New York, NY – Late last week, an article in the Wall Street Journal revealed that federal authorities are preparing explosive new charges against a wide range of market participants which could expose a “culture of pervasive insider trading in the U.S. financial markets”, capping a three year investigation into the matter. One part of this investigation is purportedly whether nonpublic information was provided to hedge fund and mutual fund investors by independent analysts and consultants that were introduced to them through expert networks, and other boutique research providers.
The Explosive New Case
The upcoming case could be extremely widespread. According to the WSJ article, “The criminal and civil probes, which authorities say could eclipse the impact on the financial industry of any previous such investigation, are examining whether multiple insider-trading rings reaped illegal profits totaling tens of millions of dollars, the people say. Some charges could be brought before year-end, they say.”
The likely charges stem from investigations by Manhattan U.S. Attorney Preet Bharara who has publically stated that his office is focusing on potential insider trading abuses. In addition, over the past few years, the SEC has been investigating potential leaks on M&A deals going back to at least 2007. Last fall, the SEC sent subpoenas to more than 30 hedge funds and other investors as part of this probe.
The WSJ article mentioned a range of firms that are being examined by New York federal prosecutors, the FBI and the SEC, including Mountain View California-based expert network Primary Global Research; Portland Oregon-based research boutique Broadband Research; investment bank Goldman Sachs; and broker-dealer First New York Securities, LLC.
Click here to read more details about the pending investigation.
Past Related Developments
This investigation follows closely on the heels of the SEC’s insider trading charges in early November, 2010 against Dr. Yves Benhamou for warning a FrontPoint Partners portfolio manager about negative developments with clinical drug trials of potential hepatitis treatment, Albuferon. Based on this tip, FrontPoint sold its shares of Human Genome Sciences shares before this information was made public, allowing it to avoid a $30 million loss. FrontPoint allegedly used expert network GuidePoint Global to get access to Dr. Benhamou, though it also likely that Dr. Benhamou signed Terms and Conditions prohibiting him from discussing the details of any clinical trials he was involved in with clients.
In October of 2009, billionaire founder of hedge fund the Galleon Group, Raj Rajaratnam, as well as five others was charged with using inside information about a wide range of public companies to make investments that earned them $60 million in profits. Eventually 19 traders, lawyers and executives were included in this case. While Galleon used a number of expert networks, this case focuses on information Raj Rajaratnam supposedly gathered from his own network of contacts.
In 2007, the New York Attorney General issued subpoenas to expert networks Gerson Lehrman Group and Vista Research, as well as to hedge funds clients of the two firms. The focus of the investigation was to determine whether “experts” who were current and former employees at public companies had disclosed material nonpublic information to investors. No official charges were ever brought against the two expert networks or their hedge fund clients as a result of this investigation.
In August of 2005, the Seattle Times published an article which revealed an investigation which found at least 26 cases in which doctors had leaked confidential details about their ongoing drug trials to Wall Street firms. The Seattle Times reported that although a few of these leaks came from sell-side research, some leaks came as a result of the use of expert networks.
How Much is Enough?
It is important for readers to understand that the expert network industry has come a long way since the initial Seattle Times article appeared in 2005. In fact, many of the largest expert networks in the business, including Gerson Lehrman, Guidepoint Global, and Coleman Research have invested millions of dollars into developing and maintaining state of the art compliance systems to help clients manage their compliance risks. In fact, even some boutique firms like Primary Insight have seen the commercial importance of developing sophisticated compliance tools for clients.
However, some industry observers argue that expert networks are not doing enough to limit investors’ ability to collect material nonpublic information from their networks. Based on the work we have done in evaluating firms’ compliance practices in the past, we think many expert networks are already doing quite a bit in this regard. The following are a few of the steps that the leading expert networks take to keep this kind of information from being communicated.
Terms and Conditions – Almost every commercial expert network we know of has their experts sign “Terms and Conditions” which clearly outlines what experts can and cannot speak about in their engagements with clients. As mentioned before, GuidePoint’s Terms and Condition clearly prohibited experts like Dr. Benhamou from sharing the developments from the clinical trials he was involved in with clients.
Restrictions on Speaking with Public Company Employees – Every expert network we have evaluated prohibits investors from speaking with employees of the public companies that they are considering (or have already) an investment in. A few expert networks have gone even farther by prohibiting investors from speaking with employees of any public companies through their networks. Unfortunately, the Galleon case shows that many people who are not employees also might have material nonpublic information.
Expert Training – Many expert networks require their experts (and in a few cases even their clients) to undergo training on a periodic basis to highlight what they can and cannot talk about with expert network users.
Positive Affirmations – Many expert networks require that their experts proactively agree to their Terms and Conditions annually or in some cases immediately prior to being hired for any engagements, thereby addressing the possibility that an expert has forgotten the rules of engagement.
Do Not Call List – A few expert networks maintain a list of public companies that have requested in writing that those networks not contact their employees for expert engagements. Only one company we know of (GLG) actively reaches out to public companies to determine what their policies are regarding employees participating in outside consultations, and bars employees from companies that prohibit such activity from engaging with clients.
Custom Compliance Rules – Many expert networks provide clients with the ability to implement custom compliance requirements on a client-by-client basis. In other words, these firms can restrict the experts they provide to investors based on the clients’ requirements, rather than forcing the client to adopt the firms general compliance rules.
Compliance Dashboard – A few expert networks also have developed sophisticated software tools that enable compliance officers at hedge funds and mutual funds to have considerable control over the types of experts their analysts and portfolio managers can see. Not only will these systems enable a compliance officer to see a history of all experts used by that firm, but these systems can enable compliance officers to have the ability to prohibit or allow their users to get access to specific experts.
In fact, the only major compliance capability that we can think of that expert networks have not offered their clients is the ability to have their calls recorded and archived (like what is required for sell-side brokers). Interestingly, a few expert networks provided this capability to clients in the past, only to have this feature consistently rejected.
Based on this analysis, we are hard pressed to conclude that expert networks in general are not doing enough to keep material nonpublic information from being communicated to investors. However, we need to make the disclaimer that not all expert networks are equally committed to providing state of the art compliance systems to their clients.
A Better Option?
As you can see from the information provided above, expert networks have been cited numerous times in the past few years as potentially being involved in facilitating investors’ access to material nonpublic information. However, we are convinced that the financial markets are better off using “best of breed” expert networks than without them.
One perfect example is the Galleon case. In this case, Raj Rajaratnam is accused of investing on material nonpublic information gathered from a series of company executives, consultants, accountants, and other experts that he had developed personal relationships with throughout his career. In other words, he had used his own personal network, not a commercial expert network.
Alternatively, Mr. Rajaratnam could have used a well-developed third-party expert network like Gerson Lehrman or Coleman Research to identify potential experts to speak with. However, if he had done so, Coleman or GLG would have had a complete audit trail of the experts he had spoken to, when he had spoken with them, the basic topic he had spoken to them about, and how much he had paid them. In other words, the regulators would have easily been able to access these records and make whatever case it needed to.
The upcoming insider trading charges by the US Attorney General and SEC are likely to have a huge impact on the financial markets and how institutional investors conduct their research. In this article, we are not trying to make any comments about the substance of the accusations. However, we wonder if the focus on expert networks is a fair characterization of how this widely used research tool is typically used.
As we mentioned before, not all expert networks are created equally when it comes to the sophistication of their compliance systems. Despite this fact, we would rather have investors using an expert network that has a well developed compliance framework than use their own personal networks of contacts where they don’t worry about compliance at all.