New York – As everyone knows at this point, the hedge fund industry is under siege. The assertion is that hedge funds are benefiting from material non-public information. Investigations are turning to the sources of information that hedge funds typically utilize, including expert networks and channel checkers. As the popular media has a feeding frenzy over this issue, the risk is clearly that we throw the baby (primary research) out with the bathwater (malfeasance).
In recent comments, the SEC noted: “We at the SEC are committed to pulling back the curtain on hedge fund operations and taking a close look at their activity. We are developing a variety of initiatives to do that involving greater specialization and expertise, improved technological tools to track and analyze trading, better coordination among regulators and law enforcement, new legislative initiatives, and other means to address these areas.”
“It would be wise for investment advisers and corporate executives to closely look at today’s case, their own internal operations, and the increasing focus and scrutiny on hedge fund trading activity by the SEC and others, and consider what lessons can be learned and applied to their own operations.”
The term insider trading seems to be synonymous with malfeasance in recent press coverage. To be clear, however, insider trading is not illegal. Insiders trade almost continuously. Illegal insider trading is defined by the SEC as: “Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information.”
In other words the information itself is not illegal. The possession of the information is not illegal. It is the trading upon that information that makes it illegal. Expert networks are a vehicle for hedge funds, mutual funds and investment banks to glean an informational edge on their competition. To the extent that there are leaks of material non-public information to a money manager that is traded on, it must be prosecuted.
That being said, it is also foolhardy to make any significant investment without sufficient research. It is research that makes markets more efficient and has an important role in price discovery. By our definition, primary research includes (but is not limited to) expert networks. Expert networks have been a central aspect of investment research for decades. The information gained is one way for an investor to get information about corporation that is not provided by the management of that corporation. In this sense primary research provides a counterbalance to relying on potentially biased information received from the corporation.
Indeed, if investors were unable to use expert networks, they would need to rely on their own network for research. As we have seen from the Galleon case relying on one’s own network can be even worse than relying on an expert network. As well, expert network systems generally provide an audit trail that can be helpful in investigations of, for example, illegal insider trading.
We believe that both investors and regulators would be better served through by a well-functioning expert network system that has adequate compliance policies, processes and systems to severely limit illegal insider trading from occurring across the network. In cases where investigations arise, the records of the expert network can provide critical evidence for both sides in the investigation.
In a near prescient move, Integrity Research published a ResearchFocus report on the expert network industry in November 2009. Within this 143 page document, extensive analysis of compliance covering the general attributes of policies, procedures and tools used in compliance: providing recommendations for compliance practices; and rating the expert networks by compliance polices, compliance practices and compliance tools, utilized by the major players in the space.
For more information about this report, please call Matt Bannister at 646 786 6851, or go to www.integrity-research.com/cms and follow the link for the ResearchFocus: Expert Networks report.