New York – On January 31st, the Managed Funds Association (MFA), a hedge fund lobbying group, asked the Securities and Exchange Commission for guidance on using “expert networks,” a business that has been under scrutiny after a series of arrests linked to an investigation of insider trading. Expert network firms connect investors with individuals that have specialized information within the scope of the investor’s request. The ongoing investigation into the Galleon Group’s insider trading violations, centered on expert network Primary Global Research in the fall, prompting hedge funds to question whether there was any safe way to use these research resources.
Richard Baker, president of the MFA, said “Our industry would like to know where the sidelines are right now so that we can stay well within them. The trouble is the referees aren’t quite clear where those lines are right now.” The organization has about 3,000 members in the so-called alternative investments industry, which includes hedge funds and fund of funds.
The expert network firms say they have strict rules regarding the disclosure of nonpublic information between consultants in their networks and their clients. In our 2009 review of the expert network space, we took a look at of some of the more complete policies and procedures posted on the expert network websites. The documents, among other things, establish rules for information exchange, force experts to reaffirm their ability to consult prior to each new project and allow for users to include specific prohibitions as to what is and what is not allowable in terms of expert selection. Of course, a complete policies and procedures document can be ineffective, unless there is a high degree of commitment, process and follow through that accompanies the policies.
In a recent blog post, Integrity reported on a survey conducted by the TABB Group, a consulting firm focused on financial markets, which conducted a survey of 112 institutional equity market participants, including individuals from investment management companies, hedge funds, brokers, exchanges, advisory firms, and regulators during the week of December 22, 2010. One of the more striking results of the study was the fact that 78% of those surveyed said the compliance controls at expert network firms were not sufficient to prevent violations.
Subsequent to the verbal request for greater clarity on expert network usage, the MFA invited a senior SEC official to address its membership on insider-trading law and the so-called mosaic theory of investing, in which investors piece together bits of information to build the basis for a trade. No news yet on whether anyone has accepted.
There is an excruciating amount of uncertainty in the hedge fund community about what is onside or offside with respect to expert network usage. Yet, it is also clear that hedge funds believe the use of expert networks is a vital part of their investment process. In this context, we certainly understand the motivation for the statements the MFA has been making. However, there is an obvious risk to being vocal in this environment. “Be careful what you wish for – you might just get it”.
We don’t expect the SEC to shoot from the hip on this issue. They have a long laundry list of regulatory implementations to work through relating to the Dodd-Frank legislation, such as getting a grip on municipal securities markets, setting tighter registration criteria for investment advisers and dealers, and getting the over–the-counter swaps market onto Swap Execution Facilities (trading platforms) or exchanges to name a few. These are not small tasks and the SEC’s band width has been stretched both in terms of staffing and budget. Perhaps this is not the best time for the MFA to waving “me first” to the Securities Exchange Commission.