(Adds that Don Chu was fired in the 7th paragraph.)
An insider trading investigation is causing confusion for some investors and disrupting the fast-growing "expert network" industry, even though securities lawyers and law professors say the probe is unlikely to change the rules investors must follow when researching stocks.
On Nov. 29, U.S. Attorney General Eric Holder said the Justice Dept. is pursuing a "very serious" criminal investigation of illegal trading activities on Wall Street. Investigators haven't detailed what they're examining, but the probe has had an immediate impact on Wall Street research practices, says Michael W. Mayhew, founder of Integrity Research Associates, which tracks trends in investment research.
"Expert networks"—firms that, for a fee, connect knowledgeable people with investors and others seeking expertise—have grown into an industry with $450 million to $500 million in sales in the past year, Mayhew estimates. The FBI searched the offices of three hedge funds on Nov. 23, part of an investigation begun by federal prosecutors in Manhattan. The investigation, reported Nov. 20 by The Wall Street Journal, has caused much of the expert networks' business to disappear, Mayhew says. "Use of their services has been suspended or stopped, because their clients are concerned," he said.
In the stock market, modest but crucial pieces of information can reap big rewards for investors who find them first. The growth of expert networks—from eight firms a decade ago to 40 today—is part of a drive by hedge funds and other investors to be more aggressive about gathering information. Expert networks match investors examining a particular company or industry with customers, clients, suppliers, competitors, professors, or anyone who, for a fee, can offer valuable information or insights on that topic.
Legal experts say it's not the idea of expert networks that is illegal in itself, but how they are used, and particularly which experts investors consult. "A simple question every investor should ask themselves [is], 'How did you get this information?'" says Christopher Robertson, a partner at the law firm Seyfarth Shaw in Boston.
Raiding Fund Offices
Don Ching Trang Chu, 56, a wireless broadband expert and employee of expert-network firm Primary Global Research, was arrested Nov. 24 on charges he provided inside information to hedge funds. The FBI has questioned John Kinnucan, who runs Broadband Research, a research firm in Portland, Ore., while various hedge funds and mutual funds that were customers of expert networks have been raided or asked for documents. Primary Global Research, in Mountain View, Calif., has denied any wrongdoing, and no one other than Chu has been arrested.
Chu, who had worked at the Mountain View, California-based firm for seven years, was dismissed, said Dan Charnas, a spokesman. Chu's attorney, James DeVita, has declined to comment.
Kinnucan, 53, said the FBI asked him to secretly tape a conversation with a fund manager they were targeting. He refused and has spoken out against the government's tactics. In an interview with Bloomberg News, Kinnucan said: "The Justice Dept. evidently would like to retroactively criminalize research activities" that, he believes, the SEC has condoned implicitly for years. "If I don't raise my voice, nobody will, because everyone has gone underground."
Is Digging Deeper Illegal?
The probe "has a chilling effect" on Wall Street, says Perrie Weiner, international co-chairman of securities litigation at law firm DLA Piper in Los Angeles, because it raises questions about what sort of research practices are legal. "Analysts have become very sophisticated," Weiner says. "The question is: When you have expert analysts digging deeper than average analysts would dig, at what point have they dug too far?"
Legal experts argue that while recent cases highlight some unclear areas of the law, the investigation may be less a reinterpretation of the law and more a hunt for the usual kinds of insider trading abuses in an area that has until now escaped scrutiny. "I don't think the rules are changing," says David S. Stone, chairman of the corporate and securities practice at Neal, Gerber & Eisenberg, a Chicago law firm. "What's happening is the [Securities and Exchange Commission] is focusing their resources on a different group that has previously not been in the limelight."
Asked to comment on whether the definition of insider trading is evolving, SEC spokesman John Nester said, in a brief e-mail: "Illegal insider trading is the act of trading, or causing someone to trade, on the basis of material non-public information in violation of a duty."
Where One's Duty Lies
That's the traditional definition, and securities experts say that, in recent cases, the key phrase is the last one—"in violation of a duty." The rumor mills of Wall Street or Silicon Valley—or even company holiday parties—have always been places to glean juicy information on public companies. Such information is illegal to trade on when it comes from someone who had a duty to keep it secret.
Thus, the problem is not when research analysts talk to a company's competitors or industry experts, or when they survey hundreds of customers, Robertson and other legal experts say. Legal trouble comes when they get information from people—current or former employees, attorneys or consultants—who are obliged to remain quiet. Research networks routinely have a policy against connecting investors with employees of public companies if clients are looking to invest in them, Mayhew says, although he notes that networks can't be sure their clients are being honest about their intentions.
According to the charges against him, Chu passed on insider tips about Atheros Communications (ATHR), Broadcom (BRCM), and Sierra Wireless (SWIR) to Spherix Capital, a hedge fund run by Richard Choo-Beng Lee. Lee had been cooperating with investigators as part of another investigation, started in 2009, looking at the Galleon Group, a hedge fund in New York. Although the full details of Chu's alleged crimes are not detailed, the complaint says Chu had found ways to "obtain inside information," such as sales and contract figures, from public companies before they released quarterly results. It's likely that no one possessing such sensitive information would be allowed to disclose it, and thus, if the charges are true, Chu had a duty not to pass those tips on to investors.
Many other research methods remain O.K., as long as no one with such duties is consulted, says Harold Gordon, a partner at the law firm Jones Day in New York. "There is still room for good, fundamental research," Gordon says, especially when analysts "piece together a portrait of how a company is doing" based on various sources of information: by surveying competitors, monitoring parts orders or freight shipments, or collecting other tidbits. "Going out and finding information about a company without going through insiders has always been permitted," Stone said.
When Information Is Material
One area of confusion among legal experts and analysts is whether store managers or other low-level employees can be legal sources for research data. Inside information is illegal only if it's material—i.e. significant enough to move a stock price. "If you're really low in the food chain, the amount of information you have is arguably not material," says Eric W. Orts, a management professor who specializes in legal studies and business ethics at the University of Pennsylvania's Wharton School.
On the other hand, prosecutors can argue that, while each manager may not possess material information, a survey of hundreds of managers yields important, invest-able information, Stone says. "You get into gray areas when you start surveying store managers," he said. Another question is whether store managers or other low-level employees are prohibited by company policy from responding to such surveys—and thus would be speaking "in violation of a duty." The answer can vary by company, and many employees probably don't know their own company's confidentiality policies, Orts says. "There needs to be better information given to employees about what their responsibility is."
With so much firepower aimed at getting better information to investors, there may be an inevitable temptation for some to push research to its legal limits. "If your whole job is to get an edge on information," Orts says, "there are a lot of people tempted to step over that line."