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Next Up: A Crackdown on Outside-Expert Firms

With the government securing a conviction against Raj Rajaratnam of the Galleon Group, federal prosecutors will shift their focus to expert networks — the intricate web of money managers, corporate executives and consultants at the center of another wave of insider trading cases.

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Over the last few years, the Justice Department has built dozens of insider trading cases. The government’s effort has sent shivers through the hedge fund industry, the influential investors that have figured prominently in an investigation into Wall Street.

Prosecutions have developed mainly along two tracks. One group of cases aimed at Mr. Rajaratnam, the founder of Galleon, and the cadre of corporate insiders and investment traders from whom he solicited confidential information. The other group has involved expert network firms, the Wall Street matchmakers who connect large investors with outside experts.

In several indictments involving expert networks, authorities claim that hedge fund managers paid outside consultants handsome fees for providing nonpublic information. The government has also charged executives at the expert network firms, the ones who brokered the connections, with knowingly facilitating the exchange of illegal stock tips.

Prosecutors say the money managers often sought impending information on large technology companies, like Apple and Dell, whose stocks can turn quickly on tidbits about financial performance and forthcoming products. On Wednesday, a former account manager at the Taiwan Semiconductor Manufacturing Company, Manosha Karunatilaka, pleaded guilty to insider trading, admitting that he leaked details about the company’s sales and shipping orders to clients of Primary Global Research, an expert network firm.

“The cases send a good signal that firms need to remain vigilant,” said Carlo V. di Florio, the Securities and Exchange Commission’s director of compliance.

The insider trading investigation has had a chilling effect on the expert network industry, which is struggling to maintain its Wall Street client base. Scared of being ensnared by scandal, large financial firms are reducing their use of expert networks and reviewing their internal policies regarding outside consultants. In the last year, revenue at these firms dropped 20 to 30 percent, according to Integrity Research, which tracks the industry.

“Managers are studying those complaints carefully and saying, ‘O.K., what can we do to make sure that we’re not doing anything like this?’” said Marc E. Elovitz, a lawyer at Schulte Roth & Zabel, which represents some of the country’s largest asset management firms. “With the increased attention to it, there’s been some more selectivity in the use of these services.”

The expert network industry developed after the S.E.C. enacted the Regulation Fair Disclosure rule in 2000. The rule, which bans public companies from disclosing “material nonpublic information to certain individuals or entities,” makes it illegal for corporate executives to share information only with certain parties. Lacking that exclusive pipeline, some big investors began relying on expert networks to supplement traditional sources of research.

Now, Wall Street is distancing itself from the industry. The hedge funds Balyasny Asset Management, Millenium Partners and Och-Ziff Capital Management have suspended their use of such consultants, according to people close to the firms who were not authorized to speak publicly on the matter.

Other firms are adjusting their rules. Credit Suisse has restricted the use of expert networks to certain departments. Morgan Stanley is hammering out a firmwide policy that will effectively limit their use, according to one person with knowledge of the situation who was not authorized to speak publicly.

Some hedge funds are barring the use of consultants who work at publicly traded companies, while others are encouraging compliance officials to randomly monitor phone conversations.

Federal authorities have tried to quell the anxiety by drawing a distinction between the legitimate players and the bad actors. In March, Preet S. Bharara, the United States attorney in Manhattan, said that there was “nothing inherently wrong or bad about hedge funds or expert networking firms or aggressive market research, for that matter.”

Such statements have provided little reassurance. Many financial firms that are still using expert networks have moved their business to the largest outfits with the most established compliance practices

“If this little industry is to survive, it’s going to have to glow with virtue, which means a lot of self-regulation,” said Robert Weisberg, a professor of criminal law at Stanford.

But comprehensive systems to vet consultants, train employees and maintain sprawling databases requires significant capital and human resources. The Gerson Lehrman Group, the industry’s largest player with a roughly 60 percent share, employs a full-time compliance staff of about 20 people.

Compliance is a heavy burden for the smaller players. There are only about 40 expert network firms in the United States, according to Integrity Research, and only a handful have annual revenue in excess of $40 million. Given the costs associated with compliance, Professor Weisberg predicts that many smaller firms will have to team up with their larger brethren or shut down.

Mr. di Florio said the S.E.C. was paying greater attention to compliance by expert networks. “Firms recognize that regulators, like the S.E.C., have their radar up on these insider-trading practices, and we’re looking to see that they have effective regulatory compliance and risk management programs in place,” Mr. di Florio said.

Several states, using powers under the Dodd-Frank law to police hedge funds, are starting to outline new rules to govern the industry.

Earlier this month, William F. Galvin, the chief financial regulator in Massachusetts, proposed regulations to force investment advisers to obtain certification from expert network consultants that they will not provide any confidential information.

“I hope this leads to more sensitivity in the industry that they cannot simply purchase insider information,” said Mr. Galvin said. “We are going to be as aggressive as we can.”

—Azam Ahmed contributed reporting.