Views on improving the integrity of global capital markets
20 May 2011

Reputation or Information — Must One Choose?

Posted In: Insider Trading, US SEC

Investment professionals spend years building their reputations with their clients and peers. Their hard work and diligence in conducting investment analysis may include periodic discussions with experts arranged through the myriad of placement networks. But with the recent insider-trading convictions and guilty pleas of both portfolio managers and such experts, is this association likely to tarnish their reputations?

Fundamental analysis depends on quality information. When the U.S. Securities and Exchange Commission passed Regulation FD (Fair Disclosure), the investment community turned to another avenue for information: the expert network industry, which connects people knowledgeable of a specific field with investors and others looking to better understand the dynamics of that area.

Information legally gathered in this manner is typically used as part of the analyst’s application of the so-called “mosaic theory.” Under the mosaic theory, analysts may act upon a collection of public information and nonmaterial nonpublic information. Raj Rajaratnam, co-founder of Galleon Group, claimed his disputed trades were based on such legitimate analysis. Unfortunately for him, the recorded phone conversations played during his trial formed a different mosaic of his actions, leading to his conviction on all 14 counts of insider trading.

Given the value of one’s reputation to long-term professional success, many on Wall Street are now reconsidering their association with expert networks. The New York Times has reported that both buy- and sell-side firms, including Millennium Partners, Och-Ziff Capital Management, Credit Suisse, and Morgan Stanley have either stopped using or are adjusting their policies regarding expert consultants. According to Integrity Research, “usage by financial clients is reportedly down 40-60%,” leading one to wonder if additional Wall Street firms will distance themselves given fallout from the large number of insider-trading indictments related to expert networks.

It is not just the firms using expert consultants that are beginning to worry about their reputations. Michael Lynch, a consultant working through the Gerson Lehrman Group, recently commented on the company’s blog that he may consider withdrawing his consultant services if the expert-network industry cannot improve its overall image. Lynch noted that the hourly rate he earns cannot replace the loss of personal reputation through guilt by association with those who are simply peddling inside information.

The news is not all negative for the expert network industry. The SEC has clarified many times that its investigative focus was on the fraudulent use of material nonpublic information — not on investors using outside experts to obtain information and inform analysis. The Commonwealth of Massachusetts went one step farther in affirming the expert network industry in April, when Secretary of the Commonwealth William Galvin proposed new requirements for firms dealing with outside consultants. The new regulations clarify the shared responsibility among the expert networks, consultants, and users to restrict the potential dissemination or use of material nonpublic information. It further reinforced the illegality of trading on such confidential information.

CFA Institute strongly supports the fundamental analytical process and the various sources that may be legally used within a mosaic theory analysis. When someone crosses the line, we also stand behind the regulators and courts that punish those taking short cuts around the law.

The investment industry is resilient and will continue conducting diligent company research and analysis while the investigations play out. As part of that process, companies and individuals will need to individually judge the potential reputational impact of using expert consultants. But given the need for quality information, the expert network industry — or its next incarnation — undoubtedly will remain a part of many analysts’ toolboxes.


About the Author(s)
Glenn Doggett, CFA

Glenn Doggett, CFA, was a director of professional standards for CFA Institute. His responsibilities included providing member guidance in applying the ethics and standards of practice policies, supporting related educational and public awareness activities, and working with the Standards of Practice Council of CFA Institute on its initiatives. He was a co-host of the free, live, interactive webinars used by CFA Institute to promote ethical decision making and global best practices. Previously, Mr. Doggett, as a member of the CFA Institute Financial Reporting Policy Group, represented membership interests regarding reporting and disclosures initiatives, including XBRL. Prior to joining CFA Institute, he worked in the financial information sector with SNL Financial, where he focused on the real estate and energy industries, directing the development and maintenance of a financial data storage system. Mr. Doggett holds a BA in economics from the University of Virginia. He was awarded the CFA charter in 2006 and is a member of CFA Society Virginia.

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