SEC Reaffirms Expert Networks Okay

1

New York – In a broad ranging speech to investment advisers, Carlo di Florio, Director of Compliance Inspections and Examinations at the SEC, discussed a number of issues relating to new regulations, registration guidelines for IAs, and finally some recent enforcement cases. The venue was the Annual IA Compliance Best Practices Seminar held in Washington by IA Watch (March21, 2011). While the body of the speech deals with the intricacies of navigating Dodd Frank and improving compliance, the final section has extremely relevant information for the expert network community.

It’s Not the Model

Mr. di Folorio commented on the “Expert Network” insider trading cases stating “I believe these cases do not represent some inherent hostility by the Commission toward expert networks, nor do they indicate that the Commission is seeking to undermine the mosaic theory.” What is targeted by these proceedings is the exchange of insider information, breach of fiduciary responsibilities to employers or other confidentiality agreements the expert may have.

In fact, Mr. di Folorio says that the use of expert networks, or information networks in general, is an important part of the investment research process. Having said that, though, he indicated that there is a clear responsibility on the part of the investment advisors to have strong internal policies and procedures that address the exchange of material non-public information between the expert and the investor, advisor or asset manager.

Mr. di Folorio highlighted what he called front-end and back-end controls, which are a helpful construct. However, it may be more instructive to think about the information exchange as a “trade” of information.  In this construct there are pre-trade controls, trade controls and post-trade controls that need to be examined by the asset manager.

“Pre-Trade” Controls

The pre-trade elements might include having the IA acknowledge and attest to the insider trading polices of the investment adviser before setting up a conversation, reviewing the policies and procedures of the expert networks, and perhaps applying internal screening procedures that, for example, prohibit the use of public company employees.  Of course, there is a large body of more specific prohibitions that might apply, but these should be well established and agreed to by the asset manager and the expert network prior to conversations.

“Trade” Controls

In every case we are aware of, the trade of information between the expert and the investor is a private conversation.  As has been mooted by us and others on several occasions, perhaps there should be some degree of intervention in these conversations. This could be achieved by announcing that they would be randomly taped, or, even better, that a compliance professional would be passively involved in at least a sampling of conversations to ensure that material nonpublic information was not being exchanged.

“Post-Trade” Controls

Mr. di Folorio also suggested that the auditing of an information exchange could include “testing trading”.  This would be an analysis of the time-stamped tickets of the investor post-conversation and their proximity to major corporate events, such as earnings announcements, press releases, or other significant events affecting the corporation.

Integrity Interpretation

We have previously reported that it is becoming clearer that US regulators have no specific concern about mosaic theory or the use of expert networks.  However, compliance officers are generally more conservative in their views of potential abuses than other market participants: and SEC compliance professionals are about as conservative as they come.  As such, the endorsement of the mosaic theory and the exoneration of the expert network model in particular is a significant indication that the there is no intention by the regulators to actively undermine expert networks.  In fact, we suspect that the regulators understand that the alternative to formal expert networks would be for analysts and portfolio managers to develop their own ad hoc networks (what Raj Rajaratnam is accused of in the Galleon case), which would be much more difficult to police.

While the asset manager, investment adviser or investor has complete control over the administration of internal controls, they have to rely on self-reporting by the expert networks to assess what their written policies and procedures are.  Unfortunately, this level of due diligence won’t help them understand what the expert network’s practices are on a day to day basis, nor the compliance culture of the firm.  This might lead one to wonder if simple compliance policy reviews are strong enough to protect the asset manager from reputational (or even legal) risk.

 

Share.

About Author

1 Comment

Leave A Reply