital Inc., was fined by the UK’s Financial Services Authority for alleged insider trading, indicating that regulatory concern about insider trading has traveled outside the US.

FSA Ruling

The FSA fined Einhorn and Greenlight a total of $11.2 mln for information that Mr. Einhorn received in a 2009 conference call with management of UK-based Punch Taverns, PLC.  The FSA alleged that the trades that Einhorn made as a result of the information obtained in this call enabled his fund to avoid $9 million in losses.

Although Einhorn claims his innocence in a letter to investors, he has agreed to pay the fine and not fight the FSA’s charges.

Details of the Case

According to the FSA, Mr. Einhorn learned of a plan to issue a significant amount of new equity by Punch Taverns’ company management during a conference call held on June 8^th, 2009.  The call was arranged by a Bank of America Merrill Lynch broker, Andrew Osborne.

Immediately following the call, Einhorn directed traders at his firm to sell their holdings of the company.  The firm sold 11.7 million shares of Punch Taverns.  Apparently, the price of Punch shares dropped by a third after the call.

On June 15, 2009, Punch publically announced a “rights issue” where the company offered existing shareholders new shares at a discount.  The price of the company’s shares dropped further is response.

The FSA said that Mr. Einhorn’s actions were a “serious breach of the expected standards of market conduct.”  The FSA also admitted that additional investigations relating to the case are ongoing.

Issues Raised by the Case

The FSA’s fine of Einhorn and Greenlight Capital raise a few interesting issues for investors.  These include:

• Einhorn was held personally responsible for the purported insider trading.  As a result, both he and the firm were fined.  This is a rare stance for the FSA.
• The $11.2 mln fine is the second largest ever imposed by the FSA on an individual in a market abuse case.  We think this reflects the FSA’s desire to communicate how seriously they take insider trading.  Unlike the US, the FSA has not brought a large number of insider trading cases in the past few years.
• Even though Einhorn received this information in a management conference call, he was held responsible for trading on the information about the “rights issue” as it was both nonpublic and material.
• The lack of Regulation FD in the UK allowed Punch Tavern’s management to discuss their plans for the rights issue with investors without any concern of regulatory response.

Ticonderoga Securities, an agency broker which had absorbed research staff from Soleil Securities and Pali Capital, will be shutting down this week.  The firm’s failure underscores the pressure on all cash equity participants brought on by low commission volumes.

Ticonderoga Securities launched in 2009 and took on former Pali Capital traders and research staff in 2010.   The firm merged with Soleil Securities in May 2011, adding to its research and trading staff.

According to Traders Magazine, the Soleil deal never delivered the business that Ticonderoga had hoped.  Much of Soleil’s business was reportedly paid with a check through commission sharing arrangements, not helping Ticonderoga’s trading desk.

Ticonderoga had listed 14 research analysts covering 12 sectors on its website prior to closing.  The firm also had a distribution arrangement with Shenyin Wanguo Securities (H.K.), a Chinese securities firm, to distribute research on 350 Chinese A & B listed companies and 150 Hong Kong listed H Share companies.

Ticonderoga’s demise highlights the difficult environment facing all equity research participants.  Equity trading volumes are down prompting asset managers to reduce their research payments and shift more payments through CSAs to stretch commission dollars further.

The pain is particularly acute among agency brokers.  WJB Capital, which distributed third party research, shut down earlier this month.  Susquehanna Financial Group, with research coverage of around 300 stocks, fired 15% of its cash equities staff, roughly 30 people earlier this month.

A key factor in our relatively sanguine outlook for independent research in 2012 is the state of the hedge fund industry.  If hedge funds languish, it is unlikely the research industry will flourish since hedge funds are large consumers of investment research.

2011 Performance and Assets

2011 was a challenging year for hedge fund performance, with the industry posting its second largest annual loss (the largest being -20% in 2008).  Hedge funds on average lost 5% in 2011, according to Hedge Fund Research (HFR).  Eurekahedge Hedge Fund Index declined 4 percent last year, according to preliminary data.  Overall, 40 percent of investors saw lower-than-expected returns in 2011, according to a survey conducted by market data provider Prequin.

The second half of 2011 was brutal for hedge funds, with assets under management dropping below $2 trillion, only to rebound as markets recovered in the fourth quarter.  Nevertheless, investors allocated $70 billion of net new capital to hedge funds across all strategies in 2011. Despite disappointing third-quarter performance, the industry saw net outflows of only $127 million in the last three months of the year.

Macro hedge funds had inflows of $7.9 billion in the fourth quarter, the most of any hedge fund strategy. Investors allocated $27.9 billion of net new capital to macro funds in 2011, according to data from Hedge Fund Research.

Equity Hedge Funds

More problematic for the equity research industry, equity hedge funds suffered $8.6 billion in net outflows in the last quarter of 2011 reducing full year inflows to $2.2 billion. The HFRI Equity Hedge Index finished 2011 down 8.25%. According to HFR, 60% of all hedge funds experienced outflows during the fourth quarter.

Large hedge funds continue to receive the bulk of new assets.  Hedge funds with over $5 billion in assets accounted for $50 billion of the total $70 billion in net inflows in 2011, with smaller funds capturing $20 billion.

We were also concerned by reports from commission management professionals at major broker dealers that a large number of hedge funds were closing at the end of the year.   High-profile closures in the U.S. were Arrowhawk Capital Partners, Sursum Capital Management and Goldman Sachs’ Global Alpha.  Asia reportedly saw the most hedge fund closures since the financial crisis first hit in 2008.

Hopeful Surveys

Two recent surveys suggest that investors plan to increase allocations to hedge funds.  Barclays released a report predicting an inflow of $80 billion in new capital to hedge funds globally this year, the most since 2007.   About 56 percent of investors surveyed by Barclays plan to increase hedge fund investments in the coming year, more than seven times the number that plan to reduce their allocations.

Barclays predicted pensions will provide about half the net inflows this year, followed by $20bn from private banks and their clients, $8bn from insurers, and $6bn from endowments and foundations, and family offices.  The survey included 165 investors who, in the third quarter of 2011, had about $500bn invested in hedge funds.

Meanwhile a survey from SEI showed nearly four out of 10 institutional investors investing in hedge funds intend to increase their allocations to hedge funds this year.

Barclays predicts that smaller hedge funds will get funding this year.  According to their report, investors will increasingly invest in hedge funds with less than $1 billion of assets this year, Barclays said.  Smaller funds already doubled their share of the net industry inflows to 18 percent last year over 2010, it said.

Merlin Securities sees more interest developing in equity hedge funds.  “Event-driven and global long/short are two strategies where we’re seeing new assets flowing for the first quarter of 2012,” says Ron Suber, the head of global sales and marketing at hedge fund brokerage Merlin Securities.

Barclays is less sanguine.  “Equity hedge funds should prepare to fight for reallocated flows, as they are likely to see $100bn of reallocations but close to zero in new flows. We expect a ‘shakeout’ in the equities space as many investors will use 2011 performance to separate ‘winners’ from ‘losers’,” the bank said.

More Regulation

The increased institutional interest in hedge funds will also result in more regulation.  For one thing, institutional investors conduct extensive due diligence of hedge funds.  The process of identifying, evaluating and then investing in a hedge fund will easily range between six and nine months, according to Sameer Shalaby, the president of buy-side technology provider Paladyne Systems.

During that period, Shalaby says, investors will be looking into a hedge funds’ performance, technology, trading platforms and the quality of its leadership. They’ll also investigate a firm’s accountants, lawyers, fund administrators and prime brokers before deciding whether or not to invest. “In general the process is tougher, and we expect it to get worse,” Shalaby says.  Research providers, especially expert networks, are also becoming part of the due diligence process.

“[Hedge funds] kind of have to behave as if they were regulated, because their clients are,” said Ross Ellis, a vice president at SEI.  More regulation among hedge funds implies more scrutiny of the research providers they utilize.

New York, NY – Despite declining sales over the past few years, Integrity Research projects that the global market for independent research will rebound modestly in 2012 as the buy-side resumes their search for unique (and legal) sources of alpha.  However, Integrity’s forecast does not suggest that all alternative research providers will fare equally well as some segments will continue to face headwinds during the year.

Estimates on a Geographic Basis

According to our estimates, the global independent research industry is expected to rise 2.4% to $2.15 bln in 2012 after seeing revenue fall in the last few years.  The modest increase we project in alternative research revenues reflects a slight gain in equity commissions.  However, we don’t see these gains spread evenly on a geographic basis.

In fact, we estimate that the alternative research industry in the Americas will rise less than 1.0% in 2012 as the industry continues to struggle with tight commission budgets and continued concerns about the safety of using unregulated research sources.

Independent research firms headquartered in Europe and Asia are expected to rise a more robust 5.0% as buy-side portfolio managers look outside the US for attractive investment opportunities.  It is also important to note that the alternative research industry in Europe and Asia has not been impacted as severely by the US insider trading investigation.

Estimates by Research Category

We do not expect that all types of research providers will do equally well in 2012.  In fact, we project that in 2012 the healthiest segment of the research industry will be macro-economic and policy research providers which are projected to grow 3.7% as the 2012 US election cycle is expected increase investors’ appetite for these insights.

We estimate firms that produce fundamental research will post a modest 2.1% gain in 2012.  However, the entire increase is expected to come from fundamental research providers in Europe and Asia.

Specialized research providers, including firms that produce forensic accounting and short ideas, ESG analysis, patent research, and analysis of management quality are expected to experience a meager 0.9% increase in 2012 as the buy-side tries to find innovative sources of investment ideas.

Two of the smallest research segments – technical analysis and quantitative research – are projected to post modest gains in 2012 of 2.9% and 1.8%, respectively.  While investors typically don’t spend much on these types of research, the fact that they are devoid of potential insider information should help these segments grow.

Primary research firms, including expert networks and channel check providers, are projected to record a meager increase of 0.4% in 2012 as buy-side investors continue to remain wary of introducing risky information into their investment process.

Risks to Integrity’s Forecast

Despite our estimate of a modest gain in the alternative research industry in 2012, we believe there are a number of downside risks which could prompt a significantly weaker performance than expected.  These include:

• Equity commissions have fallen the last few years.  One risk to our forecast is that commissions could continue to fall in 2012.   This would severely impact indies if the increased market share that the sell-side experienced in 2011, continues this year.  This would result in a smaller pool of commissions that buy-side investors would have to spend on alternative research providers.
• Hedge funds underperformed in 2011 when compared to other investment vehicles.  Another risk to our forecast is that poor hedge fund performance, and increased government regulation of the industry could prompt a significant reduction in the number of active hedge funds in 2012 and beyond.  This would reduce the number of active consumers of alternative research.
• One development that has clearly dampened demand for US alternative research in 2011 was the US insider trading investigation.  A third risk to our forecast would be continued insider trading arrests might scare the buy-side from using of alternative research in the US.
• In the last few months, legislative focus on limiting insider trading among US congress has risen.  One of the bills aimed at addressing this issue includes mandatory registration of “political intelligence” firms.  Another risk to our forecast is that increased attention on this issue, or outright legislative action, could hamper investor interest in the use of policy research or insight from firms providing “political intelligence”.

Summary

As we mentioned above, Integrity Research Associates projects that the global independent research industry will increase a modest 2.4% to $2.15 bln in 2012, reversing a downtrend seen over the past few years.  However, we also see a number of downside risks to our forecast which could lead to another year of reduced spending on alternative research.  We will keep an eye on the buy-side’s demand for independent research over the next few months and see which scenario plays out.

New York, NY – Earlier this week, FINRA announced that it had fined Citigroup Global Markets $725,000 for failure to disclose various conflicts of interest in its research analysts’ public appearances and in Citi’s equity research reports published between January 2007 and March 2010.

FINRA said in a statement that Citi had “failed to make required conflict of interest disclosures which prevented investors from being aware of potential biases in its research recommendations.”

Besides other disclosure problems, Citi apparently did not disclose its role as a manager or co-manager of a related public offering in 8% of the 80,000 reports it issued annually; it neglected to report investment banking revenue it had received in 330 research reports; and it didn’t disclose its beneficial ownership in about 1,800 companies its analysts covered.

FINRA noted that it believes Citigroup failed to disclose the required information in part because the database it used to identify and create the disclosures was inaccurate or incomplete.  FINRA took into account a number of factors in determining Citi’s penalty, including the fact that several of the disclosure problems were self-reported.

The recent fine is not the first time that Citigroup has run afoul of the regulators for problems with its research disclosures.  Previously, Citi was fined $350,000 for lapses committed between 2004 and 2006.  Consequently, Citi has attempted to address these issues in the past.  In fact, Citi conducted two internal reviews of its research disclosure systems, one in conjunction with the previous $350,000 fine, and again in 2010, after continuing problems with internal systems and data from outside affiliates.

In concluding the settlement with FINRA, Citigroup neither admitted nor denied the charges, but agreed to accept FINRA’s censure over the matter.

New York, NY – Yesterday, federal authorities formally charged seven current or former analysts and portfolio managers at US buy-side institutions for illicitly collecting and trading on insider information related to computer-maker Dell Corp.  These most recent charges extends the government’s fourteen month long insider-trading investigation.

The Latest Round of Charges

Based on information from cooperating witnesses, as well as hundreds of hours of wiretapped conversations between hedge fund analysts and public company employees, federal authorities charged seven people yesterday in Boston, New York and California.  Authorities said that the co-conspirators in the case netted more than $61.8 million in illegal profits based on trades of Dell between 2008 through 2009.  These arrests include:

• Todd Newman, a former portfolio manager who oversaw technology investments at Diamondback Capital
• Jon Horvath, a technology analyst at Sigma Capital Management, an affiliate of SAC Capital Advisors
• Anthony Chiasson, a co-founder of hedge fund Level Global Investors
• Danny Kuo, a VP and technology fund manager with Whittier Trust Company

Also charged in the investigation were Spyridon “Sam” Adondakis, a former Level Global analyst who worked for Mr. Chiasson; Jesse Tortora, an ex-Diamondback analyst who worked for Mr. Newman; and, Sandeep “Sandy” Goyal, an analyst who worked for mutual fund Neuberger Berman Group, but who previously worked at Dell’s corporate headquarters from the summer of 2006 through May 2007.  Mr. Adondakis, Mr. Tortora, and Mr. Goyal have entered guilty pleas and are reportedly cooperating with the government in their investigation.

It had also been previously reported by the Wall Street Journal that federal authorities had been pursuing charges against Neuberger Berman analyst Fayad Abbasi.  Since the initial WSJ article mentioning him, Mr. Abbasi was put on leave and has hired a defense attorney.  Mr Abbasi was not among those arrested yesterday, though Mr. Abbasi worked with Mr. Goyal who was charged.

According to court papers, after Mr. Goyal became an analyst at Neuberger Berman, he obtained inside information from a co-conspirator who worked in Dell’s investor relations department from March 2007 through March 2009 and in its corporate development office from March 2009 through April 2010.  The SEC said Goyal tipped Tortora who then tipped several others, leading to insider trades at Diamondback Capital and Level Global.

Since the start of the broad insider trading investigation, the office of Manhattan U.S. Attorney Preet Bharara has now charged 63 people with insider-trading – 56 of whom have either pleaded guilty or have been convicted at trial.

Impact on Research

The latest round of insider-trading charges are unlikely to dampen the buy-side’s appetite for external research, as most institutional investors spent much of 2011 vetting their existing pool of research providers and implementing formal procedures to better manage their use of these firms.  However, we do think the ongoing insider-trading investigation will keep buy-side compliance officers very focused on managing the risk of using external research providers – a factor which will keep them immensely involved in the process of accepting new research providers into a buy-side firm.

It is also important to note that in the latest charges by federal authorities, asset managers are reported to have cut out “expert networks” or other alternative research firms and developed their own sources of information, which they then shared with each other for mutual benefit.