New York, NY – On September 29th, 2011 SIFMA released a set of “best practices” to provide guidance to its members on how they might engage expert networks and their associated consultants who provide information that could be useful in developing investment views and in making investment decisions. While these recommendations are targeted at registered broker-dealers’ use of expert networks, some asset managers might also find these “best practices” to be useful in managing their use of expert networks, or in their hiring of individual “consultants” to support their analysts and portfolio managers.
Application to All Broker-Dealers?
One of the most interesting aspects of these “best practices” was included in the introductory paragraphs leading up to the specific recommendations. In the third paragraph of this document, SIFMA explains:
“Finally, firms should consider whether these suggested best practices may have applicability to situations where firms have direct relationships with Consultants.”
In our view, this is a clear acknowledgement by SIFMA that a broker-dealer’s use of “consultants” could be seen to be no different than a firm’s use of an expert network to find specific consultants. This is particularly interesting because a limited number of broker-dealers use actual “expert networks” (most tend to use them in their investment banking groups). However, a large majority of broker-dealers hire consultants directly.
Core Assessment; Policies and Procedures
The first recommendation SIFMA makes to member firms is that they should develop policies and implement procedures for the use of expert networks and the consultants they are provided through these networks.
While the remainder of the best practices document addresses some of these policies and procedures, it does not go into great detail about the specific policies and procedures that might be helpful in mitigating the risk of using expert networks.
In this set of “best practices”, SIFMA also recommends that member firms provide training for both their users of expert networks, and the consultants they are provided through these networks. This training is supposed to focus on the firm’s policies and procedures for expert network use. In addition, this training could cover confidential information, insider trading laws, material nonpublic information, and conflicts of interest.
It is interesting to note that SIFMA thinks that its member firms should train the consultants it uses in addition to its own staff. We suspect this reflects SIFMA’s concerns that individual consultants are not receiving sufficient training and/or reminders about what kind of information they should or should not communicate to their clients.
Role of Firm Supervision
SIFMA also makes it clear that member firms that use expert networks should develop systems to provide supervisory oversight of their use of expert networks and the consultants engaged through these networks. The supervisors need to address and/or escalate any issues that arise between their users, the expert networks, and the specific consultants they engage.
While this is not specifically addressed, it would seem logical that part of this supervision might include prior supervisory approval before contacting any specific consultant. Another relevant procedure might be sporadic monitoring of specific calls between internal users and consultants. A number of buy-side firms have chosen not to implement such a process as they fear that they won’t be knowledgeable enough about the topic or industry to be able to determine if inappropriate information were being passed during the calls.
Firm Monitoring and Oversight
In addition, SIFMA has recommended that member firms develop and implement procedures to monitor and test their usage of expert networks to determine if certain “red flags” are triggered which could suggest potential risk to the firm. Some of the “red flags” identified include excessive payments to specific expert networks; over reliance on specific consultants; or the failure of an expert network to follow its own policies and procedures. In addition, SIFMA suggests that member firms might want to consider performing due diligence reviews on the expert networks they use or on their control persons.
It is interesting that SIFMA recommends that broker-dealers that use expert networks perform this type of monitoring and testing of their own usage. Integrity Research has found that only a few of the largest expert networks do this this kind of monitoring and testing of their clients’ use of their networks – an aspect of most expert networks’ compliance platforms that we have found to be weak.
Agreement Between the Firm and Expert Networks; Recommended Terms
SIFMA also recommends that member firms have written agreements in place with the expert networks they use which include a number of terms and conditions, like i.) a requirement that the Expert Network conducts a minimum level of due diligence on the experts provided; ii.) a written prohibition that consultants will not disclose MNPI or confidential information, or that they will not violate any terms of employment or contractual obligations they might have with customers; iii.) periodic training of consultants; iv.) regular certification by consultants that they will abide by these restrictions.
For the most part, the recommended contractual terms with the expert networks don’t appear to be terribly unreasonable. It is interesting to note that in the past, few expert networks did any significant amount of background checking on the consultants in their networks. Fortunately, the recommendation that expert networks check their consultants “for securities law violations and for certain other relevant factors” is certainly more workable than a more comprehensive “background check”.
Advising Consultants of Firm Policies
SIFMA also recommends that member firms develop procedures to enable them to directly inform the consultants they engage through the expert networks about their policies regarding the use of MNPI and Confidential Information before any new engagement is initiated with a Consultant.
Fortunately, most expert networks have systems in place which enable them to add a client’s policies and procedures directly to an invitation to engage in a consultation with the firm.
Additional Firm Policies and Controls
Lastly, SIFMA recommends that member firms should develop procedures so they can determine if Consultants they are considering to use might have Confidential or Material Non-Public Information through employment or consulting arrangements they have been involved in, and what controls they need to establish to mitigate the risk of receiving this type of inappropriate information from these Consultants.
None of the “best practices” provided by SIFMA to their members regarding the use of expert networks is particularly surprising or unreasonable.
Clearly, the good news for expert network providers is that SIFMA, by providing these “best practices” is acknowledging that the use of expert networks by their members is an acceptable practice.
It is also important that SIFMA has suggested that these “best practices” might also be relevant to the majority of broker-dealers that engage consultants directly rather than through an expert network. We think this is likely to have the greatest impact on broker-dealers, as many firms have historically engaged consultants directly. We also suspect that few broker-dealers have developed the compliance oversight to address the risks of receiving MNPI and confidential information from the direct relationships they have had with consultants in the past.
The following is the full text of SIFMA’s recommended “best practices” for using expert networks.
Best Practices for Use of Expert Networks
These best practices have been developed by SIFMA member firms (“firms”) to provide guidance to broker-dealers on engaging and interacting with Expert Networks and their associated Consultants who provide information that might be useful in the formulation of investment views and in making investment decisions. SIFMA does not believe that there have been any recent changes to permissible information usage and the insider trading laws, including the well-recognized materiality thresholds and “mosaic theory.” Both continue to be regularly applied by the courts in analyzing the permissible use of nonpublic information. SIFMA believes the recent increased enforcement focus on the use of expert networks warrants the development and suggestion of these best practices for SIFMA member firms.
For purposes of this document, “Expert Networks” are defined as entities that refer paid industry professionals (“Consultants”) to third parties for a fee. Such Consultants provide such third parties with information, advice, analysis, market expertise, or industry expertise for use in formulating investment views and in making investment decisions. “Confidential Information” is defined as any non-public information that is covered by a confidentiality agreement or otherwise subject to a fiduciary (or similar) duty that would prohibit its disclosure. “Material Non-public Information” (“MNPI”) has the meaning under the federal securities laws as applied by court of relevant jurisdiction.
Finally, firms should consider whether these suggested best practices may have applicability to situations where firms have direct relationships with Consultants. Further, these best practices are intended only to provide guidance to SIFMA member firms, and do not in any way dictate how firms must interact with Expert Networks and Consultants.
1.) Core Assessment; Policies and Procedures. Firms that use Expert Networks should develop policies and implement procedures concerning the use of Expert Networks and the Consultants identified by the Expert Networks. The policies and procedures may employ – or may result from – a risk-based approach to determine what controls are appropriate to adequately address each firm’s particular use of Expert Networks. This assessment would be relevant and applicable to all the points that follow in this Best Practices guidance.
2.) Training. Firms should provide training for their associated persons who interact with Expert Networks and the Consultants identified by the Expert Networks. The training should focus on policies and procedures concerning the use of Expert Networks and such Consultants. The training may be presented separately or as part of broader training on the laws of insider trading, Confidential Information, MNPI, information barriers, and conflicts of interest.
3.) Role of Firm Supervision. Firms’ systems of supervisory oversight should be designed with a view of securing an understanding of such firm’s use of Expert Networks and their associated Consultants. Such oversight may be part of a firm’s existing supervisory systems or a new system. In addition, relevant supervisors should be specifically aware of the firm’s relationships with Expert Networks and Consultants and should address and/or escalate any material issues that may arise in the course of the overall arrangement or any specific engagement.
4.) Firm Monitoring and Oversight. Firms should develop policies and procedures, or supplement existing policies and procedures, as necessary, that require firms to escalate for review and take appropriate action on “red flags” that become known to the firm that may be indicative of, or give rise to increased risk of, concerns of conflicts of interest and disclosure of Confidential Information or MNPI. For illustrative purposes, some examples may include: excessive compensation to particular Expert Networks; over-dependence on specific Consultants; failure of an Expert Network to adhere to its own policies or procedures or provide requested information; or similar indications. Firms may also choose to perform due diligence reviews of the Expert Network and/or its control persons that may include OFAC reviews.
5.) Agreement Between the Firm and Expert Networks; Recommended Terms. Firms should favor written agreements with Expert Networks when those arrangements are of a repeating and/or substantial nature. Firms should consider requesting certain representations from Expert Networks through such agreements or other undertakings that may include: (i) requiring the Expert Network to assess Consultants’ backgrounds for securities law violations and for certain other relevant factors before retaining the Consultants as part of the Expert Network; (ii) prohibiting Consultants from disclosing Confidential Information or MNPI, violating any terms of employment to which the Consultant is subject regarding communication of information to third parties, or otherwise violating any contractual obligation or law in providing consulting services; (iii) requiring periodic training of, and/or communication to, Consultants regarding the above restrictions; and (iv) requiring periodic certification by Consultants of their adherence to the above restrictions. Firms may choose to accept the incorporation of the Expert Network’s policies and procedures into any agreement or undertaking. The written agreements between the firm and Expert Network should be kept in accordance with firm document retention policies.
6.) Advising Consultants of Firm Policies. Firms should develop procedures, on a risk-assessed basis, for directly advising Consultants associated with Expert Networks on such firm’s policies regarding the use of MNPI and Confidential Information, at the outset of any new engagement of such Consultant.
7.) Additional Firm Policies and Controls. Firms should develop procedures for obtaining from the Expert Network or an associated Consultant, relevant and non-confidential information regarding any employment and/or other arrangements whereby the Consultant may have access to MNPI and Confidential Information (consistent with applicable legal restrictions). Firms should determine, on a risk-assessed basis, what controls are appropriate to adequately address risks of interacting with Consultants associated with Expert Networks that possess Confidential Information and/or MNPI (current or recent employees of public companies; known significant suppliers, distributors, etc. to public companies; attorneys, accountants and consultants engaged by public companies; doctors serving on Data Safety Monitoring Boards for clinical trials).