Expert Networks: The challenges facing fund managers
“It’s a mystery wrapped in a riddle inside an enigma,” bellows Joe Pesci’s terrified character in Oliver Stone’s conspiracy theory-cum-thriller JFK.He is voicing his bewilderment about the complexity of the motives behind President Kennedy’s assassination. Like everyone else in the room listening to his exploits, they are unsure about the intricacies of what exactly is going on. Expert networks seem to be generating similar uncertainly among hedge funds – although it is doubtful managers and their staff are reacting to it with an Oscar-worthy performance quite like Mr Pesci. However, there is reason to be concerned.
The last few months have seen significant clampdowns by the US Securities and Exchange Commission (SEC) on these expert networks – firms that match industry specialists including those working in public companies with money managers. For a fee, these managers can gain cutting edge information and analysis.
While many expert networks do provide a legitimate research facility, regulators believe some have been providing material, non-public information to fund managers and other investment professionals. San Francisco-based Primary Global Research (PGR) is one firm facing the SEC’s wrath. Several of its consultants who were also employed by technology companies are accused of supplying material, non-public information regarding those companies “to facilitate widespread and repeated insider trading by numerous hedge funds and other investment professionals.”
An SEC statement reads: “Each obtained material non-public information about sales, earnings or performance data, concerning various public companies and shared that inside information with hedge funds and other clients of PGR who traded on the information.” It adds that the hedge funds and other traders who received this information reaped approximately $30 million “in illicit profits.”
However, there are concerns that the SEC’s interpretation and stance on expert networks is unclear and muddled. The Managed Funds Association (MFA), the US hedge fund lobbying group, recently asked the SEC to clarify the guidance on using expert networks following a series of arrests by the Federal Bureau of Investigations (FBI). At a press conference in January, Richard Baker, president of the MFA said its members had expressed concerns. “Our industry would like to know where the sidelines are right now so that we can stay well within them. The trouble is the referees aren’t quite clear where those lines are right now,” he added.
The prevailing uncertainty does need to be clarified. It is sometimes difficult for fund managers to know when they have crossed the line as information that constitutes non-public information has been defined by case law as opposed to statutory law – therefore making it dependent on circumstances. “There are black and white situations where people get information from company insiders or advisers with fiduciary relationships to a company. For example, if a company insider gave non-public information about an upcoming merger or acquisition, or what the upcoming earnings will be - that is clear-cut and inappropriate. However, banks and funds spend a great deal of time on research analysis and gathering facts. They put these facts together with their own analysis and research tools to identify potential trades. I often hear people ask ‘where does good research end and crossing the line to gather information inappropriately begin?’ It is a difficult question to answer. There is a grey area where research and fact gathering stops and where inappropriate conduct begins and it is not always clear where that begins,” says Holland West (pictured), US-based partner at law firm Dechert.
This problem is compounded by the fact that many of these expert network consultants will undoubtedly have an edge when identifying market trends or giving analysis. It is inevitable – they wouldn’t be employed if they didn’t have this quality knowledge. “The issue of where that edge actually is causes uncertainty and potential problems. People want clarity and the SEC so far has not been clear and neither have the courts,” adds West. It is understandable that hedge funds are becoming increasingly concerned about these developments and will certainly be watching the pending cases with eagle eyes.
Given these unanswered questions, what should hedge funds do to ensure they are not breaking the law? Michel Van Leeuwen is group chief executive of consultancy shop The IMS Group. He is also a member of several expert networks which provide information to hedge funds, private equity firms and other professional institutions. He stresses that the top expert networks adopt a high level of professionalism and ethical standards.
He acknowledges best practice is predominantly down to self-discipline. “When I am on a call to another party, I have a level of professionalism to abide by. If someone asks me something that I am an expert on, which might be a grey area to discuss, I state clearly that I cannot discuss the issue because it is something I could only know about due to my involvement with a certain company. However, the people posing the questions also need to be disciplined about what they ask,” says Van Leeuwen. While self-discipline is important, there do need to be more checks to ensure that managers are playing above board and not straying into illegality.
The industry is clearly worried about the situation. A survey of 122 investment professionals, regulators and other market players by research specialists TABB Group revealed that 78% felt compliance controls in expert networks were insufficient. Furthermore, 63% of interviewees said the investigations into expert networks would bruise investor confidence. Given the renewed vigour in which institutional investors are pursuing their operational due diligence, it is essential managers rethink how they deal with expert networks.
West believes the agreements between hedge funds and expert networks need to be revisited. Checks and balances need to be imposed in these documents specifying that the expert network will not provide illicit information to the fund. Having such an agreement, says West, could minimise damage to the fund if the expert network did provide material non-public information.
One solution gaining traction could be having expert network observers sitting in on the meetings between fund managers and expert networks. However, Van Leeuwen believes it might cause concern to managers if there were a third party sitting in on the conversation – after all, managers do not want to reveal their potential trades or investment strategies.
Monitoring phone calls as a default between expert networks and hedge funds would also be a step in the right direction. If conversations are taped, some believe it will be easier for compliance staff in funds to identify illegal information flow and halt any potential trade or investment that might follow. These conversations too will be on record on an exchange for future reference. It might also be advised that traders not use their personal cell phones when chatting to expert networks – instead opting for an office landline. Greg Collins, chief executive officer at IT and telecommunications consultancy firm JP Reis, acknowledges expert networks are unregulated and phone recording technology could prove useful in weeding out malpractice. However, he adds: “While recording telephone conversations is useful at capturing information, the best way to control the situation is by improving corporate ethics.”
Banning expert networks outright would be counterintuitive and a step too far – many do in fact provide an excellent, legitimate service. Nevertheless, there is still a lot of suspicion hanging over them - more than two thirds of TABB’s respondents reckon individuals sitting on public companies should be prohibited from sitting on these expert networks.
Expert networks’ shelf life and sustainability, given the uncomfortable revelations in the press, has been questioned. Some 98% of TABB’s respondents believe current investigations would reduce revenue at expert networks. Of this, 39% said the decline would be minimal – however, 29% anticipated a significant drop in revenues for these firms. West agrees the expert network model is in danger of extinction given the US government’s investigations.
Regulators or the hedge fund industry itself need to clarify the grey areas which have caused managers consternation when dealing with these networks. Setting in stone guidelines identifying expert network best practices would alleviate many of the concerns rife among managers and their end investors. In the meantime, managers and expert networks need to improve their compliance operations to provide peace of mind to investors and regulators.