Preparing for the SEC’s New Focus on Inside Information (Part 2 of 3)
In last weekís issue, we took a look at the various SEC enforcement cases against
advisers that alleged inadequate Section 204A insider trading procedures. In each of those cases, you might have noticed, a member of the firm was in a unique position to obtain material, nonpublic information.
The moral of the story: If a member of your firm, particularly a senior officer or principal, is in a position where he is likely to obtain inside information, your procedures should do more than politely wait and hope that the person self-reports any inside information they happen to come across.
Think Chinese walls. Training. Vigorous back-end testing. And, perhaps, after weighing the benefits vs. risks to the firm, asking that person to consider resigning from the position or situation that exposes him to inside information in the first place.
If, on the other hand, no one in your firm is in a unique position, then perhaps the standard "if you think you have inside information, go talk to the CCO, donít trade on it or talk about it" procedures are adequate. "To me, it seems that if you are a firm with no unique or special risks for your firm or your employees, self-reporting ó in connection in with robust training and testing ó should suffice," said Investment Adviser Association general counsel Karen Barr. The key, she said, is to look at the unique risks posed by the firm and its personnel. Some firms, she noted, have no unique risks with respect to insider trading. On the other hand, some firms may be activist investors that try to obtain a seat on the boards of companies in which they invest. Other firms may have personnel who serve on creditors committees, or may have deep relationships with prime brokers. CCOs, she said, should perform an "inventory of relationships." If there are unique or special relationships that may result in firm personnel obtaining possible inside information, the compliance officer needs to consider whether to impose additional procedures with respect to that risk.
Stepping back a bit, letís look at what type of information poses a concern. Obviously, the cliched "Pssst! My brother-in-law just told me his company is about to be acquired!" sort of thing is clearly inside information. But what about all that other information "sloshing" around out there, as OCIE associate director Gene Gohlke recently put it?
We liked this formulation, provided by SEC Division of Enforcement associate director Thomas Newkirk in a 1998 speech: Insider trading, he said, "is the trading that takes place when those privileged with confidential information about important events use the special advantage of that knowledge to reap profits or avoid losses on the stock market, to the detriment of the source of the information and to the typical investors who buy or sell their stock without the advantage of Ďinsideí information."
Hereís another way to think about it (which, quite frankly, we pretty much made up): If you have an "edge" that others in the marketplace could never in a million years hope to achieve, regardless of how much hard work, intellect, and analysis they throw at it, your "edge" might actually be inside information.
Of course, if you talk to a lawyer, youíll probably be told that inside information is that which is "material" and "nonpublic." The problem, of course, is that material nonpublic information is not always labeled as such. And the concepts of "materiality" and "nonpublicness" are squishy, having been developed over the years in a series of judicial decisions. "If you are trying to figure out what the law is," said Willkie Farr partner Barry Barbash, "youíve got to go through a whole lot of sources to come up with a picture."
Letís poke at those terms a bit.
Whatís material? The general platitude goes as follows: Information is "material" if there is a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision. The SEC, in its 2000 Reg. FD adopting release, provided a non-exclusive list of things that might be material:
mergers and acquisitions;
changes in assets;
developments regarding customers or suppliers (such as the acquisition or loss of a contract);
changes in control;
changes in management;
change in auditors, or an auditorís notification that the issuer may no longer rely on the auditorís audit report;
bankruptcies or receiverships; and
events regarding the issuerís securities, such as defaults on senior securities, calls of securities for redemption, repurchase plans, stock splits or changes in dividends, changes to the rights of security holders, and public or private sales of additional securities.
Reg. FD, by the way, is the set of rules that basically say that if an issuer is going to disclose some material information, it has to do so broadly (i.e., no more selective disclosure to a handful of analysts; Joe Public has to be invited to the conference call).
The SEC added two bits of caution. First, just because somethingís on the list of "what-might-be-material" doesnít necessarily mean itís always material. "By including this list," said the SEC, "we do not mean to imply that each of these items is per se material." For example, some new contracts might be material (a $100 million contract to produce 50,000 widgets), others may not be (a $10,000 contract to produce a measly 7 gizmos).
Second, the SEC cautioned that signals about earnings information are likely to be material. "When an issuer official engages in a private discussion with an analyst who is seeking guidance about earnings estimates, he or she takes on a high degree of risk under Regulation FD," said the SEC. "If the issuer official communicates selectively to the analyst nonpublic information that the companyís anticipated earnings will be higher than, lower than, or even the same as what analysts have been forecasting, the issuer likely will have violated Regulation FD." The SEC cautioned that this risk is present regardless of whether the information about earnings was communicated expressly or through indirect code "where the meaning is apparent although implied." Later, in additional guidance, the SEC staff indicated that in some circumstances, an issuer can confirm previous earnings guidance without blowing Reg. FD. For advisers, the take-home point is that advance predictions about earnings information are "gold" to a potential insider trader.
Whatís nonpublic? Information is nonpublic if it is not widely available or has not been widely disseminated. Information is public if it has appeared in the Wall Street Journal, Bloomberg, or similar news publications. Information is public if it appears in an 8-K filed on Edgar.
Beyond that, however, it quickly gets fuzzy. Say, for example, an issuer posts information on its corporate website. Would such information be deemed widely-disseminated and therefore publicly available?
Funny you should ask. Just a few weeks ago, Jonathan Schwartz, CEO of Sun Microsystems, urged the SEC to clarify that information posted on a website or corporate blog would be deemed widely-disseminated for Reg. FD purposes. Currently, he noted, companies must hold conference calls or issue press releases, so that news organizations can turn around and disseminate the news. In Schwartzís view, a simple notice posted on Sunís corporate website should do the trick.
You would think that technology-embracing SEC Chairman Christopher Cox would be all for it. But he wasnít (although we do note that Cox took the unusual step of posting his November 3 reply on Schwartzís blog). Even if the SEC were to agree that information posted on a corporate website would be widely-disseminated, said Cox, there would still be some questions to address. For example, would there be "effective means" to guarantee that a corporation uses its website in ways that assure broad non-exclusionary access? That, noted Cox, would depend on the particular facts.
Enough with the law. Letís get practical. Whatís an adviser concerned about the new SEC focus on advisory firmsí use of inside information to do?
Step 1: Designate an "insider trading point person." If you havenít already, pick a person to serve as your firmís resident insider trading expert. For starters, we recommend reading U.S. v. O'Hagan, the 1997 U.S. Supreme Court opinion that explained the "misappropriation" theory of insider trading, most relevant to advisers, as well as Newkirkís 1998 speech, mentioned earlier. The point person should be charged with conducting a risk assessment to determine channels by which inside information may enter the firm, overseeing the firmís internal training program, and answering any insider-trading related questions that arise.
Step 2: Perform an inside information risk assessment. As Barr suggested, firms should identify all the relationships through which their personnel might obtain inside information.
Hereís a list to get you started:
Bankruptcy committees/creditors committees. If an adviser has invested a significant amount of client assets in an issuer which later declares bankruptcy, the firm may seek to sit on the creditors committee established by the bankruptcy court, so as to have a voice in the process of reorganizing the issuer. "Bankruptcies are a hard situation," said Barbash. In his view, firms should take steps to protect themselves against a claim that they used information obtained in connection with participation on a bankruptcy committee "one way or another" to benefit itself. To that end, he said, a trading order "gives you the advantage of having a procedure that is generally accepted."
Whatís a trading order? Under the theory that it would be unfair to force an advisory firm to choose between sitting on the bankruptcy committee, on one hand, and forsaking investment opportunities for its clients, on the other, advisory firms routinely seek trading orders from the bankruptcy court, approving specified information-blocking procedures and permitting trading of claims against the company that has declared bankruptcy. The typical trading order requires advisory firm personnel who will be active on the bankruptcy committee to sign a letter acknowledging that they may receive material, nonpublic information as a result of serving on the committee, that they are aware that information-blocking procedures will be applied, and that they will follow them and not share any material, nonpublic information obtained as a result of their committee activities. The firmís compliance department may be required to review the firmís personnelís trades of the issuer, to determine if there is any reason to believe that the trading activities were not made in compliance with the information-blocking procedures.
Next week: PIPEs, boards, loans, and more!