MNPI Fears Harm Sector Specialists and Others

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New York, NY – Over the past eight months, institutional investors have reigned in their use of many primary research providers for fear of introducing “material nonpublic information” into their research process.  However, as the buy-side has ramped up their due diligence process of their third-party research suppliers, an increasing number of other research firms have been judged to be too risky to use, including boutique sector specialists and industry consultants.


Initial Response

In the wake of the insider trading investigation involving Mountain View California-based expert network Primary Global Research, many buy-side firms dramatically reduced, or even eliminate their use of expert networks.  In addition, the Big Lots lawsuit of Retail Intelligence Group prompted a chill to descend over the use of channel check providers.

After the initial shock of these developments passed, many buy-side users of these services responded by conducting due diligence of expert networks’ and channel check providers’ compliance policies and procedures.  The buy-side also revised their vendor contracts by inserting extensive legal representations and warrantees to insure that these firms would not pass on MNPI or confidential information to them.  Most buy-side firms also hired outside counsel to develop internal procedures for their use of expert networks.   


Additional Steps

In recent months, a growing number of buy-side firms have come to the realization that a wide range of research providers could potentially introduce MNPI or confidential information into their research process.  Consequently, these buy-side firms have rolled out more extensive due diligence programs aimed at identifying which research providers have the compliance infrastructure required to protect them from receiving inappropriate information.  


Impact on Other Firms

Unfortunately, this process has raised buy-side concerns over the use of certain types of research providers, including boutique sector specialists and industry consultants.  The reasons for these concerns are two-fold. 

First, most of these specialist research providers have access to a wide range of potentially risky information sources, including current and former company employees, consultants, and other professionals with direct access to confidential company information and possible MNPI.  

The second reason for the buy-side’s concerns over the use of this type of research is that many of these providers are small and do not have the compliance infrastructure required by an increasingly fearful buy-side.  Not only does this include appropriate policies and procedures, but it also includes the compliance personnel needed to implement ongoing compliance processes and oversee the training needed to mitigate the risk associated with a research provider’s day-to-day operations.

Ultimately, these concerns have led some buy-side firms in recent months to fire a number of small fundamental sector specialists and industry consultants rather than accept the risk that they might provide them with inappropriate information.    


Potential Solutions

What can boutique sector specialists or industry consultants do to address these buy-side concerns?  We see a few potential solutions, including:    

  1. Do it yourself:  One obvious option would be for a research firm to hire legal counsel or another compliance specialist (like Integrity Research) to help them develop internal compliance policies and procedures.  The second step would be to appoint an existing employee to act as compliance officer, or hire a full-time compliance officer to manage the firm’s compliance processes and to oversee compliance training for the staff.  The big issue with this option for most sector specialists or industry consultants is the cost.
  2. Join a regulated platform:  Another option would be for licensed analysts from a sector specialist or industry consultant to join a regulated platform which would provide them with all the compliance oversight inherent in a broker-dealer or investment adviser.  Analysts could either decide to work for such a firm on a full-time basis, or they could have their licenses registered with the broker-dealer.  If they decide on this second approach, the analysts would publish their research as part of this registered relationship, and they would then be subject to the compliance policies and procedures and ongoing oversight of the broker-dealer.  It is important to note that a broker-dealer that accepts this type of arrangement accepts the legal liability of overseeing the analyst’s regulatory compliance.  Of course, this option only works for a licensed analyst and the analyst is likely to have to share a portion of the revenue generated from their research with the broker-dealer for the services provided.
  3. Hire an outsourced compliance provider:  A third option would be to hire a third-party compliance provider.  This firm could develop a research firm’s policies and procedures, oversee the firm’s day-to-day compliance processes, implement any training required for the research provider’s staff, and would act as the research provider’s compliance officer.  Besides the cost of this outsourced solution, the big drawback of this option is that some asset managers may not feel this provides enough protection from potential risky information.  However, we suspect that an asset manager’s ultimate comfort would depend on the professionalism of the compliance provider.  
  4. Get audited:  Besides the above options, some research providers might also find it useful to have their compliance policies, procedures and practices audited by an objective third-party.  Providing these audits to buy-side clients might increase their level of comfort that they can use the research providers’ services with confidence.  Integrity Research provides this type of compliance audits of research firms.

 

Integrity’s Take

As we mentioned earlier in this article, many buy-side investors have become nervous that they might receive MNPI or confidential information from the third-party research firms they use.  As a result, firms have taken a wide range of steps to protect themselves – from having research firms sign extensive reps and warrantees, conducting due diligence of the research providers they use, and implementing new internal procedures for the use of third-party research. 

However, the fear that they might be provided with inappropriate information has led some asset managers to limit their use of a variety of different types of research, including expert networks, channel check providers, fundamental sector specialists, and industry consultants.  Ultimately, we believe that these research firms need to come up with a strategy to help their clients to feel comfortable about using their research.

For more information about the various options discussed above, and potential providers of these services, please contact Michael Mayhew at Michael.Mayhew@integrity-research.com or call me directly at 646-786-6859.

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