New York – The complaint against Don Ching Trang Chu, formerly of Primary Global Research (PGR), an expert network based in Mountain View California, is the first substantive action impacting expert networks, after a long and ongoing campaign of innuendo. Today’s Wall Street Journal continues the whisper campaign with an insubstantial article noting that one of Gerson Lehrman’s Group’s 200,000+ consultants has been questioned by authorities. Let’s focus instead on the substance of the Department of Justice’s complaint against Don Chu to see what that tells us about the government’s case against expert networks.
From Galleon With Love
The bulk of the 18 page complaint against Chu revolves around conversations recorded by Richard Choo-Beng Lee, a defendant in the Galleon case. Lee, a former Galleon trader and SAC analyst who was at the time a principal at a small hedge fund called Spherix Capital, flipped in April 2009 in the hope for a reduced sentence from prosecutors. The more dirt he delivered, the more lenient his sentence. Lee attempted to get rehired at his former employer, SAC Capital. Failing that, he had to work harder to find others to offer up to the government. At the FBI’s direction, Lee began communicating with Chu in June 2009. The complaint provides ample evidence of Lee’s proactive efforts to ensnare Chu and other employees of PGR.
Spherix Capital, Lee’s firm, apparently became a client of PGR at the end of 2008 or beginning of 2009, as a result of a relationship developed by Don Chu. Chu met with Lee at an industry conference in Las Vegas in early 2009. Lee also met with an expert named in the complaint as “CC-1” (co-conspirator 1) employed by an unnamed technology company, which some have said is Advanced Micro Devices (AMD).
Chu was apparently employed by PGR as a liaison to Taiwan, and was paid $6,000 per month in addition to covering expenses, according to the complaint. Chu appears to also have had a sales role, as evidenced by opening the Spherix account for PGR. The complaint alleges that “Chu promotes the Firm’s (PGR’s) consultation services by arranging for Firm consultants to provide material nonpublic information regarding certain public companies releases of significant financial information or other market-moving events (the “Inside Information”).”
Evidence Against Chu
The complaint against Chu alleges that he passed inside information to Lee on Atheros Communications Inc. (ATHR), Broadcom Corporation (BRCM) and Sierra Wireless Inc. (SWIR), in addition to the unnamed tech company thought to be AMD. The evidence is pervasive.
- On June 19, 2009, Chu sent an email regarding ATHR titled “Just In…” The text of the email: “ATHR [Atheros]: Q2 [second quarter] better than expected, over 105M. GM [gross margins] ok. Q3 [third quarter] internal target at 123M [million dollars], guidance pending ?115 [million dollars] or so? will be aggressive in the pc/nb [personal computer/notebook] ASP [average sales price] to stop competitors. Hopes to maintain GM on (1) Nintendo shipment back in and (2) new 65 nm lIn chip[.] Q4 [fourth quarter] likely has GM under pressure with ASP expected even bloodier. Have fun!” ATHR did not report Q2 results until July 21, 2009.
- On July 14, 2009, Chu left a voicemail for Lee saying in part: “okay on Atheros, ah since, the last update’s still good. Uh, you know, Q2 definitely over 105 depends on how they going to guide it. Margin on Q2’s good.”
- On July 20, 2009, Chu sent an email to unnamed PGR employees asking to arrange a consultation for Lee with CC-1 (reportedly an expert employed by AMD). Chu did not state the purpose of the consultation, saying only that the consultation should be arranged ASAP. On July 21, 2009, Lee called CC-1 and received revenue numbers, average sales prices, unit sales for different product lines, gross margin figures and revenue forecasts for the unnamed company, presumed to be AMD, which reported its results later that evening.
- On August 4, 2009, Chu met with Lee in person. Lee said he was going to Taiwan in September, noting that it was just before earnings announcements. Chu said he would set up meetings for Lee during his trip. Chu said he had good contacts at SWIR and BRCM. “Lee mentioned to Chu that Lee was surprised that CC-l, ‘gave me the number last quarter it’s like on the spot.’ Chu replied ‘On the spot. All depends on the person. It, some guys willing to talk, some are not.’”
The information that the complaint alleges that Chu passed to Lee is not gray area information, but clearly material non-public information. The information in question was confidential financial information for publicly traded firms, and provided prior to the public release of the information.
Evidence Against PGR
Although Chu was Lee’s main contact at PGR, Lee made efforts to entrap other PGR employees. The complaint does not present any evidence of other PGR employees providing material non-public information to Lee or others.
- After his consultation with CC-1 (reportedly the AMD expert), Lee wrote an email to an unnamed PGR employee, ‘Firm Employee-1’ saying that he was not in a position to pay for the consultation (presumably because his firm had effectively been shut down by the FBI) but happy to pay out of his own pocket. He also praised CC-1 and asked if there were other experts like him that PGR would recommend. Firm Employee-1 responded in an email: “Do not worry about paying for [CC-l], [the Firm] will pay him. You can still access your portal – I will send you a link. [Firm Employee-3J will work with you. Please continue to place calls (we have several mechanisms in place to enable folks who are in similar situations as yourself, to call experts and use the portal, while trying to maximize value to the Firm and yourself).”
- Since Firm Employee-1 did not respond to Lee’s question whether there were other experts like CC-1, Lee called Firm Employee-3. Lee said, “You guys have been great, I uh, I had a call with [CC-I] early this morning and he was very good. He’s ah, his revenue number, his estimate was spot on.” After a long pause, Firm Employee-3 responded: “Yeah, he’s well, he’s one of our, uh, I guess, more liked guys… That’s what you try to get into, but anyway. . No, I just yeah, I was just gonna say he is one of our, you know, top guys who’s been known as being fairly accurate. [CC-l] and [another Firm expert].”
- During Lee’s meeting with Chu in August, Lee asked whether “you guys” were “nervous”. Chu responded that he was nervous. Lee asked whether Firm Employee-1 and other PGR employees were nervous. Chu apparently did not respond, but instead warned that Lee to be careful because PGR recorded some of its calls.
- After the FBI arrested Chu, they questioned him about Firm Employee-1 and other PGR employees. The complaint states ambiguously, “Firm Employee-1 knows that hedge funds want revenue numbers from Firm consultants. Certain hedge funds ask Firm consultants about their respective companies’ revenue numbers and how their companies will report their earnings numbers prior to their earnings report.”
It does not appear from the material provided in the complaint that Lee was able to find evidence of PGR employees other than Chu passing inside information. This does not mean that there are not difficult questions for PGR to answer, including to what extent were they were supervising Chu, and whether there were other employees like Chu who were knowingly trafficking in inside information.
The allegations against Chu are clear cut examples of insider trading, and, if substantiated, demonstrate abuses of the law and the compliance systems that the expert network industry has put in place. As is true of any industry, whether it is banking, accounting or other professions, bad actors can commit fraud no matter what safeguards are in place. Nevertheless, the Chu case will prompt expert networks to review existing compliance standards, and consider proactive measures such as internal audits or periodic recording of calls, such as those that Chu feared and warned Lee against. Expert networks will also need to consider when it is appropriate to “fire” a client. To the extent an expert network has reason to suspect that a client is misusing its network, it is not good practice to continue to keep that client. Ultimately it comes down to the quality of the staff the firms hire, and the culture instilled by the firm. The Chu case will provide a bracing example for all.
The bigger problem for expert networks, and the research industry generally, is that the government is conducting a well coordinated campaign of innuendo and guilt by association. Today’s WSJ article on Gerson Lehrman is a case in point. The fact that one of Gerson’s experts (an expert shared with other expert networks, and perhaps the same unnamed Marvell expert cited in the Chu complaint) is hardly proof of any wrong-doing by Gerson, despite the prominently placed article. Media reports characterize expert networks as systematically trafficking in inside information, even though the Chu complaint does not provide any evidence to support this.
More broadly, reporters are jumping to the conclusion that all primary research is under assault, including the mosaic theory. The media is questioning whether firms that routinely conduct channel checks, or even fundamental research firms including investment banks that conduct primary research are breaking the law. Again, the Chu case provides no support for this. The case relies on classic inside information, maintaining a distinction between material non public information, such as revenue numbers received from insiders prior to public release, and non-material non public information, such as information received from a supplier.
Doubtless the government’s whisper campaign will continue. Nevertheless, actions speak louder than words, and so far, we have yet to see evidence supporting the broader allegations being made in the press.