New York, NY – Over the past few months, as US Federal Authorities have continued one of the largest insider trading investigations in history, many institutional investors have become increasingly afraid of using expert network firms to conduct investment research. Since the start of this investigation, many on the buy-side have tried to get clarity from regulators about the use of expert networks. However, in recent public statements authorities have made a number of specific comments about the legitimacy of using expert networks – a development that has received very little coverage by the mainstream press.
February 3rd SEC Press Release
The first comment by federal authorities indicating what they thought about the use of expert networks came in a February 3rd Press Release where the SEC announced that they were bringing civil charges against three consultants and three employees of expert network firm Primary Global Research with insider trading for illegally tipping hedge funds and other investors to generate nearly $6 million in illicit gains.
“The charges stem from the SEC’s ongoing investigation into the activities of expert networks that purport to provide professional investment research to their clients. While it’s legal to obtain expert advice and analysis through expert networking arrangements, it’s illegal to trade on material nonpublic information obtained in violation of a duty to keep that information confidential.”
In other words, the SEC acknowledged that the use of expert networks to conduct legitimate research is perfectly legal. What was and is illegal is to collect and trade on material nonpublic information regardless of the way it is collected.
February 8th Press Conference
US Attorney for the Southern District of New York, Preet Bharara made a number of more pointed comments about expert networks at a press conference held on February 8th when a new round of insider trading charges were made against hedge fund professionals Samir Barai, Donald Longueuil, Noah Freeman, and Jason Pflaum.
Bharara explained, “The charging documents do not describe people engaged in legitimate market research or innocent channel checking or otherwise benign behavior. They allege hard- core insider trading and stock after stock after stock people boldly trafficking in still secret revenue numbers, gross margins, earnings per share, and other clearly material non-public information so that they could cheat their way to more and more profit.”
Later in the press conference, Bharara made an even more direct comment about the use of expert networks.
“Now let me begin by making something crystal clear. There is nothing inherently wrong with or bad about hedge funds or expert networking firms or aggressive market research for that matter. Nothing at all. But if you have galloped over the line, if you have repeatedly made a mockery of market rules, if you have converted a legitimate enterprise into an illegal racket then you have done something wrong and you will not get a pass.
If you made criminal activity your business model, then business as usual has to stop or the consequences, as dozens of defendants have now discovered will be severe. There are rules and there are laws and they apply to everyone. No one is above the law, and those who would excuse or rationalize, brazen criminal conduct of the type of alleged today, are neither friends of Wall Street nor allies of business and they are certainly not supporters of the investing public.”
The Director of the Securities and Exchange Commission’s Enforcement Division, Robert Khuzami also made a number of direct comments about the use of expert networks.
“Today’s actions are not a condemnation of all expert networking firms or the consultants who are associated with them who provide legitimate expertise and experience to assist investors in making investment decisions, but that is not what occurred in the events underlying today’s actions. We allege that the charges reveal thoroughly corrupt conduct through and through.”
Debate About Public Company Employees
Later in the press conference, during the question and answer period, both Bharara and Khuzami were grilled by an unidentified speaker about whether an expert network that uses public company employees was appropriate.
“I’d like to ask you, you or Mr. Khuzami – you both said in different words that there’s nothing inherently wrong with expert networking firms. When an expert networking firm uses an expert who is employed by a public company, it seems like even if the expert isn’t explicitly disclosing inside information, he’s disclosing expert advice that is informed by inside information. So, I guess I don’t understand why there isn’t something inherently wrong with using experts employed by public companies to inform a limited universe of investors with expert opinions if the broader investment community doesn’t have access to it.”
Bharara responded to this question by stating, “I’m not going to wade into the debate about what additional regulation or rules should be in place with respect to whether or not people who are employed … by companies are working at expert networking firms. What I did say was there’s nothing inherently wrong with a company that purports to be an expert networking firm and to arrange for conversations between traders, analysts, or hedge fund portfolio managers to speak with experts.
Regardless of whether it is okay or not in your view… for someone who is employed by a company and gets permission from that company to work for an expert networking firm, we have not in our criminal charges waded into… any gray area with respect to whether or not that information is informed by knowledge that that person has that was developed from employment at the public company. What we are alleging is people who were acting as consultants at the expert networking firm gave away specific, in advance, secret information about hard revenue numbers, earnings per share, and other information and whether or not there is some other area that would or would not have been appropriate, those are not addressed by our charges here today.”
Khuzami added his own views to the discussion about the use of expert networks that used employees of publicly traded companies as experts.
“The only thing I would add to that is if you engage an expert networking firm, you are wise to conduct due diligence, to determine whether or not public company employees are engaged as consultants, and if so, there are a variety of devices and practices, that have arisen, across Wall Street, and in many regulated entities, to ensure that material non-public information is not crossing the transom, and that you are not receiving it.
Do due diligence. Find out the nature of the information. You can monitor and chaperone calls. You can consult lawyers. You can do many things to make sure you are not obtaining material nonpublic information, but obviously if the employee is a public company employee, that is a higher risk factor.”
Integrity’s View of these Comments
It is clear to the team at Integrity Research Associates that US federal authorities wanted to make sure that everyone understood what was and what was not being deemed to be illegal by the insider trading arrests that had been made since the beginning of this investigation.
Preet Bharara and Robert Khuzami noted a number of times in their most recent press conference that the cases they had brought thus far were about fairly standard and obvious insider trading charges.
Even when a questioner tried to drag Bharara and Khuzami into a debate about whether expert networks that used public company employees should be banned or not, the two refused to take the bait. Instead, they openly admitted that their insider trading cases did not address this “gray area”, but they said that investors who used expert networks that engage public company employees as experts had a large number of practices they could adopt to protect themselves from obtaining material non-public information.
Both Bharara and Khuzami agreed that conducting channel checks and using expert networks to undertake legitimate investment research was perfectly legal. However, they also warned that experts who provided or sold material non-public information in violation of a duty were committing a crime. Bharara noted that, “whether or not it’s done through an expert networking firm or its done as a McDonalds, it really doesn’t matter.”