The following is a guest article by Susan Mathews, Principal & Founder of Madigail Consulting, LLC a securities compliance consultant providing research and ethics compliance, training and external CCO services to Wall Street entities. Susan was previously an Enforcement Attorney at the SEC and was the Regulator Liaison for the independent research portion of the SEC’s Global Research Analyst Settlement.
As a former enforcement attorney, I have encountered an increasing number of compliance issues related to expert networks (ENs). Although regulators have lessened their scrutiny of these entities, the proliferation of new expert networks and concomitant potential for violative conduct is on the rise. This article explores some of the most salient risks that expert networks currently pose.
Flawed Incentives Lead to Poor Experts
EN incentive structures have created challenging issues for compliance and clients alike. Although most ENs have in place compliance basics, they have created new problems with skewed incentives and inexperienced employees.
A core problem is that ENs are paying experts exorbitant fees, as high as $1,500 per hour or per call. ENs tend to pay their experts a minimum, regardless of the actual amount of time a call takes and regardless of whether a client found the call helpful. In many cases, clients are required to pay for either 30 or 60 minutes, even if they do not communicate with the expert for the allotted time or if they found the expert lacking. Moreover, ENs have created a higher “premium” level of expert based on their seniority in a business or their experience, thereby allowing the EN to charge higher rates for their “premium” experts’ time.
High fees have led to an influx of supposed “experts” who ultimately do not satisfy the client’s needs. Because agreeing to work with an EN is so lucrative, many experts function as “professional experts” after creating LLCs in which to funnel their EN earnings. In some cases, the LLC’s formed by these professional experts sound similar enough to other companies in the industry to be misleading about the expert’s true job function and level of firsthand knowledge.
The EN fee bonanza has attracted many experts who do not have firsthand knowledge of the issues of interest to EN clients. Rather, they are often “industry experts”- – professors, retired professionals or consultants who advise clients in a certain industry. Although this type of expert can help with gaining a general understanding of an industry, they are not the experts who have their feet on the ground, actually witnessing events firsthand.
Recruiters Reinforce Problems
Compounding the difficulty of finding appropriate experts is a skewed recruiter incentive structure. EN staff who are hired to recruit experts have a very challenging job because they are often new to the securities industry and do not have the requisite knowledge to understand a potential expert’s actual expertise. At the beginning of a project, EN recruiters are often presented with a list of questions that the client is hoping can be addressed by the EN’s experts. Many recruiters simply forward these questions directly to prospective experts and accept the experts’ representations that s/he has the requisite expertise to satisfactorily educate the investor client.
Some ENs do not cross-check an expert’s self-reported education, employment, or current position with publicly available information. I have compared the self-reported information from many EN experts with their LinkedIn profiles and they are often very different. Prospective experts often exaggerate their areas of expertise because they want to earn the EN fee.
Moreover, in many cases, EN recruiters are incentivized to ignore contradictory background information because they are compensated based on how many experts they can recruit and how many expert calls they set up. I have chaperoned many calls during which the expert attempts to cover up his/her lack of firsthand knowledge by speaking in general terms and using phrases such as “I’ve seen,” or “I’ve heard.” It takes a very skilled analyst to drill down to what firsthand knowledge the expert actually has. Thus, many EN clients are finding that their scheduled calls with experts are a waste of time.
Weak Training and Screening Questions
Even ENs with the most stringent compliance frameworks are reticent to require what I would consider comprehensive training or screening questions, for fear that they will be unable to attract good experts. Most experts are reluctant to go through time-consuming training or long lists of questions. Consequently, EN training is usually a very basic tutorial on what might constitute confidential information.
ENs are reticent to share with their clients explicit details about their training of experts, as this is viewed as “proprietary.” However, my review of what ENs are willing to share revealed a shockingly poor attempt at explaining material inside information and confidentiality obligations. Compliance screening questions are typically structured as a simple “yes” or “no” answers rather than requiring more complete responses. The “real life” examples are basic enough for a grade-school student to guess correctly.
Compounding the lack of training and inability to apply comprehensive screening questions is the current practice of ENs obtaining “consent” from a company’s Human Resources department (HR), rather than legal or compliance. Many clients demand reassurance that an employee has permission to participate in EN calls prior to speaking with that expert. However, most ENs view this consent requirement as a barrier to growing their networks’ roster. In fact, EN recruiters contend that most experts refuse to obtain this consent. To work around this deterrent, ENs either pose the question directly to the expert (“Do you have consent to participate in an EN?” Yes or No?) or accept an email from HR. Neither method constitutes effective consent and would prove to be an inadequate defense were the client or EN to be scrutinized by a regulator.
I have found that many ENs have remarkably insufficient tools to allow compliance or legal officers to ensure information exchanges with experts do not contain confidential or proprietary information. In some cases, ENs require compliance to either chaperone ALL calls with an expert or NONE. This confines compliance in an irrational way. If an expert is new to the EN system, compliance might want to chaperone the first few calls until reaching a comfort level with that expert. Or, compliance might want to randomly join in any call without having to inform the EN or analyst beforehand.
Additionally, most EN portals have inadequate communication channels for compliance or legal chaperones. For example, most ENs allow compliance to either summarily reject or accept an expert prior to scheduling an analyst call; there is typically no allowance for provisional approvals of experts. I have screened many experts who have red flags that I want to highlight for the analyst before the call so the analyst can steer clear of certain topics or obtain clarification from the expert, but the red flags do not rise to the level of an outright rejection of the expert. For example, an expert might be an active officer of an industry association or may consult for public company clients. Although I would not outright reject such an expert, I would like to alert the analyst to these issues and have a documented record in the EN portal to indicate that the analyst clarified these issues or compliance chaperoned the call and noted clarifications. However, most ENs do not offer these options. Moreover, recruiters often question expert rejections by compliance because they reflect poorly on the recruiter and effect the recruiter’s ability to be promoted or receive a bonus.
If chaperoning a call, EN portals should provide a seamless way for compliance to instant message the parties on the call to obtain clarification of a compliance or legal-related issue while the expert is still on the call. When compliance is listening on a call, experts often become nervous if compliance verbally interrupts the call, which results in the expert being overly-cautious and not as forthcoming with salient information. To more effectively address tricky gray issues, ENs should provide ways compliance can better communicate with analysts without disrupting a call.
The expert network industry is becoming more competitive as new entrants have flooded into the space, attracted by the high profit margins of incumbents. A recent survey by Integrity Research and Inex One found 110 active expert networks – – nearly triple the population of ENs prior to the insider trading scandals. As a result of the influx of new entrants, there is a concern that compliance standards will suffer.
Consequently, many hedge funds and banks are bringing expert consultations in-house by internally creating their own rosters of experts – – bypassing the need to use an external EN. In this way, analysts can be sure they are talking to appropriate experts with firsthand knowledge and develop a rapport with the experts upon whom they depend for accurate primary research.