New York, NY – Last week Galleon Group founder Raj Rajaratnam was found guilty on all 14 counts against him for insider trading. Immediately, many journalists concluded that this outcome could have a serious negative impact on the expert network industry. While we disagree, we don’t think that hedge funds, expert networks, or other independent research providers are out of the woods yet as federal authorities continue to investigate hundreds of individuals for potential insider trading violations.
Galleon Verdict Not About Expert Networks
It has been a widely spread misconception that the Galleon case was related to the use of expert networks. However, this is not the case. Every one of sources that Raj Rajaratnam received material nonpublic information from were individuals that Raj knew personally and who he developed relationships with over the years. He did not use expert networks to meet the people who provided the illicit information discussed in the trial (though Galleon did use expert networks at various times).
In fact, we think that it would have been MUCH easier for the government to catch Raj if he had used expert networks to source the providers of the material nonpublic information discussed in the trial. Today, most expert networks keep logs of all the experts used by clients, the dates clients called them, the amounts the experts were paid, and the general topics of the engagements. Consequently, investigators would have had a clear trail to follow by going to the expert networks.
Regardless, the financial press has tried to tie the Galleon case, and most other insider trading cases to the use of expert networks. Certainly, expert network Primary Global Research was involved in a number of cases – but Galleon was not one of them.
Of course, regardless of whether expert networks were involved in the Galleon case, some argue that the guilty verdict against Raj Rajaratnam will send a clear signal to hedge funds that the collection and use of insider information will be punished – a development that could cause a long-term reduction in investor demand to use these services.
We don’t completely agree with this argument. First, we suspect that many investors will continue to use expert networks in the future as they have in the past – to conduct legitimate research on industries, technologies, trends, regulatory developments, etc.
Over the past six months, the impact of the insider trading investigation on the use of expert networks and other independent research has been large. Feedback that we have obtained suggests that most buy-side firms reduced their use of expert networks by 40% to 60% over the past six months while they conducted due diligence of their research providers, made any necessary internal compliance changes, and looked for more clarity from regulators about whether expert networks were problematic or not.
However, we think a thaw might be in the offing. As we have written a few times, regulators have clearly indicated that expert networks and channel checks are not inherently a problem. Instead it is how they are used that is the issue. In addition, we have heard from a number of expert networks and channel check providers that buy-side usage has been slowly picking up in recent weeks as investors are becoming more comfortable with the new, more compliance sensitive environment.
Intermediate and Long-Term Consequences Unclear
The big question everyone is asking is whether investors are likely to go back to “business as usual” anytime soon. We are not convinced this is in the cards. In fact, we think there is a very real possibility that we could be heading for another period of paralysis on the part of buy-side investors in the not too distant future.
A number of sources have told us that federal authorities have already identified between 300 to 400 potential cases of insider trading involving company employees, institutional investors, lawyers, and others. The culmination of the Galleon trial will enable them to refocus their attention on these cases. We have also heard that close to a dozen federal agents have been relocated to the east coast to progress the investigations in these cases.
If this is true and federal authorities continue to bring charges against new experts and investors of insider trading – whether expert networks are involved or not – we suspect that a number of institutional investors will once again reign in their use of expert networks and other external research sources for fear of getting caught up in the investigations.
Impact on the Industry
The tough market conditions over the past six months, and the possibility that investors might choose to limit their use of expert networks and other third-party research providers if new insider trading charges become public, suggests that external research providers could face a brutal market environment for the foreseeable future. In fact, we would not be surprised to see a slew of research firms shut down or consolidate as a result.