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News October 30, 2006 Issue

SEC Scrutinizing Advisers' Use of Non-Public Information

Move over, gifts and entertainment. Thereís a new hot topic in town.

According to OCIE associate director Gene Gohlke, SEC examiners will be looking closely at advisory firms to determine whether they are improperly using non-public information when making trading decisions. Speaking at last weekís Investment Adviser Association compliance seminar in Washington, DC, Gohlke listed a number of areas that examiners "are going to be paying attention to during routine exams" conducted during the SECís fiscal 2007 year, which began this month. "Probably at the top of the list," he said, "is making investment decisions based on non-public information."

Gohlke said that he was trying to stay away from the term "insider trading." For advisers, "itís really making investment decisions based on non-public information," whether for client accounts, firm proprietary accounts, or individual access person accounts. "To what extent are advisers using that information to get a little more alpha?" he asked. "Itís about standing out from the crowd." A portfolio manager might think, "Gee, if I can make a few decisions based upon information that my competitors donít have, all the better."

The SECís interest in the area undoubtedly has been fed by recent press attention about hedge fund managersí alleged use of non-public information. In fact, Gohlke acknowledged that there recently have been "quite a few articles" on the topic.

He cautioned that the type of information that should be considered non-public goes "well beyond" what has been traditionally linked to insider trading involving equities. "There is lot of information sloshing around that [may not have Ďnon-publicí] written all over it, but is still non-public." He gave the example of an adviser that invests in bank loan participations. In connection with those investments, the adviser may receive access to non-public information about the borrower, which it might use to inform its decisions about investments in the borrowerís equity securities, or in the borrowerís competitorís equity securities.

Gohlke also gave the example of an adviser that takes positions in debt securities and learns of non-public information about a possible downgrade. If the adviser turns around and buys credit default swaps based on the downgrade information, "thatís trading on inside information, too."

Of interest to wrap sponsors and overlay managers: Gohlke indicated that pending orders can be non-public information. He noted that the SEC staff hears "a lot of complaints" from large institutional managers that "thereís a lot of front running out there" of their trading intentions. "Is that trading on inside information?"

According to Gohlke, SEC examiners will be looking at how advisers obtain non-public information and how that information is managed. "We are going to be taking a very broad look at how firms identify non-public information to which the firmís people might be exposed," he said. Examiners will consider the types of research that the firm obtains, the firmís contacts with its affiliates, as well as contacts the firm may have "with the Street." Portfolio managers, noted Gohlke, may have "back channel discussions" with research analysts and others at brokerage firms. If an adviser "places a lot of brokerage with a particular sell-side firm," a portfolio manager might have the clout to press that firmís analysts, saying "Yeah, thatís what you are telling all your clients, but can you tell me something about this issuer or this class of issuers that isnít known by everybody?"

Of course, advisers already are required by Advisers Act Section 204A to establish, maintain, and enforce written insider trading policies and procedures. Those policies and procedures must be reasonably designed to prevent the misuse of material, non-public information by the adviser or any of its employees or other associated persons.

Gohlke said that examiners will be "very much interested" in how a firmís policies and procedures address whatever non-public information the firm has access to. Examiners will want to know how non-public information is managed and whether the procedures are "appropriate" and "robust enough." Advisory firms "have a whole bunch of smart people" working in-house, such as portfolio managers, traders, research analysts, as well as people in the back office. "With all these smart people," said Gohlke, someone might think to themselves, "Hey, if I can figure out a way around those procedures and use some of that great information that is flowing in from wherever, I can really use it to my advantage."

To that end, Gohlke suggested that firms test "after the fact" to detect investment decisions that may have been based on non-public information. "What Iíve tried to emphasize to our staff" and what "is very much the thing that firms should think about" is "what sort of lookback testing can you do to see whether there might be patterns out there" that merit follow-up investigation, he said. The tests might not definitively point to investment decision-making based on non-public information, but rather only that "there might be" such activity and that the person or area "warrants further review." If a manager had traded on non-public information, he said, "hopefully there would be patterns in that trading that you could see."

Gohlke then proceeded to give several examples of lookback tests that could be performed to detect investment decisions made on the basis of non-public information. "These are some of the tests that examination staff certainly will be thinking about doing," he said. "I would very much commend those to firms to think about as part of their compliance program."

  • Test #1: "On a semi-annual basis," the CCO could "look through all client trading and identify the ten or fifteen positions that were the most profitable for the firm" during that period of time. The CCO could then perform additional research on those positions, by reviewing various news sources to see what information about those issuers came out shortly after the investment decision was made. "If thereís a pattern there," he said, the CCO could investigate further. If in ten out of fifteen positions, "there was a significant announcement two days after the investment decision was made, if I was the CCO I would want to do some more work."
  • Test #2: Same as test #1, but instead of looking at the ten or fifteen positions that were most profitable for the firm, look at the ten or fifteen positions that were most profitable for each portfolio manager during the period.
  • Test #3: Firms could determine whether any access personsí personal account shows that "90 percent of their trades, 100 percent of their trades" were profitable, and take a closer look to determine whether the trades reflect the misuse of non-public information.

Gohlke made a point of acknowledging that there is nothing wrong with investment advisersí aggressively seeking out information. "Go out there and get all the information you can get, because youíll make better investment decisions for your clients." However, he added, "just make sure that that information doesnít cross the line." Distinguishing between public and non-public information, he said, "is really something that each firm has to pay a lot of attention to" when developing policies and procedures. "Itís very hard to make that call."

In conclusion, Gohlke said that examiners "will really be focusing on" this area. "Firms that trade on non-public information tend to get whacked by the Commission," said Gohlke. "Just a word to the wise."

Gohlke then briefly touched on two other OCIE areas of focus:

Portfolio risk management activities. Gohlke said that in light of the Amaranth situation, "it makes sense" for examiners "to look at the portfolio risk management activities [and] processes" of advisory firms, particularly for firms that follow a "more esoteric, complex investment strategy." Examiners, he said, will ask how the firm makes sure that "what it is doing from the investment point of view is consistent with what it has told its clients," whether they be hedge funds, mutual funds, or separate accounts. However, he added, examiners will ask questions about the risk management process only "where it makes sense." A long-only, short-term, high-quality fixed income money manager may not need to pay a whole lot of attention to risk management, he said.

Side agreements. Gohlke highlighted the recent BISYS enforcement proceeding. "Definitely read that," he said. The case, he said, is just one instance of undisclosed arrangements. "There are other situations where there can be side agreements Ö that either use mutual fund money or hedge fund investment money or simply other advisory client money in ways that arenít disclosed but that somehow benefit the adviser."

Gohlke noted that recent standard OCIE exam request lists contain an item asking firms to report all side arrangements in writing. He suggested that compliance officers "do something comparable to all of the people within your firm that are responsible for various contractual arrangements."