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Our biggest fear is Raj was found not guilty

Lee S. Ainslie III, managing partner of Maverick Capital: via WSJ

The expert network brand has been severely damaged. Most insider-trading investigations to date have more to do with direct, corrupt relationships between insiders and their investment brethren. But these became synonymous with the handful of exchanges alleged to have been facilitated by the likes of Guidepoint Global and Primary Global. Through a failure of analysis, insider trading and expert networks became one and the same.

Whether it was Rajat Gupta and Raj Rajratanam or the alleged extracurricular activities of various attorneys and accountants accused of passing along material nonpublic information to a scurrilous group of investors in search of an edge, though they weren’t facilitated by a network, they certainly stained the networks. The consequences will be pervasive and persistent for the industry, and we can already see a handful of changes – among them, compliance, consolidation and repositioning. Nonetheless, the consequences will be good, and they will reinforce the benefits of expert networks. Read the rest of this entry »

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Even inside information from an ‘expert network’ would not have helped.

–Yves Smith, Naked Capitalism

Not even an expert network would have helped, says Yves Smith of the earthquake in Japan, rather blithely suggesting that an expert network is nothing more than a vehicle with which to exchange material non-public information. Would it were the case. If only inside information equated to expert networks, imagine how easy enforcement of insider trading would be! Shut down the networks, Smith might say, and we will purge the rot of a rigged game from the system.

But inside information and expert networks are different things. To conflate them is a failure of analysis and a lazy view on the role of expert networks, the problem of inside information, and research in general. Read the rest of this entry »

Is the smoke clearing for expert networks?

From a modest hotel room in the Omni Shoreham in Washington DC, the SEC gathered a smattering of reporters, lobbyists, and others for a best practices seminar. But the somber title belied a dramatic observation to be made by an SEC official on expert networks. They’re not the problem.

Carlo di Florio, director of the U.S. SEC Office of Compliance Inspections and Examinations, spent just over six thousand words on reforms made under Chairman Mary Schapiro, the implementation of the Dodd-Frank Act, the focus on examination and training, and various enforcement actions in the advisory community. And then, almost 6000 words in and nearing his final remarks, he decided to “briefly mention the ‘Expert Network’ insider trading cases that the Commission and the Department of Justice have recently brought, and that have received much recent press coverage.”

Contrary to some reports that I have seen, I believe these cases do not represent some inherent hostility by the Commission toward expert networks Read the rest of this entry »

Contrary to some reports that I have seen, 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, under which analysts and investors are free to develop market insights through assembly of information from different public and private sources, so long as that information is not material nonpublic information obtained in breach of or by virtue of a duty or relationship of trust and confidence.

Carlo V. di Florio, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, remarking on the misplaced focus on expert networks during the unfolding of the various insider trading scandals that “seem to have spawned some urban legends and misunderstandings”: via speech at the Omni Shoreham Hotel, Washington, D.C., March 21, 2011

Does relying on “industry experts” constitute insider trading?
There is nothing inherently wrong with hiring a company that arranges conversations between analysts or hedge fund managers and those who offer legitimate expertise to assist investors in making investment decisions. The information provided by experts can be part of the “mosaic” of information gathered by analysts or investment managers to assist them in the process of investment decision making. This type of information can include economic or industry forecasts.

Even if a piece of non-public immaterial information takes on significance when combined with primary research or other non-public immaterial information, the information may still be considered immaterial. This concept is known at the mosaic theory.

Michael McMillan, director, ethics and professional standards at CFA Institute, and Jon Stokes head, standards of practice, driving at the difference between expert networks and insider trading: via FT

Integrity Research has done the investment industry and general public the good service of providing more lengthy excerpts from the February 8th news conference in which Preet Bharara and Robert Khuzami outlined the contours of their investigation into insider trading. At the time, most major news coverage centered on a single quote from Bharara that suggested the networks were “verging on a corrupt business model” — without qualification. The expanded excerpts provided by Integrity Research, however, provide a great deal of qualification.

Neither Khuzami or Bharara would say that expert networks are verging on corruption. Bharara, to whom the press has attributed the statement, specifically says, “There is nothing inherently wrong with or bad about hedge funds or expert networking firms.” Khuzami, who heads the SEC’s enforcement division, echoed his statement: “Today’s actions are not a condemnation of all expert networking firms or the consultants who are associated with them who provide legitimate expertise and experience to assist investors in making investment decisions, but that is not what occurred in the events underlying today’s actions.” Far from suggesting that expert networks are verging on a corrupt business model, Khuzami and Bharara understand and validate the role of expert networks in primary research.

The US Attorney and SEC’s focus is insider trading, not expert networks. Bharara later clarified that the exchange of insider information could transpire in any circumstances, and expert networks may encounter these situations just as any other circumstances might. What matters to the SEC and the US Attorney is that it’s bad people doing bad things: “whether or not it’s done through an expert networking firm or its done as a McDonalds, it really doesn’t matter.”

Why, then, did the press come to characterize expert networks as verging on a corrupt business model?

Now let me begin by making something crystal clear. There is nothing inherently wrong with or bad about hedge funds or expert networking firms or aggressive market research for that matter.  Nothing at all. But if you have galloped over the line, if you have repeatedly made a mockery of market rules, if you have converted a legitimate enterprise into an illegal racket then you have done something wrong and you will not get a pass…If you made criminal activity your business model, then business as usual has to stop or the consequences, as dozens of defendants have now discovered will be severe. There are rules and there are laws and they apply to everyone.  No one is above the law, and those who would excuse or rationalize, brazen criminal conduct of the type of alleged today, are neither friends of Wall Street nor allies of business and they are certainly not supporters of the investing public.

Preet Bharara, US Attorney for the Southern District of New York: via Integrity Research

Today’s actions are not a condemnation of all expert networking firms or the consultants who are associated with them who provide legitimate expertise and experience to assist investors in making investment decisions, but that is not what occurred in the events underlying today’s actions. We allege that the charges reveal thoroughly corrupt conduct through and through….The only thing I would add to that is if you engage an expert networking firm, you are wise to conduct due diligence, to determine whether or not public company employees are engaged as consultants, and if so, there are a variety of devices and practices, that have arisen, across Wall Street, and in many regulated entities, to ensure that material non-public information is not crossing the transom, and that you are not receiving it.

Robert Khuzami, Director of the Securities and Exchange Commission’s Enforcement Division: via Integrity Research

The New York Times headlined this advertisement in today’s DealBook. The subject line of the email was:

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Expert networks and traders of inside information are analytically separate categories, not synonyms. This has been the main failure of the press’ coverage of the insider trading scandal. Expert networks match experts with those in need of their expertise. That’s it. Done properly, they bring transparency and compliance to conversations that are otherwise already happening between outside experts and analysts. Expert networks are not clearinghouses for inside information.

Bloomberg News finally brought basic analysis to the discussion around expert networks, rather than the prevailing tone of crude refutation.

Dealbook provides a useful recap of the facts, essentially collecting many of the extant who and what’s that have been involved, along with a fresh set of juicy complaints.

There are users of expert networks, be they hedge funds or mutual funds, that have been known to put a good bit of pressure on the experts to give them more than what they know is permissible information. And anyone who put that kind of pressure on an expert should be very worried right now.

Sean O’Malley, partner with White & Case: via Reuters

The information trafficked by the four ‘consultants’ went way beyond permissible market research. It was insider information.

Janice Fedarcyk, a Federal Bureau of Investigation assistant director in charge of the investigation: via WSJ

Few hedge fund managers have the investment skill to deliver the benefits that they promise. They have to find an edge however they can — in this case through the expert networks.

James Fanto, a professor at Brooklyn Law School in New York, mistaking expert networks for the ethical failings of those alleged to have traded in inside information: via Bloomberg

When I was an analyst, I used build my own network. I’d spot names in magazines where someone was quoted about a company and call them — that’s part of doing fundamental research.

Dan Chung, CEO, Fred Alger, remarking on how, back in his day, they didn’t rely on expert networks or outside consultants. No, they called people quoted in trade magazines themselves, asked all those probing questions, and walked uphill, in the snow, to school, both ways. Chung is the son-in-law of the gentleman behind the eponymous firm: via Marketwatch

Steve Cohen has had among the highest returns in the industry….Insiders in the business for a long time suspected that his special sources amounted to privileged information. The debate amongst insiders was, “Was the special information on the right side of legality or the wrong side?” But I think it was a pretty common view that it was close to the edge….

When you have somebody who doesn’t appear to have that readily identifiable edge, who nonetheless makes much higher returns than other people, you wonder.

Sebastian Mallaby, author of More Money Than God. He went on to share that “in the past, successful investors constructed their own expert networks,” just like Dan Chung, which he attributed to the master networking skills of those such as Julian Robertson, when who you knew was the currency, and those that were known were former executives and outside of the circle of those normally considered insiders. So if what Julian did was ok, why won’t Mallaby afford Steve Cohen the same safe-harbor? Is it any different than a service which will connect anyone else to former executives and others outside of the circle of those normally considered insiders? After all, it’s hard to see a difference in kind between what Julian and Steve are described as having done. The interview merely insinuates. It does not specify: via LA Times update – this was also posted as a comment on the LA Times blog-piece, but they seem to have removed it.

The McClellans might have thought that they could conceal their illegal scheme by having close relatives make illegal trades offshore. They were wrong.

Robert S. Khuzami, enforcement director for the SEC, commenting on a specific insider trading scandal involving the general misbehavior of consultants at Deloitte who misappropriated and tipped material non-public information to trade for their and their relatives benefit: via NYT

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