Buy-Side Compliance Response to Research Providers

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New York, NY – Over the past few months, buy-side investors have responded in a number of ways to address concerns that the external research providers they use might introduce material non-public or confidential information into their investment process.  The following blog outlines these responses.

The insights included below are based on over three dozen meetings that the team at Integrity Research Associates has had over the past few months with General Counsel’s and Chief Compliance Officers at some of the largest mutual funds, hedge funds, and long only asset managers, as well as conversations we have had with a few dozen smaller money managers to discuss Integrity’s new research compliance services. 

During these meetings we have learned a great deal about what buy-side firms are currently doing to address their fears that external research providers might provide MNPI and confidential information to their analysts and portfolio managers.  In general, we have found that asset managers are taking four (4) different approaches to these concerns, including:

1.    Legal Response:  Most firms we have spoken with have recently developed extensive Representations and Warrantees for research providers to sign prohibiting them from providing clients with MNPI, confidential information, and covering other topics of concern.  However, it is important to understand that according to regulators we have spoken with, this step in and of itself, provides minimal protection to an asset manager, as private contractual provisions do not insulate an entity from liability.

2.    Enhance Internal Policies & Procedures:  Most asset managerss we have spoken with have also hired outside counsel to help them develop new policies and procedures around how they use expert networks.  Some of these policies address issues such as:    

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    • Evaluating the controls in place at the expert networks;
    • Restricting consultations with employees at public companies;
    • Or if they don’t do this, then they require “employers consents” from employees to participate in expert engagements; 
    • Pre-approving all questions and topics the company wants to cover with the expert;
    • A more controversial policy is that of chaperoning conversations between an expert and the adviser’s staff.  Some asset managers believe this increases a firm’s liability as their compliance staff could easily miss the communication of important confidential information;
    • Obtaining meaningful certifications from the asset manager’s staff who utilize expert networks that they understand and will not trade or pass insider information.  During our conversations with the SEC they pointed out that to be meaningful, the certifications have to explain in painful detail what kinds of confidential information might be revealed  and what kinds of info might be material- – they cannot just be a declarative statement
    • Identifying any trades made by the asset manager following a conversation with an expert, and testing some of those trades against publicly available information, 
    • Monitoring personal trading by an asset manager’s staff who may have access to material nonpublic information.

3.    Due Diligence:  Some firms we have spoken with have developed multi-functional teams to conduct due diligence of the compliance policies and procedures of their external research providers.  This would include:

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    • Reviewing a firm’s research;
    • Reviewing a provider’s written policies and procedures through the use of standard questionnaires.  It is important to note that it is not sufficient to rely on a research provider’s responses to questionnaires or written policies, as these reveal nothing about actual practices and do not reduce your risk just because you have these papers in your files.  This was clearly evident from the Primary Global case which had reasonable policies on paper.
    • Interview the firm’s CCO.  It is our experience that the only way to truly get a sense of whether a provider actually practices compliance is through interviews at many different levels  – – not just relying on the word of the compliance officer;
    • Some of the asset managers we have spoken with conduct due diligence on all their providers, while other firms focus primarily on their “high risk” firms.  In fact, we have worked with a few asset managers to help them develop a “risk based” approach to identifying the most risky firms to conduct due diligence on.

4.    Nothing:  A large number of asset managers have decided to do little to nothing, relying on the fact that they don’t use expert networks, and they get most of their external research from registered broker-dealers.  Many of these firms tend to be smaller hedge funds and asset managers with limited internal compliance resources.

 Of course, the firms that have the most well developed programs to mitigate the risk of using external research providers do a combination of developing new internal policies and procedures; rolling out new Reps and Warrantees for all their external research vendors; and conducting extensive due diligence on the research providers they use.  The number of firms that do all these things is relatively small.

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  1. Rx for Expert Networks
    What hedge funds can do to minimize insider trading risk

    Funds that use expert networks to provide their research analysts with specialized company and industry intelligence constantly face the risk that some of the information so obtained is both material and non-public and cannot therefore be used in trading.

    Funds have reduced this risk by prohibiting their analysts from speaking to employees of public companies about their employers and, in some cases, by reminding all the experts they consult that they must not divulge any information they are duty-bound to keep confidential.

    Nevertheless, there is no foolproof way to prevent someone with material, non-public information from passing it on to someone eager to trade on it. It is also generally impossible for fund lawyers or compliance personnel to monitor every research call with an outside expert. As a result, probably the best a fund can do to minimize the risk of its trading on insider information provided by outside experts is to (i) tape record all expert calls (where legal to do so) and (ii) advise its portfolio managers and research analysts that any trade that closely predates a corporate earnings or deal announcement that was influenced in any way by an outside expert consultation will be investigated by compliance and that the investigation will include a review of the taped calls and an interrogation of the expert or experts consulted in connection with the trade. The same warning should be given in writing to each outside expert prior to his or her engagement by the fund so that both sides of every call are on notice that the transmission of material, non-public information between them is ultimately discoverable.

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