Advisers Relying on Research Must Take Steps to Prevent Insider Trading
Advisory firms that use extensive research before making investment decisions need to put policies and procedures in place to ensure that those investments are not based on material, nonpublic information. It’s the kind of thing the SEC keeps an eye out for, as one large hedge fund adviser recently discovered.
New York City-based Deerfield Management Company agreed to pay an almost $4 million civil money penalty, in addition to disgorgement and interest, to settle charges from the agency that it failed to establish, maintain and enforce compliance policies and procedures reasonably designed to prevent the misuse of inside information – in this case, information about confidential government decisions.
From at least May 2012 through November 2013, according to the SEC administrative order instituting the settlement, a political intelligence analyst retained by Deerfield passed MNPI in regard to three upcoming confidential decisions from the Centers for Medicare and Medicaid Services. "Deerfield analysts based trading recommendations on that information, and Deerfield made timely trades that resulted in more than $3.9 million for certain of its hedge funds once CMS announced its decisions."
The advisory firm, according to the SEC, was not adequately prepared to address the issue. "Despite red flags that the political intelligence analyst was conveying material, nonpublic information to Deerfield analysts, Deerfield continued to retain the political intelligence analyst’s firms and did not address the weaknesses in its policies and procedures."
"An investment adviser’s policies and procedures must be tailored to address the specific risks presented by its business," said SEC Division of Enforcement Market Abuse Unit co-chief Robert Cohen. "Deerfield relied on political intelligence firms, creating a risk that it would receive and trade on illegal insider information. As it turns out, that is exactly what happened."
"We are pleased to have resolved this matter," a spokesperson for Deerfield said.
"Advisory firms and their employees need to be vigilant," said Brown Rudnick partner Alex Lipman. "They need to follow the procedures they have in place and also need to review their procedures critically to make sure they are adequate."
The best policy in regard to MNPI is that "when you have MNPI, suspend investing in the relevant issuer until the information is made public," said Faegre Baker Daniels partner Jeffrey Blumberg.
The policies and procedures
Deerfield, an advisory firm with approximately $6.4 billion in assets under management, provides its services to hedge funds it manages that invest in healthcare, according to the agency’s administrative order. It adopted its first compliance manual in 2012, then revised it the next year, the SEC said. That version remained in effect through 2014.
The manual, according to the agency, "stated that concerns about the misuse of material, nonpublic information by the firm or its employees could arise primarily in two ways." Those two ways were:
When the advisory firm, in the course of conducting "extensive fundamental research on the entire healthcare sector in order to develop and implement investment theses," receives nonpublic information about the companies it researches "despite efforts to avoid receiving nonpublic information;" and
If the firm, "on its own," possesses MNPI "relating to its own business and the investment activities of the funds."
Those two concerns were apparently not enough, however, to prevent the SEC from bringing charges. Specifically, the agency said that "Deerfield did not establish or maintain policies and procedures reasonably designed to address the risks created by its practice of using research firms. . . . Deerfield engaged research firms and their political intelligence analysts to provide information regarding government decision-making."
The settlement also shows how the adviser made a distinction between how its compliance policies and procedures treated the potential for receiving information from research firms and what it received from expert firms.
All experts and expert networks engaged by Deerfield were required to undergo due diligence "to evaluate their compliance controls," the agency said. "In addition, at the beginning of any expert consultation, the Deerfield employee consulting with the expert was required to provide an oral reminder to the expert not to disclose information that would constitute material, nonpublic information. After the conclusion of the consultation, the employee was required to enter a report of the discussion" into a database created by the adviser to retain and organize investment research.
The SEC’s administrative order says the policies and procedures were different for research firms. "In 2012," the agency said, "Deerfield provided training to its employees that specifically excluded [emphasis SEC] research firms from the requirements for expert consultations."
Why the difference? According to the SEC, "Deerfield distinguished research firms from expert consultants by defining research firms as firms that provided ‘a finished product’ based upon the research firm’s ‘internal expertise and research.’ The training materials stated that [Deerfield] would conduct ‘diligence’ on research firms, but Deerfield would rely upon the research firms to police their own conduct." Nor were Deerfield employees working with research firms required to give a cautionary statement or make a database entry following consults with the research firm, the agency said.
Failure to enforce
The SEC’s allegations did not stop with inadequate compliance controls, however. Deerfield, the agency charged, did not enforce its own policies and procedures.
Specifically, in regard to the requirement that the firm determine whether research firms observed policies and procedures designed to prevent disclosure of MNPI or any information in breach of a duty, the agency said that "Deerfield did not enforce this requirement," which it said "was critical because it was Deerfield’s sole procedure in place to prevent the receipt and misuse" of MNPI from research firms.
As examples, the SEC listed a number of "red flags" that it said were missed by the adviser:
Form ADV. A research firm retained from at least 2009 until early 2013 indicated on its Form ADV "that the political intelligence analyst also served as the research firm’s chief compliance officer," which the agency described as a "conflict of interest posed by a chief compliance officer overseeing his own work which involved a risk of obtaining material, nonpublic information and providing such information to his investment adviser contacts."
Communications between the political intelligence analyst and the advisory firm. In July 2010, the political analyst "emailed several Deerfield analysts about a forthcoming regulation by CMS. . . . One of the analysts forwarded the email to other Deerfield personnel, including traders, portfolio managers, the chief compliance officer/general counsel," the SEC said.
Some of the communications resulted in trading by the adviser, the SEC said. "Between at least May 2012 and November 2013, the political intelligence analyst transmitted material, nonpublic information regarding CMS decisions to Deerfield analysts, which the Deerfield analysts then used as the basis for trading recommendations." As examples, the agency provided these:
CMS deliberations in May and June 2012 regarding cuts to Medicare reimbursement rates for certain radiation oncology treatments;
CMS deliberations in May and June 2013 regarding a proposed 12 percent reduction to Medicare reimbursement for certain kidney dialysis treatments, services and drugs; and
CMS deliberations in November 2013 regarding a final decision to phase in, over a four-year period, a 12 percent reduction to the Medicare reimbursement rate for certain kidney dialysis treatments, services and drugs.
"As a result of these trades, hedge funds advised by Deerfield received profits totaling approximately $3,946,267," the SEC said. "Through its management agreements with the hedge funds, including performance-based compensation, Deerfield received approximately $714,110 due to these trades."