Trends in Insider Trading Investigations Part II: How to Navigate Expert Networks

As discussed in Part I of this series on insider trading investigations, hedge funds and other institutional investors rely upon various sources of information in connection with their investment research activities. ¹Arian June, Trends in Insider Trading Investigations Part I: How to Navigate Political Intelligence, 45 Sec. Reg. & L. Rep. 287 (BNA) (Nov. 4, 2013)213 Securities Law Daily, 11/4/13. Part I discussed the ways investors use political intelligence firms, the risks associated with the use of such firms, and several practices investment firms can consider adopting to mitigate those risks. Another related resource for hedge funds and other institutional investors as they conduct investment research includes so-called expert network firms. When used properly, these expert network firms provide useful market color about a company or industry without providing investors any inside information. The use of such firms can also present heightened risks of government scrutiny and insider trading liability.

Indeed, while there is nothing inherently improper or illegal about expert networks, they have been at the center of several recent Securities and Exchange Commission, Department of Justice and New York Attorney General investigations where the government has alleged that so-called experts improperly provided investors with material nonpublic information. ²See, e.g., Chad Bray, U.S. Expands Case Against Former SAC Trader, Wall St. J., Aug. 22, 2013 (discussing new allegations that hedge fund portfolio manager Mathew Martoma received confidential information about clinical drug trials from a second doctor through his arrangement with an unnamed expert-network firm), available at http://online.wsj.com/article/SB10001424127887324619504579029311215
807186.html; Ronald D. Orol, Expert Networks Key to SEC Insider-Trading Cases, Market Watch, Wall St. J., Nov. 21, 2012 (discussing charges brought by the SEC alleging that Martoma traded on material non-public information about a drug trial provided by a paid consultant to an expert networking firm), available at http://articles.marketwatch.com/2012-11-21/economy/35250133_1_primary-global-research-expert-network-expert-networkfirms.

In light of the increased risk of exposure to insider trading liability, some investment firms have prohibited the use of expert networks altogether. Others have adopted clearly defined controls, policies and procedures to mitigate against the risks associated with the use of such firms.

What particular practices or combination of practices can hedge funds and other investors consider adopting to avoid insider trading exposure associated with the use of expert network firms?

• Conduct Due Diligence. Prior to engaging an expert network firm, evaluate the compliance controls, policies and procedures in place at the firm. Before communicating with a particular expert, conduct due diligence on the expert’s background, including employment history and past contractual relationships. Search the expert’s background for any history of regulatory noncompliance. Consider the various sources of the expert’s information about a given industry. Avoid experts who promote access to information from close personal relationships with company or industry insiders.

• Prohibit Access to Public Company Employees. Restrict the use of experts who are currently employed by, or consulting for, any companies being researched. Establish clear parameters for the “cooling off” period that defines how long an expert must have been away from the company before he or she may be retained. Ensure that these limitations are included in the firm’s written policies and procedures to govern the use of expert networks.

• Limit Communications to Market Color—Not Facts. Ensure that information received from experts is limited to the expert’s observations and impressions based on years of experience and expertise, rather than facts or knowledge of actual events. Highly specific information about a given company or industry can be a red flag for material nonpublic information.

• Maintain Restricted Lists. Consider using restricted lists to ensure that investment personnel are aware of companies whose securities cannot be traded—whether due to the receipt of material nonpublic information or for some other reason.

Other practices investment firms can consider adopting to avoid insider trading exposure when using expert networks overlap with measures for mitigating the risks of using political intelligence firms. Those practices include:

• Establish Procedures Focused on the Use of Experts. Maintain clear written policies and procedures to govern communications with expert networks.

• Monitor Compliance of Firm Controls. Enhance supervisory and oversight processes to monitor employees’ compliance with the firm’s established procedures and to identify any potential weaknesses.

• Provide Training on a Regular basis. Train investment personnel on the permissible uses of industry experts and how to identify and guard against the receipt of material nonpublic governmental information. Include examples of improper communications with expert consultants in the firm’s insider trading policies, training materials and in periodic compliance reminders.

• Document Communications. Adopt procedures providing guidance about documentation of communications with expert consultants. Compliance personnel can review these records periodically or as warranted.

• Use Scripts and Seek Certifications. Before communicating with an expert consultant, confirm that the expert will not share material nonpublic information, or any other information that was received from a corporate source in breach of a duty. Provide investment personnel with a script to use at the outset of every communication with an expert consultant that makes clear that the investment firm does not want to receive any such prohibited information.

• Monitor Corporate Announcements Against Trading Activity. Establish procedures for monitoring major corporate announcements to identify any coincidental trading.

While investment firms are not required to adopt these or any other particular procedures, and none of these measures will completely eliminate the risk of insider trading exposure, implementation of these or other tailored procedures can mitigate a firm’s potential liability.