Preparing for the SEC’s New Focus on Inside Information (Part 1 of 3)
As reported in last weekís IM Insight, one of the highest priorities for the SECís examination program is investment advisersí use of nonpublic material information in making trading decisions.
Hedge fund advisers should be particularly attuned to this issue. In her recent testimony before the Senate Judiciary committee, SEC Division of Enforcement director Linda Chatman Thomsen described insider trading by hedge funds "an area of significant concern to the Commission."
The use of inside information by hedge funds also is receiving scrutiny by the United Kingdomís Financial Services Authority. "We believe some hedge funds may be testing the boundaries of acceptable practice with respect to insider trading and market manipulation," said Hector Sants, managing director of the FSAís Wholesale and Institutional Markets division, in a September 2006 speech. "In addition, given their payment of significant commissions and their close relations with counterparties, [hedge funds] may create incentives for others to commit market abuse. We are supporting and testing these assertions by devising metrics to measure the incidence of unusual price movements."
Hedge fund manager or not, all advisers should be on notice that insider trading is going to be a hot issue. Itís definitely one youíll want to have thought about before your next SEC exam.
Basically, there are two ways that advisers can get in trouble for insider trading: for failing to have adequate insider trading procedures, as required by Section 204A, and, less commonly, in connection with actual insider trading. The SEC can and does bring enforcement cases against firms for merely having inadequate procedures, even if there is no evidence that actual insider trading has taken place. For example, last June, Morgan Stanley agreed to pay $10 million to settle SEC charges that it failed to maintain adequate insider trading procedures. The SEC did not allege that any inside information was actually misused as a result of the firmís allegedly deficient procedures.
Because it is a required procedure under Section 204A, your firm already should have a written insider trading policy, which may exist as a stand-alone policy or be integrated into your firmís code of ethics. Pull it out and take a look. Chances are, it reads along the following lines:
No partner, officer, or employee of the firm may trade in a security, either personally or on behalf of any firm client, while in possession of material, nonpublic information regarding that security; nor may any partner, officer, or employee of the firm communicate material, nonpublic information to others in violation of the law.
[Description of whatís material and whatís non-public.]
If you believe that you have obtained material, nonpublic information about an issuer, you must report the matter immediately to the CCO. You must refrain from purchasing or selling the issuerís securities on behalf of yourself or others, and you must not communicate the information to anyone inside or outside the firm.
Thatís pretty typical language. Unfortunately, in enforcement case after enforcement case, the SEC has faulted insider trading policies that rely on advisory firm personnel to self-evaluate whether they have obtained material nonpublic information, particularly where individuals are in a unique position to obtain that information.
Take, for example, the SECís May 2001 enforcement proceeding against Guy Wyser-Pratte, whose advisory firm engaged in merger arbitrage activities and other investment strategies relating to changes in companiesí governance structures. The SEC said that it was a "foreseeable consequence" of Wyser-Pratteís participation in such investments and interaction with market participants that he would be regularly exposed to persons in possession of material nonpublic information. Notwithstanding his role, said the SEC, "Wyser-Pratte was not subject to any procedures other than the general requirement to self-evaluate information that came to his attention and to refrain from trading that would violate the law."
Similarly, in the June 2002 case against DePrince, Race & Zollo, the SEC alleged that the firmís insider trading procedures did not adequately to take into account the special circumstances presented by one of the firmís principalís position as a member of the board of directors of an issuer, as well as a portfolio manager at the firm. The firmís Section 204A policies and procedures, said the SEC, relied primarily on the principal to determine when he came into possession of material, nonpublic information about the company.
And again, in its November 2002 case against Robert Gintel, owner of Gintel Asset Management, an adviser, and Gintel & Co., a broker-dealer, the SEC alleged that the firmsí insider trading procedures required employees "to make a self-evaluation of whether information might be material and nonpublic and, if so, to report the matter to the compliance officer and refrain from trading." Once again, the SEC highlighted the founderís role: "Given Gintelís central position in the firms and likely access to material, nonpublic information, these self-evaluation and self-reporting procedures were not reasonably designed to prevent the misuse of such information."
If a simple prohibition and requirement to self-report possible insider information is not adequate, what is?
More next week.