naked capitalism

Yours truly has complained off and on over the years about “consulting” and “research” firms whose entire business model revolves around the procurement and sale of inside information. These companies solicit consultants, who in the vast majority of cases are employees of major corporations, to provide insight into what is going on at their employer’s operations. These vendors are generally smart enough to make their consultants sign various waivers, which have the effect of shifting liability on to the hapless chump paid a couple of hundred dollars an hour for an hour or two for information worth vastly more than than. They are effectively exploiting the contract worker’s lack of understanding of the finer points of SEC regulations and corporate policy.

We first wrote about this abuse with weeks of starting this blog, in January 2007, when a Wall Street Journal investigation of the biggest player in this space, Gerson Lerman, led to an investigation by the New York attorney general, Eliot Spitzer (the SEC reportedly had investigations underway, although it was not clear whether Gerson Lerman was a focus). The two paragraphs from this January 2007 post are extracted from a contemporaneous Wall Street Journal piece, the balance is our commentary:

Regulators are focusing on whether consultants who are or were employed by public companies have shared nonpublic information with the investors they talk to, either knowingly or unintentionally…

In a page-one article on Gerson, The Wall Street Journal reported in November that Gerson consultants employed by public companies sometimes are unaware of their own companies’ restrictions or have a hazy understanding of what qualifies as nonpublic information….

A colleague who once ran one of the biggest international research operations says that this sort of, ahem, research is as suspect as it sounds. Hedge funds and investors use Gershon and its lot for “channel checking,” that is, they ring up people at companies who are buyers of certain goods to see what kind of orders they are placing. It’s not hard to see why employers would object to this information being shared. First, the employee has no right to trade on his employer’s data. Second, information on how certain products are selling could also give an early warning of the company’s overall revenue trends. Third, disclosure might damage its relationships with suppliers.

You can see why this information is prized. It’s clearly non-public; the only question is whether it is confidential, and the answer is likely to be yes.

Why did the SEC and Eliot Spitzer take so long to act on this one? Hard to know, but our guess is that, unlike the insider trading cases, these breaches of confidentiality don’t lead to huge trades. It’s more like a death of a thousand unkind cuts. But as Gerson and its ilk extended the reach of their operations, and became more visible, the powers that had to be were forced to act. Faith in the markets rests on the (often mistaken) belief that the participants have (or can have if they spend the time) reasonably equal access to information. Gerson Lehrman makes a mockery of that idea.

The Wall Street Journal reports tonight that, years later, the SEC investigation is finally bearing fruit, although the Gerson name is nowhere to be found in this initial leak. So the question remains whether the SEC is merely going to go after the sloppiest actors in this space, or intends to take down this entire dubious category. From the Journal:

Federal authorities, capping a three-year investigation, are preparing insider-trading charges that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders and analysts across the nation, according to people familiar with the matter.

The criminal and civil probes, which authorities say could eclipse the impact on the financial industry of any previous such investigation, are examining whether multiple insider-trading rings reaped illegal profits totaling tens of millions of dollars, the people say. Some charges could be brought before year-end, they say….

One focus of the criminal investigation is examining whether nonpublic information was passed along by independent analysts and consultants who work for companies that provide “expert network” services to hedge funds and mutual funds. These companies set up meetings and calls with current and former managers from hundreds of companies for traders seeking an investing edge….

Among the expert networks whose consultants are being examined, the people say, is Primary Global Research LLC, a Mountain View, Calif., firm that connects experts with investors seeking information in the technology, health-care and other industries. “….

In another aspect of the probes, prosecutors and regulators are examining whether Goldman Sachs Group Inc. bankers leaked information about transactions, including health-care mergers, in ways that benefited certain investors, the people say. Goldman declined to comment.

Independent analysts and research boutiques also are being examined. John Kinnucan, a principal at Broadband Research LLC in Portland, Ore., sent an email on Oct. 26 to roughly 20 hedge-fund and mutual-fund clients telling of a visit by the Federal Bureau of Investigation.

“Today two fresh faced eager beavers from the FBI showed up unannounced (obviously) on my doorstep thoroughly convinced that my clients have been trading on copious inside information,” the email said. “(They obviously have been recording my cell phone conversations for quite some time, with what motivation I have no idea.) We obviously beg to differ, so have therefore declined the young gentleman’s gracious offer to wear a wire and therefore ensnare you in their devious web.”

The email, which Mr. Kinnucan confirms writing, was addressed to traders at, among others: hedge-fund firms SAC Capital Advisors LP and Citadel Asset Management, and mutual-fund firms Janus Capital Group, Wellington Management Co. and MFS Investment Management. SAC, Wellington and MFS declined to comment; Janus and Citadel didn’t immediately comment. It isn’t known whether clients are under investigation for their business with Mr. Kinnucan.

The investigations have been conducted by federal prosecutors in New York, the FBI and the Securities and Exchange Commission. Representatives of the Manhattan U.S. Attorney’s office, the FBI and the SEC declined to comment.

I would expect less rather than more from this effort. Even though any prosecution of unsavory practices is welcome, this report sounds as if the investigators are focusing on the worse abusers, rather than seeking to make a broader case against the entire practice.