Compliance Issues Raised By Expert Networks

The government’s current insider-trading investigation is looking into the possibility that hedge funds traded on material non-public information gained from consultants who participate in expert networks.  News stories about the investigation, which have included reports of raids on hedge-fund offices and consultant arrests, got me interested in what these networks do and the compliance issues that flow from their use.

What are expert networks?  They’re firms that maintain rosters of experts in various fields who are available for ad hoc telephonic consultations, often with professional investors.   The experts receive an hourly fee for their services.  There are about 40 expert-network firms in business (up from just 8 in 2001).  The largest firm, Gerson Lehrman Group (“GLG”), has about 250,000 experts on its roster and about 60% of the market.

Expert networks can provide valuable background to professional investors.  For instance, a mutual fund or hedge fund that’s considering a large investment in a biotechnology company might need expert advice to understand the regulatory or commercial potential of one of the company’s products.  In an article earlier this week, the Wall Street Journal noted that networks allow a potential investor to connect quickly with a cross section of experts in a given field.  The article also observed that, because their internal policies restrict or prohibit trading when they’ve received non-public information about an issuer, most hedge funds and mutual funds that make use of expert networks don’t want their personnel to receive questionable information.

Some expert-network firms have adopted policies to prevent consultants from sharing non-public information with clients.  GLG, for instance, requires consultants to execute a contract that contains detailed provisions on confidentiality, conflicts of interest, and the types of conversations that are off-limits.  GLG also requires its consultants to complete an online compliance tutorial, and permits employers to specify whether, and under what circumstances, their employees may serve as GLG consultants.  The contract language that’s posted on GLG’s Web site was updated on 11/19/10, possibly in response to the current insider trading investigation.

It’s unclear how common such compliance policies have been in the expert-network industry, or how rigorously they’ve been enforced.  Whatever past practice has been, however, it’s clear that the current insider-trading investigation will prompt expert network firms to review and tighten their compliance practices, especially if they get pressure to do so from nervous clients.  Clients, for instance, might want to know whether a network makes ongoing efforts to reinforce its confidentiality policies, whether telephonic consultations are recorded for compliance review, and what due diligence is performed into consultants’ representations about their backgrounds.

The government’s investigation also seems likely to prompt hedge funds and mutual funds to address expert networks in their insider trading policies, and to take steps to raise awareness of the potential risks of working with industry experts.  Among other things, funds will likely offer guidance on what employees should do if they believe they’ve received, or in danger of receiving, inside information.  In some cases, a investment professionals might choose to have its legal or compliance personnel monitor conversations with consultants to ensure that non-public information isn’t discussed.

Lastly, the insider-trading investigation should prompt in-house compliance and ethics officials who have not already done so to decide whether, and under what circumstances, employees may participate in expert networks, and to take steps to communicate their policies on this topic clearly.   Companies that prohibit or restrict their employees’ participation in expert networks can be expected to take advantage of the “do not call” registries that some network firms have created. These registries allow an employer to make expert-network firms aware that its employees are off-limits.

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