Insider trading probes shine spotlight on expert industry

The ongoing trial of a Wall Street hedge fund co-founder accused of making more than $45 million from trading on illegal stock tips has thrust new attention on a little-known industry known as expert networks.

An expert network connects institutional investors, hedge funds and others with industry specialists and consultants, helping them gather data to make investment decisions. Their use has been a de rigueur practice for years, but a recent inside-trading probe led to the arrest of some consultants and landed Raj Rajaratnam, the leader of the Galleon hedge fund, in court.

The hedge fund lobbying group Managed Funds Association in January asked the Securities and Exchange Commission to clarify its guidelines on how the two industries should interact. The most prominent network, Gerson Lehrman, which has not been implicated in any wrongdoing, recently hired the lobbying shops Elmendorf Ryan and Clark & Weinstock to represent it before lawmakers. Attorneys say the scrutiny surrounding the oft-used source of information on Wall Street is prompting a lot of inquiries from clients.

“One question that is frequently asked in the financial industry is ‘Should we stop using expert networks?’ ” said Cadwalader Wickersham & Taft attorney Bradley J. Bondi, who joined the firm’s District office from the SEC. “My answer to that is no, but compliance programs need to be re-evaluated, investment firms need to look at where their expert networks are getting information, firms need to fully vet the experts and have procedures in place for dealing with the experts they use.”

A central question in the ongoing trial of Rajaratnam, 53, is what to make of the information he obtained. Was it the sort of market-moving confidential tips that can be considered insider trading, or was the hedge fund power player merely adept at assembling information to make savvy investment decisions?

The line can be a fine one. It is generally illegal to trade in stocks and securities based on non-public inside information about a company that the average investor would like to know. But the use of such information is permitted when it’s part of a larger analysis drawn from piecing together tidbits of non-public information that did not come from inside a company — a long-sanctioned practice known as the mosaic theory. Rajaratnam’s legal team, led by local Akin Gump Strauss Hauer & Feld attorney John M. Dowd, has cited the theory in his defense.

“The mosaic theory concept is that a smart analyst takes pieces of non-public information and puts together a picture that’s material for that person,” said Karl A. Groskaufmanis, an attorney at Fried Frank.

To create these mosaics, the investment industry typically brings in expert networks to act as go-betweens. A witness in Rajaratnam’s trial last week referenced Galleon’s use of such consultants and experts, testifying that Rajaratnam was willing to pay any price for useful information.

An expert network, for example, might link a hedge fund with consultants who examine a retail stock by studying the brand’s marketing strategy and advertising. It might provide experts to monitor the factories overseas that supply products to that retailer, trying to get an idea of supply and demand. Or it could send out people to visit hundreds of a chain’s stores. Though visiting a single store might not yield non-public, material information, visiting many might result in a relevant conclusion to which a member of the general public is not privy.

“You’re entitled to look at that information and develop your own mosaic,” Groskaufmanis said.

In a March 21 speech at the District’s Omni Shoreham Hotel, Carlo V. di Florio, the SEC’s director of compliance, said the commission had not changed its stance on the mosaic theory, despite the spate of recent cases involving allegations of insider trading.

But he warned firms to take precautions.

“One aspect of these cases that I want to highlight is how it underscores the need for advisers to have reasonable policies to prevent insider trading,” di Florio said. “I am not suggesting that advisers must avoid using expert networks, but that they should address any increase to their compliance risks that expert networks may pose.”