Corporate compliance and investor relations officers beware: Employees at your companies may be participating in so-called “expert networks,” which could expose them to charges of insider trading and the company to reputational damage.

Indeed compliance and IR officers would be wise to warn employees company-wide that any participation in expert networks may be hazardous to their future employment.

The world of information exchange in the securities business has always been shadowy, but now it's getting even murkier. Case in point is the saga of the Securities and Exchange Commission's pursuit of insider-trading cases, particularly its current effort to tighten the noose around SAC Capital Advisors and its billionaire founder and owner Steven Cohen for alleged insider trading. In late May, Cohen informed the SEC that his cooperation with its investigations was ending, leading to speculation that he might be the next domino to fall in the SEC's effort to clamp down on insider trading.

The Commission's recent insider-trading crackdown has led to 73 defendants that have pleaded guilty since 2009.  Of those, 37 were convicted, and 10 took their cases to trial and were found guilty.  Four of those were SAC employees, three of whom are serving prison sentences between two and four years, while a fourth awaits sentencing.

Expert networks are groups of professionals often working inside an industry with specialized information and research who are paid by expert network firms to provide that information to hedge fund managers and others who are looking for a competitive edge in trading. These professionals may be doctors, engineers, technology experts, or your employees. Recently, the SEC has accused some expert networks of using their connections to aggregate material, non-public information.

“I'm not saying there aren't legitimate expert networking firms, but they are a little bit like putting a group of teenagers together in one room with a lot of booze— something is going to happen.”

—John Coffee,

Professor,

Columbia Law School

In one of the most notorious cases, the SEC filed a complaint last November against a former SAC portfolio manager Mathew Martoma alleging he was behind the largest insider-trading case in history—resulting in $2 million in illegal gains—by getting inside information about the clinical trial of an experimental Alzheimer's drug being developed by Dublin-based Elan and Wyeth, a New Jersey drug company that was eventually acquired by Pfizer. Martoma had developed a relationship with Dr. Sidney Gilman, a University of Michigan professor of neurology who was also chairman of the committee that was monitoring the experimental drug's clinical trial. Gilman was put together with Martoma through expert network firm Gerson Lehrman Group and SAC paid $108,000 for his insights, according to recent reports.

 An Integrity Research Focus survey of 301 hedge funds and investors in Europe and North America says found that expert networks are one of the most heavily used forms of primary research and the number of firms has increased from a handful several years ago to at least 38 today. The leading firm is Gerson Lehrman Group, with as many as 250,000 experts world-wide. GLG says it has a compliance department and about 20 staff who vet consultants, train employees, and maintain databases.

Enter Reg FD

The SEC's 2001 Regulation Fair Disclosure rule is credited with the explosion in the number of expert networks as communication between companies and shareholders was commoditized in the process of disseminating information with equal access for all. The edge that had been provided by selective disclosure to certain analysts and investors was gone.

Are all expert network firms operating in compliance with insider-trading laws? Columbia Law School Professor John Coffee says they are not. “I'm not saying there aren't legitimate expert networking firms, but they are a little bit like putting a group of teenagers together in one room with a lot of booze— something is going to happen.” In February 2011, the SEC charged six expert network consultants and employees with insider trading for illegally tipping hedge funds and other investors to generate nearly $6 million in illicit gains. Four were technology company employees “moonlighting” as consultants to Primary Global Research. With the knowledge of their employers, they “abused their access to inside information about such technology companies as AMD, Apple, Dell, Flextronics, and Marvell,” the SEC alleged. Robert Khurzami, former director of the enforcement division said, “Company executives and other insiders moonlighting as consultants to hedge funds cannot blatantly peddle their company's confidential information for personal gain.” By November 2012, the SEC had charged 25 defendants as part of its expert network investigation with alleged illicit profits of about $120 million.

 A former SEC enforcement attorney Stephen Crimmins says hedge funds need to generally do a better job of setting limits on the type of individuals their portfolio managers can speak with. “If you're researching a particular pharmaceutical company, you don't want to speak to someone at the company or working on the subject but you may want to speak to other scientists that are generally familiar with that research area,” he said. While that may be good advice to hedge funds, it's not the way it usually happens. Some expert network firms consider company employees fair game and pursue them directly. And that's where the corporate compliance and investor relations officers come into play.  Strict rules need to be adopted that warn employees that cooperating with an expert network firm may result in their termination.

Company employees may be recruited as an “expert” for anywhere from $300 to $1,000 an hour to speak confidentially to a portfolio manager. That expertise, however, can sometimes cross the line into material, non-public information. For example, according to an article in Vanity Fair, a former Dell employee, Sandeep Goyal, left the computer company to join expert networking firm Level Global and used a contact at Dell's investor relations department to pass along what was described as “very specific” inside information on Dell's revenue and profits. What makes this information exchange environment somewhat judgmental is that analysts and portfolio managers are also guided by the “mosaic theory” that says that they can gather information from various sources and put the pieces of the mosaic together, come to a material conclusion and act on it, so long as the information they use to assemble the picture is not insider information. A piece of the mosaic, for example, may be an analyst's observation of the number of cars in the parking lot of a major retailer during the holiday season.  However, if a portfolio manager of a hedge fund seeking an edge is matched with a corporate insider of that retailer who provides more specific information about sales volume, that's crossing the line into insider information.

While it's unusual that an expert network develops a source in an investor relations department who has a handle on company-wide information, in most instances, company employees have compartmentalized information based on their role in the corporation. Nevertheless, those employees are still insiders and are providing insider information. Corporate compliance officers would be well advised to have the necessary procedures in place to prevent employees from developing relationships with expert networks not only to stop the practice but to provide a defense should an insider proving significant information result in an SEC insider-trading case involving the company.