Massachusetts Proposes Compliance Rules for Using Expert Networks

Expert networks have been a major topic over the last few months and we are seeing the states, in addition to the SEC, focus on this area as a compliance issue for investment advisers.  Massachusetts recently revoked the state investment adviser license of a manager who was using expert networks to gain inside information and then trade on that information.  Massachusetts is now proposing regulations which would require state registered managers to develop certain policies with respect to use of expert

networks.

The proposed regulation provides generally that investment advisers may not use expert network services unless the adviser receives a signed certification from the consultant (sourced by the expert network firm) that:

• describes the confidential restrictions the consultant has regarding confidential information and
• the consultant affirmatively states that he will not provide any confidential information to the adviser

In addition to this new compliance requirement, the proposal codifies the general prohibition against trading on inside information.

The full text of the proposed regulation is printed below and can be found here.  The Massachussets Securities Division will hold a public hearing on these and other proposed regulations on June 23 and will accept written comments until June 24.

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Preamble to Proposed Regulation

Investment Advisers Using Matching or Expert Network Services – Dishonest or Unethical Conduct in the Securities Business

The Division proposes to add a new section under 950 CMR 12.205(9)(c)(16) to the existing list of dishonest and unethical practices. The Division believes this addition is necessary to address the rising use of expert network firms by investment advisers to facilitate paid consultations between investment advisers and industry experts.

As alleged in In the Matter of Risk Reward Capital Management Corp., RRC Management LLC, RRC BioFund LP, and James Silverman, Docket No. E-2010-057, some investment advisers have paid expert networks and consultants to access confidential information about

publicly traded companies. The rise of expert network firms, and the number of abuses which have been addressed by regulators, make it clear that additional measures are required to ensure that confidential information is not being accessed and traded upon. The Division's proposed regulations, while not altering investment advisers' existing duty not to trade on insider information, seek to provide investment advisers with greater clarity as to what is impermissible conduct when paying consultants for information.

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Proposed Regulation

Investment Advisers Using Matching or Expert Network Services – Dishonest or Unethical Conduct in the Securities Business

Add the following new subsection (16) to 950 CMR 12.205(9)(c) (non-exclusive list of practices by an investment adviser which shall be deemed “dishonest or unethical conduct or practices in the securities business”):

16. a. To retain consulting services, for compensation that is provided either directly to the consultant or indirectly through a Matching or Expert Network Service, unless the adviser obtains a written certification, signed by the consultant that:

(i) describes all confidentiality restrictions that the consultant has, or reasonably expects to have, regarding Confidential Information; and
(ii) affirmatively states that the consultant will not provide any Confidential Information to the adviser.

b. Notwithstanding section (a) an investment adviser who comes into possession of material Confidential Information through a consultation is precluded from trading any relevant security until such time as the Confidential Information is made public.

c. Definitions. For purposes of this section:

(i) “Confidential Information” means any non-public information, which one is bound by a confidentiality agreement or fiduciary (or similar) duty not to disclose.
(ii) “Matching or Expert Network Service” means a firm that for compensation matches consultants with investment advisers.

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Cole-Frieman & Mallon LLP is a boutique hedge fund law firm.  In addition to investment adviser registration and compliance, we provide expert network compliance consulting services to SEC and state registered hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.