Buy Side Firms Face Scrutiny in Expert Network Probe

The recent insider trading scandal has morphed into a probe of expert research networks, and it threatens to entangle buy side clients of these firms.

After FBI agents raided two hedge funds Diamondback Capital and Level Global Investors, in late November, the FBI arrested Don Chu, a consultant at Primary Global Research of Mountainview, Calif., who was accused of arranging for hedge fund clients to receive inside tips on technology companies, according to the New York Times. The arrest raises the issue of so-called experts who are being hired to provide information to hedge funds and mutual fund companies.

Now buy-side firms that are using research from expert networks must worry whether they are obtaining non-public material information from industry consultants. If that consultant is wearing a wire and taping the conversation, that buy side firm could be implicated in insider trading. What’s most problematic is that the definition of what’s considered inside information is murky. If a consultant goes to a Starbucks store and asks about sales, and shares that information with clients, is that material non-public information, which is considered an insider tip?

Last week, the blog Fierce Finance wrote: Unfortunately, the on-going expert network insider trading scandal, about which we have few details, has ensnared a lot of mutual funds. Independent research firm Broadband Research, which was visited by FBI agents seeking cooperating witnesses, works with a lot of mutual funds including Janus, MFS Investment Management, Friess Associates, Ameriprise's Columbia Management and Wellington Management (a Vanguard subadvisor).

Taking his case to the media, John Kinnucan, principal at Broadband Research, has refused to cooperate with the FBI when he was asked to wear a wiretap to implicate a specific hedge fund. As widely reported, Kinnucan wrote an email on Oct. 26 to about 50 hedge fund and mutual fund clients telling them of the visit by two FBI agents. While most industry executives tend to go into hiding when they are contacted by law enforcement, Kinnucan has taken an unusual, if not dangerous, tactic of going to the media with his resistance to the FBI’s heavy-handed tactics.

In the midst of his media campaign, Kinnucan was subpoenaed by the Justice Department and the US Attorney’s office in the Southern District of New York. According to Bloomberg News, the information request was delivered on Friday, Dec. 3rd, and seeks e-mails, financial and trading records, client contracts and other documents for the past two years, Kinnucan said in a telephone interview with Bloomberg News. In the Bloomberg story on Friday, Kinnucan said he’s cooperating and has not been accused of any wrongdoing.

In an interview with Fox News, Kinnucan said “If he's guilty of insider trading "so is virtually everyone who works for an investment bank or a mutual fund in the United States." What is clear is that mutual fund companies and hedge funds will see their names dragged into this story if expert consultants under investigation are forced to turnover their client records to regulators.

In the mean time, buy-side firms should inform their compliance departments of their research relationships with expert networks, if they haven't already. The buy side should have internal policies to guide their usage of research consultants. In a letter to investors published in the New York Times, the co-chief investment officers of Diamondback Capital, wrote: "The firm has for many years had a written policy and set of procedures that are expressly designed to avoid having any employee receive or misuse material nonpublic information when using research consultants." Still, more clarification is needed on what types of information provided by expert research consultants is stepping over the line into insider tips. Until that happens, the buy-side should tread carefully.