While the benefits of using primary research vendors are clear, the legality can seem a bit murky.
One gray area is how analysts can safely conduct interviews with customers or suppliers of target companies. The information garnered from these subjects can be problematic in two ways:
- If the information could be considered material non-public
- If providing the information causes an employee to break a contractual or fiduciary duty of confidence
Recent insider trading cases such as those brought against Alnoor Ebrahim and Walter Shimoon exemplify how conversations with customers and suppliers can lead to the disclosure of material non-public information. Since Ebrahim worked for AT&T and AT&T is a material customer of Apple, it was a breach of his fiduciary duty for him to reveal sales figures. In Shimoon’s case, his company was a material supplier of Apple, and thus disclosing secrets about the iPad also happened to be illegal.
In addition to avoiding material customers and suppliers, funds should not conduct research calls with contacts who are not permitted to consult by their employer or who would be breaching contractual obligations. While soliciting information from these subjects may not fall under insider trading, it is still illegal. For example, the retailer Big Lots sued a research firm for digging up information from store managers, which Big Lots alleged was a violation of the employees’ fiduciary duties.
Minimum Best Practices
To ensure compliance when conducting supplier and customer interviews, when using expert network vendors funds should have a copy of the vendor’s contract with its experts. The contract needs to include language indicating that the expert is allowed by his or her employer to consult.
The researcher should also have a list of each expert’s “conflict companies” (companies on which the expert can not legally provide information), and these conflict companies should not match any of the fund’s current or pending investments.
Finally, funds should have a policy to decide what should be considered “material.” Since materiality is subjective, even to regulators, it’s not always clear who is a material supplier or customer. But if a fund establishes a threshold and does not consult with anyone clearly above this limit, they will avoid potentially troublesome situations.
Checklist for Implementation
- Procure standard consulting contracts signed by experts from each vendor, affirming that expert is allowed by employer to consult.
- Check that companies on which an individual expert cannot consult due to conflicts of interest do not include any current or pending investments. Maintain a centralized list of these “watch list” companies.
- Have a standardized policy for materiality and a procedure for handling calls with potentially material customers and suppliers. Suggested policies include having scripts prepared by analysts prior to the call or having a compliance representative ‘chaperone’ the call. Train analysts to recognize what constitutes materiality and to avoid seeking material info.
In Part 2, we will discuss advanced best practices being implemented by the world’s largest research organizations.