In December, the notorious hedge fund founder Raj Rajaratnam entered a Massachusetts prison to begin the longest-ever sentence for insider trading. A month earlier, former hedge fund manager Joseph “Chip” Skowron III got five years for using inside tips from a doctor to avoid millions in trading losses. Both cases involved the disclosure of non-public information by expert research networks (ERNs).
What’s become clear in the wake of these cases is that during the last year, the U.S. Securities and Exchange Commission and the Department of Justice have zeroed in on the practices of ERNs.
“Professional investors always want an edge,” says Mike Seery, a director in the New York office of consulting firm Kinetic Partners. Hedge funds use ERNs to develop market insights. They provide data analysis and connections to experts who might have ties to a company the fund is investing in. But while ERNs are a vital tool for providing that competitive edge, it’s up to those on the receiving end to make sure the network’s information and methods fall within regulatory guidelines.
Kinetic focuses on the asset management, investment banking, and brokering industries, with about half of its business involving compliance advisory issues. Lately, the consulting firm has increasingly been spending its time reviewing the practices of its clients’ outside research providers.
It is perfectly legal for hedge funds to gather information using the “mosaic theory”—analysts and investors routinely develop market insights by acquiring information from different public and private sources and assembling those pieces into a single market picture. But hedge funds cross the line when they base trades on material non-public information obtained in breach of a duty or relationship of trust.
“The investment adviser has an obligation to make sure that their analysts are not getting inside information from these sources,” says Seery, “and they need to have procedures in place that would prevent that from happening.”
In a speech last March, Carlo di Florio, director of the SEC’s Office of Compliance Inspections and Examinations, addressed the agency’s expectations for investment advisers using ERNs. He said that despite the recent uptick in enforcement actions, the agency wasn’t expressing hostility toward ERNs or the mosaic approach through those actions.
However, di Florio said, “One aspect of these cases that I want to highlight is how it underscores the need for advisers to have reasonable policies to prevent insider trading.”
“I am not suggesting that advisers must avoid using expert networks,” he added, “but that they should address any increase to their compliance risks that expert networks may pose, and build appropriate controls around information obtained from expert networks, at both the front end and the back end.”
Investment advisers have responded by adopting tighter controls. Some front-end precautions include:
- Reviewing the terms of an agreement with an ERN
- Occasionally, chaperoning (listening in on) conversations between analysts and ERNs
- Conducting training on insider trading
- Performing an evaluation of the controls that are in place at the ERN
Back-end controls include trade testing in order to determine what trading coincides with expert network conversations. And outside advisers can conduct the due diligence necessary to avoid the pitfalls of using ERNs before it’s too late.
“It’s definitely to the investment adviser’s benefit to take some of these proactive steps,” says Seery. “They’re very concerned about getting caught up in something which might not only damage their business, but which could potentially send them to prison.”
