U.S. financial probe digs into a murky industry

How does it feel to be in the crosshairs of an escalating investigation into illegal insider trading? For a little-known group of firms that specialize in providing expertise, it is proving a distinctly uncomfortable experience.

A continuing probe by U.S. authorities is casting a harsh spotlight on the activities of "expert networks," prompting their clients – mostly investment firms – to question their practices and in select cases, stop using their services.

To supporters, expert networks are the telephone utilities of the financial world, connecting investors seeking information with thousands of well-informed sources. In short order, they can arrange a private call with experts on anything from smart-phone sales to drug development to banking law.

To critics, however, the fast-growing field has long been a source of unease. Such networks provide a way for unscrupulous players to make a grab for confidential information, they say.

That's exactly what troubles U.S. authorities. Last month they arrested an employee of an expert network firm, Primary Global Research, and charged him with conspiring to reveal non-public information, including earnings figures that hadn't been disclosed. None of the allegations have been proved in court.

Federal authorities also raided three hedge funds and sought documents from other money managers, in some cases seeking details of their relationships with expert networks.

The chill on the industry was immediate. Several investors ended their relationship with Primary Global; one hedge fund, Balyasny Asset Management, said it stopped using expert networks altogether; still other funds wrote to their investors to assure them they weren't connected with such firms.

With the probe still under way, further charges appear likely. The fact that the Federal Bureau of Investigation and the Justice Department are involved – raising the possibility of criminal, not civil charges – means "this is a very serious matter," says one former regulator. "These aren't borderline cases, this is hard-core stuff."

Michael Mayhew, the founder of Integrity Research Associates LLC, which tracks expert networks, says that it's important not to tar the entire industry just because there may have been a few bad actors. "This kind of research is really, really important because otherwise you're relying on the honesty and transparency of managers of publicly traded companies," he says.

Expert networks have flourished in the past decade as Wall Street firms cut back on their research operations and regulators pushed companies toward fuller disclosure of market-moving information. The field consists of roughly 40 firms which pull in about half-a-billion dollars (U.S.) in annual revenue, Mr. Mayhew says.

Investment firms pay the top expert networks up to $120,000 a year to access their sources for a given industry. The networks feature a dizzying array of experts, including doctors, lawyers, consultants, scientists, and scores of current and former executives. Gerson Lehrman Group, the largest such firm, has over 200,000 experts in its network. In exchange for sharing their expertise, they receive hourly fees.

These firms know there's a potential for abuse. To control it, expert networks make their consultants pledge not to reveal anything confidential. Most also prohibit current employees from speaking about their own companies.

Yet despite considerable efforts to stamp out potential conflicts, some companies and executives remain wary. Christopher Whalen, managing director of Institutional Risk Analytics, said an experience several years ago was enough to sour him on the industry. After joining a network, Mr. Whalen recalls being contacted by a young hedge fund trader who asked for non-public information about a particular bank, which he refused to provide. Since then, Mr. Whalen says he has turned down dozens of offers to sign up with expert networks.

"I don't like the atmosphere that they operate in," he says. "The networks are the facilitators, [but] the clients are the problem."

In certain cases, firms have cut off clients who sought improper information. David Teten, the founder of an expert network who now runs his own investment firm, Teten Advisors, remembers dropping several clients who made requests he felt crossed a line. Such players aren't foolish enough ask for the next quarter's numbers, he says, but preferred a more subtle approach of asking to speak with the chief financial officer of a particular company.

Mr. Teten adds that, for now, the results of the current insider-trading probe don't suggest there is a widespread problem in the industry. "So far there is exactly one person who works for an expert network with any specific allegations against them," he notes.

Still, a number of companies and even some investors have decided it's not worth taking any chances. SAC Capital Advisors, one of the world's most well-known hedge funds, told a number of expert networks two years ago that it would no longer use their services to speak to employees of publicly traded companies, according to Mr. Mayhew of Integrity Research. A spokesman for SAC declined to comment.

Some consultants for expert networks say they've never experienced anything improper. Burton Greenwald, a veteran of the mutual fund business who runs his own consulting firm in Philadelphia, is an expert in Gerson Lehrman's network. He says hedge funds tend to ask him about operational issues for asset managers.

"I'm not of the opinion that any of the [expert networks] have tried to build businesses by suggesting or even implying that they provide non-public information," he says. "That would destroy them."