Insider Trading, Expert Networks, and a Big Honking Due Process Violation



First, a shameless plug: Tomorrow, we’ll be participating in a Dow Jones webinar for Private Equity and VC types, discussing how the current environment of insider-trading prosecutions affects them, and what they might do about it.  (Link here, if you’re interested.)  Of course, those guys aren’t so much the focus these days as, say, hedge funds and the expert networks that help them make investment decisions.  “In the spotlight” doesn’t begin to describe it.  Not a week goes by without some major news about insider trading allegations in the hedge fund world.

With all that reporting, and all the various cases that are going on, one might think the issues are pretty well understood by now.  But they’re not.  Not even by the very people who are doing the prosecuting and investigating, it seems.  It so unclear that a month ago the Managed Funds Association formally asked the SEC for guidance on what is and is not kosher when dealing with expert networks.  “Our industry would like to know where the sidelines are right now so that we can stay well within them,” MFA president Richard Baker said at the time.  “The trouble is the referees aren’t quite clear where those lines are.”

Amen.  Nobody knows where the line is between lawful and unlawful conduct.  The feds themselves admit it.  And yet they are prepared to prosecute people for crimes, when the public has no way of knowing that such conduct was criminal.  Even an investigation is enough to destroy a reputation, wipe out a career, erase a business.  A conviction will take away a real person’s liberty and rights.  Americans don’t allow their government to do that in a gray area.  But it is happening.  How that is not a serious violation of basic due process is beyond us.


Expert networks are a fairly new thing.  It used to be that research was conducted by analysts who were more akin to investigative journalists than anything else.  They poked around, talked to people, and tried to piece together useful information about a company’s value or where an industry was headed.  The goal was to gain an insight that had value — something that wasn’t obvious to everyone else analyzing the public information.  Then along came Regulation FD, and all that changed.

Reg FD came about in 2000 as an attempt to clarify what buy-side research analysts could and could not do.  Research analysts served a useful function, of getting pertinent information out there into the market, resulting in more efficient pricing, and a more efficient allocation of capital.  The problem was that this information was not generally broadcast, but only shared with a select few.  And a company’s management only talked to the analysts they liked, which often enough meant those who gave favorable reviews of the company.  There was a kind of tit-for-tat relationship, where analysts only got access if their reporting helped the company’s stock price.  (The journalism analogy is fairly strong.)  Management was making information public, but only to those who had gotten access.  Reg FD basically says you can’t do that, any more.  If the info is material, then it cannot be disclosed selectively.  It has to be generally broadcast.

Trying to suck up to management is still okay, under Reg FD.  You can still invest shoe leather, phone minutes and greens fees in trying to winkle out some better information.  But if the information is material, management is going to have to disclose it in an FD-compliant manner, basically making it public to everyone.  (If it’s not material, then it’s still okay to disclose selectively — even if it’s the last piece of a puzzle that enables you to come up with a highly material insight.  “Immaterial” nonpublic info is something that’s not important to the normal, reasonable investor.  But this is still a huge gray area.  This is essentially the “mosaic” theory, that many bits of immaterial info can be pieced together to form a mosaic that is material as hell, but that still doesn’t mean the individual disclosures were material.  It’s debatable whether this theory is going to prevent the SEC or DOJ from launching an investigation, but there’s a strong argument to be made that the person disclosing the info, at least, cannot be liable.)  Anyway, the idea is that requiring info to be disclosed in an FD-compliant manner basically undercuts the whole point of using analysts in the old-fashioned way.

At about the same time, hedge funds started doing business a lot differently.  There were more of them, transacting dramatically higher volumes than ever before, and trades were happening way faster and more often.  Old-fashioned analysts aren’t as compatible with large-scale rapid-fire trading.  Using analysts in the old-fashioned way just didn’t make as much sense as it used to.

So the “expert networks” came along as a replacement.  These were essentially consulting services that would get experts from various fields, and get them analyzing what’s going on in their respective niches.  Hopefully, they’d be able to piece together valuable insights from the public information that’s already out there, and help the funds place better bets.

That’s not a bad idea.  Seems pretty good, in fact.  Everyone’s working off the same public information, but you can pay for insights from people who can better interpret what that information means.  You might be buying or selling with a counterparty who has a better insight than you, but that’s not the same as being defrauded by a buyer/seller who has secret information that you don’t have access to.  In other words, it’s not insider trading.

But, of course, there’s a wrinkle.  Some of the experts in these expert networks were still employed by their respective companies.  There was a risk that some of them might be disclosing nonpublic information to those paying for their analyses.  That can potentially turn into an insider-trading situation.

That risk can certainly be minimized.  Public companies can and should have controls and oversight to ensure that no nonpublic info gets disclosed by employees who are moonlighting as experts.  And buyers of the information, like hedge funds, can have policies of not buying info about company X from someone who works for company X.  (A weaker solution, adopted by some hedge funds, is to get a written promise that the experts won’t violate the securities laws.  That’s not going to be much protection if the law still gets violated.  It’s not going to make the insider information any less insider.)

Still, there’s a risk of wrongdoing.  And there’s a big uncertainty as to whether expert networks are inherently suspect.  One might think that they are, given the surprising number of insider charges the feds have filed in the past few months involving expert networks.  And it’s no secret that the entire industry is freaked out at the possibility of being investigated or charged just because of the use of expert networks.

The feds did make some statements recently, in an attempt to assuage these fears.  For some reason, these statements haven’t gotten a lot of press (though had a nice summary a couple of days ago).  Though the reason might be that the feds didn’t really clear anything up.

On Feb. 3, an SEC press release about yet another expert network case said that “it’s legal to obtain expert advice and analysis through expert networking arrangement.”  So far so good.  But right before that, it said this case was part of “the SEC’s ongoing investigation into the activities of expert networks that purport to provide professional investment research to their clients.”  (Emphasis added.)  That’s a loaded sentence, and reveals a predisposition to think that expert networks are bad.  All this does is increase the fear that the feds are going to see insider trading where none occurred.

Similarly, in a Feb. 8 press conference for the latest roundup of insider trading charges, the SDNY U.S. Attorney Preet Bharara made a prepared statement that expert networks are not “inherently wrong or bad.”  It’s just that these particular defendants had a business practice that was inherently wrong.  But he opted not to discuss what is wrong or right about a situation where an expert network uses an employee of company X, even with company X’s permission.  He acknowledged that it’s still a “gray area.”

So Robert Khuzami spoke up.  Khuzami, the head of enforcement for the SEC, sent a warning that hedge funds dealing with expert networks had better do some serious due diligence, to find out whether the expert network uses employees of company X.  And if so, to make sure no material nonpublic information gets received.

In other words, there’s an affirmative burden to make sure the information you receive is not private.  Which is bizarre when there is no way to know that, in many cases, unless you’re privy to inside information.  It’s a Catch-22.


So there’s a huge “gray area” as to whether expert networks are kosher or criminal, as they currently exist and have existed for the past decade or so.  In theory, they’re lawful, but in practice the government sees them as only “purportedly” lawful.  And if you happen to use them, and you get inside information — info you couldn’t have known was secret if you weren’t an insider — too bad, so sad.  You had a duty to know the unknowable.  Maybe.

There are far too many unknowables here.

Isn’t this a classic due process violation?  For the government to be allowed to use its might to deprive individuals of their liberty, property and livelihood, the public had better damn well be on notice that the conduct is something that’s going to get punished.  If the public could not have known that certain conduct was unlawful, the government cannot be allowed to punish it.

And if the government itself doesn’t know where to draw the line…?

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3 Responses

  1. shg says:

    My sense has long been that the government has been getting away with murder (Sorry, Preet, it’s just a analogy) because defendants haven’t chosen to challenge these vagaries and fight the prosecutions. When judges are forced to make decisions, figure out whether the government has a case based on facts rather than rhetoric, determine whether the elements of an offense have been alleged, then met, we may get some meaningful decisions.

    But that requires defendants to fight. Sadly, too many are advised to make a decision in the ordinary course of business. And so we continue to wonder what’s lawful and what’s criminal.

  2. Nathan says:

    Too true, Scott.

  3. Lila Rajiva says:

    Thank you for this post. I was beginning to think I was the only who thought there’s a due process problem in all this.

    I can see where if you violate a fiduciary duty, insider trading is wrong.
    But, if you are not aware of the person on the other side trading, or if you don’t pass material nonpublic information, I think it’s a real leap to say you’re guilty of something because you chatted with a friend about something. which, while board privileged, wasn’t material or non-public.

    Take the Gupta case.

    If the entire industry is using expert networks, and if Galleon was a client of Goldman’s, and employees had gone from the latter to the former; the line between aggressive researcher and insider trader becomes very vague.

    Can you post specifically on the Gupta case. I was surprised to see a conviction so fast.

    With as many tipsters as there were at Goldman, I’d like to know how anyone can be certain who used a line to call whom and say what and how they can convict people on the basis of their associations.

    Something can be unprofessional and irresponsible, but in such a muddled area, is it wise to start putting people in jail without at least clarifying the law first?

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