Personal Trading: Take Steps to Detect and Prevent
Chief compliance officers need to monitor personal trading. It can be difficult to do, but it can be done.
Improper personal trading typically occurs in the context of either insider trading, when an employee trades based on material non-public information, or when an employee uses client information to trade to his or her benefit.
Personal trading is covered by Advisers Act Rule 204A-1, the Code of Ethics Rule. Among other things, the rule requires that registered advisers establish, maintain and enforce a written Code of Ethics requiring access persons to submit quarterly reports on certain personal securities transactions and annual reports of securities holdings. It is important to keep in mind that the definition of "access person" includes any employee who has access to non-public information; the definition is not limited to only those employees who actually obtain non-public information, said Day Pitney counsel Eliza Sporn Fromberg.
Whether you decide to limit personal trade reporting to access persons or extend it to a wider group, the requirements mean that CCOs, depending on the size of the firm "might receive a few hundred reports each quarter, and it may not be realistic, given all a CCO has to do, to go through every one," said Mayer Brown attorney Adam Kanter.
Fortunately, there are ways to handle the work flow and do an effective job of monitoring personal trades. Consider the following:
Ensure that personal trades are reported electronically. If you are not doing this already – many firms are – consider doing so. Ask your brokers if they provide electronic feeds, said Fromberg. However, brokers sometimes will not provide electronic surveillance directly to advisers, so many advisers engage a third-party service provider to assist with this. It makes the compliance department’s surveillance of personal trading much easier when compliance officers can filter and sort data, as well as search by individual names.
Review for more than what is on your firm’s restricted list. Many firms maintain a list of securities or companies for which, because of sensitive trading or other issues, personal trading is not permitted. While you certainly want to monitor for employees transacting in restricted securities, go beyond that in your searches and look for patterns of unusual activity, said Kanter. "Look for outliers. Who is doing more trading than normal? Was there a substantial amount of trading in one month and none the next? Is the security currently owned by a client or being considered for purchase by a client?" Fromberg suggested that firms "look for matches between employee trades and client trades," which she said might be understandable with widely traded stocks like Apple, but would raise more concerns with thinly traded stocks.
Require pre-trade clearance. Consider pre-trade clearance for any personal transactions involving securities that clients are also trading in or considering trading in, said Kanter. "For instance, if a firm’s bread-and-butter trading is in biotech stocks, some firms may require that all personal trades in biotech stocks be pre-cleared." Doing so, he added, may have the practical effect of stopping all personal trades in the area, as employees may simply find the process of seeking pre-clearance time consuming and too much bother. Fromberg noted that Rule 204A-1 requires pre-approval only for access persons’ investments in IPOs and private placements, but suggested that firms consider requiring pre-clearance for personal trades by all employees.
Establish blackout periods. These prevent employees from trading in a particular security for a defined period of time before and after a client transaction involving that security is made. It may not always be possible, of course, to know several days prior to a client trade just what transaction for the client will be conducted, but firms should usually be able to establish a post-trade blackout period. The advantage of time restrictions is that they might prevent employees from taking advantage of time-sensitive inside information or knowledge of client activity to engage in transactions they could improperly benefit from. "Set it for as long as you can without ruffling feathers, but at a minimum for as long as you think there could be an opportunity for inappropriate trading activity," Kanter said.
Assign a particular compliance officer to certain employees. For instance, a specific compliance officer might be assigned to review a portfolio manager’s trading for certain patterns, said Fromberg. Having one compliance officer tied to particular employees for a sustained period will allow that compliance officer to become familiar with the securities the employees trade in, as well as their trading patterns – and therefore make it easier to spot aberrations to those patterns.
Review employee email. Despite warnings not to write sensitive information on company email, employees still do it, and it is quite conceivable that these emails might contain information on personal trading, said Fromberg.
Disclose. Note in your firm’s Form ADV, Part 2, Item 11C that your firm allows personal trading in certain securities that clients also trade in, and that you have compliance policies and procedures in place to prevent improper activity, said Kanter.
Remind employees regularly of your firm’s policies. For insider trading, that means those policies and procedures governing use of material non-public information, said Fromberg. Employees should also be reminded that they have a fiduciary duty not to put their own trades ahead of their clients.
The bottom line in monitoring personal trading is that it is a balancing act, said Kanter. "You don’t want to be overly burdensome, but you don’t want to open the door for something to happen."