How expert networks came to dominate Wall StreetNovember 22, 2010: 11:49 AM ET
The latest insider trading investigation is focusing on the new hub of Wall Street information: independent research networks that pay so-called experts for information on public companies.
What is it with Wall Street these days that it won't let a record stand for the usual amount of time? First, Marc Dreier gets one-upped by Bernie Madoff. Then, Bear Stearns gets bested by Lehman Brothers. And now the Galleon insider trading scandal—only a year old!—looks like it's going to get dusted by the latest insider trading probe on Wall Street.
According to the Wall Street Journal, one of the Feds' targets in this probe is not a new one: so-called expert networks, which provide research "services" to hedge funds and mutual funds. Such services can include data and analysis, but very often consist merely of connecting a hedge fund analyst with an "expert" who might be a customer, client, or even employee of a company that the fund is an investor in. The networks reportedly being investigated are ones that most of us have never heard of: Primary Global Research and Broadband Research, both outfits that provide customers with intelligence about the technology industry.
This is not the first time these kinds of companies have found themselves under the legal microscope. Nearly four years ago, the New York attorney general took a look at a couple of the big players in the third-party research space, Gerson Lehrman Group and Vista Research. Nothing much came of it at the time. And neither has been mentioned in this go-around. (Not that they're not on high alert: An email has circulated at Gerson reminding employees that they are not to speak to the press.)
The one remarkable constant in these investigations: the hope that all roads will eventually lead to SAC Capital Advisors, the high-velocity trading firm run by reclusive hedge fund billionaire Steve Cohen. Never has a target proven so tempting yet so elusive. Even Goldman Sachs (GS) pays a $550 million fine every now and then.
But I digress. It's no wonder that expert networks have taken off in recent years as an adjunct to the traditional equity research process. For one, sell side research has never been the same since the scandals of a decade ago, when the likes of Henry Blodget and Jack Grubman were exposed as mere agents of their firms' investment banking and trading franchises. The resulting investigations and fines changed that business for good.
Regulation FD also cut the phone lines that used to run directly between Wall Street and company management. The result: a game of broken telephone where the corporate intelligence has to be sourced in other ways.
The third reason Wall Street took to expert networks is because they are birds of a feather: facilitators in the flow of something—money or information—between two large groups. Wall Street has historically stood between those who have money and those who want money, and introduced hither to yon. Expert networks purport to perform the very same function, but the product is not money but expertise. A late 2009 report by Integrity Research demonstrated just how important a part of the process expert networks had become: 40% of investors in a survey considered the networks either "very" or "extremely" important.
Illegal, unethical, or above board?
The nub of the question, then: is there anything wrong with the expert network per se? No, of course there isn't. Everybody wants an edge, and if the price is right, everybody is willing to pay someone to act as a "consultant" in pursuit of that edge. Every single one of us pays "experts" pretty much every day of our lives because it helps us to make decisions that are better informed.
Problems arise, though, when people do what people are sometimes wont do to, which is to step over the ethical or legal line. Selling someone expertise is one thing. Selling illegal information is another. And while there's always plausible deniability, these people generally know quite well what they are doing. It's unlikely that Dr. Yves Benhamou told his friend at hedge fund FrontPoint partners that hepatitis drug Albuferon wasn't working because he was worried his friend might end up taking the drug himself. Far more believable: that he knew his friend's fund owned shares in Albuferon's maker, Human Genome Sciences (HGSI), and could avoid a loss by selling before the information broke. The FrontPoint partner has not been charged but remains under investigation.
It's sad to say, but if arrests do come and convictions are found in the size that the Journal suggests, it's just another confirmation that believing in a basic inclination to human decency is naive, at least when it comes to the investment world. It's the same conclusion one can draw from Bethany McLean and Joe Nocera's excellent new book about the mortgage crisis, All the Devils Are Here: the real surprise isn't that there's a new scam being run, but that there are so many willing participants. For those of us who try to give people the benefit of the doubt—even those who choose to work on Wall Street—this is nothing but demoralizing news.
One guy who doesn't seem to think he's in too much trouble is Broadband Research's John Kinnucan. He's bragging to the press that the Feds couldn't make him roll on his clients in a way that suggests he doesn't actually have much to hide. Still, Mr. Kinnucan qualifies for the dubious judgment award by virtue of his decision to alert every one of his clients that the FBI was sniffing around at all. He told the Wall Street Journal that he was "contractually obliged" to inform them of the fact. That seems a little far-fetched, as well as a little ethically challenged.
But, like I said, we live in ethically challenged times.