Restricted Lists: Update, Monitor and Avoid Common Errors

Many advisory firms maintain "restricted lists:" compiled names of companies and securities with which they do not allow trading. These lists protect an advisory firm from a number of dangers – but advisers with such lists need to ensure they are properly updated, monitored and that they avoid mistakes that may cause problems down the road.

Restricted lists protect advisory firms by, among other things, preventing trading in securities or companies where the adviser, an advisory firm employee or an affiliate may be in possession of material nonpublic information (MNPI), where a non-disclosure agreement is in effect, or in situations where a conflict of interest may exist between the advisory firm and a client.

"Once on the restricted list, the advisory firm and employees of the firm cannot trade in that security or securities of a listed company unless the adviser’s chief compliance officer makes an exception," said Ropes & Gray partner Jason Brown.

What’s listed

Advisers use different structures to determine what securities or companies are placed on a restricted list, said Perkins Coie partner Alexandra Alberstadt. It can be done by the CCO, or by a committee that includes the CCO, the portfolio manager and others, she said, adding that how the list is constructed should be documented.

"The important thing to remember is that "the list needs to be kept alive and updated," said Mayer Brown partner Adam Kanter. "Facts and conditions change, with names both going on and coming off."

Consider the following entities that advisers should consider for their restricted lists:

• Securities held in the clients’ portfolios. "Sometimes it’s a total ban, sometimes for a short period," said Alberstadt. Short listing periods may result from the portfolio manager rebalancing the firm’s portfolio every few months, or when a security is under consideration for some time, but the adviser eventually decides not to buy it, she said.
• Companies where the advisory firm or an employee has MNPI.
• Companies with distressed debt or equity into which the adviser invests. "In such cases, the adviser might be on the creditors committee, which would justify listing that company on the restricted list," Alberstadt said.
• Companies in which the adviser has an employee or a family member on the board of directors.
• Securities that an advisory firm is trading for clients. Advisers should "prevent front-running by including those securities on the restricted lists so advisory firm representatives don’t trade before the client does," said Kanter.

"The default is to have a very broad list and then you can take names off the list, rather than having a short list and having to frequently add names," said Alberstadt. Of course, even with a broad list, there will be times when names will need to be added.

"Restricted lists are most effective when there is a free flow of information between the compliance department and those in the firm who may come into possession of MNPI," said Kanter. That open culture should allow anyone who is not sure if information he or she has received is MNPI, to report it to Compliance to find out.

Monitoring

The best way to monitor trades is to compare trading records against the list – and the best way to do that is through a computer software program, said Alberstadt. Large firms typically have these programs, which can also be used to seek pre-clearance for trades.

Smaller firms should have some kind of computerized program that will catch improper trading and that can be used for pre-clearance, but if they don’t, then employees seeking trading clearances will need to manually send pre-clearance forms to Compliance and Compliance will need to do manual trading checks, both to grant trade approval and to confirm approved trades complied with the employee request, she said.

"If front-end order placement software is in place, that program can be customized to automatically prevent trading in securities on the restricted list," she said.

Expect examiners, when they visit, to ask to see the firm’s restricted list, as well as records of the compliance officer’s review of employee trading, Alberstadt said. If Compliance finds an instance of trading in a name on the restricted list, she added, Compliance needs to follow up and document its review.

The mistakes

Despite good intentions when creating a restricted list, they take some time and attention to maintain. Failure to do so may result in a number of problems. Consider the following situations that compliance attorneys have found with clients:

• Not keeping the list updated. The frequency by which one updates the list depends on the size of the advisory firm, the strategies it uses, and the number of securities it trades, said Alberstadt. "Certainly when new names come in, you need to update it, and you also need to do so when you take off names that no longer apply." Firms should document specifically why names are removed for reasons other than that the security is no longer being considered for client accounts, she said.
• Private equity firms and real estate firms thinking that they do not need to use restricted lists. "PE firms and real estate firms, because they generally do not trade securities listed on the open market, sometimes think that they do not need to have a list," said Kanter, "but you can come into MNPI here, as well. There might be even more of a risk, in some situations. For instance, a private equity firm might be involved in taking a public company private, might be purchasing a division of a public company, or might be selling a portfolio company to a public company. All of these situations might involve MNPI and therefore would require a list of restricted issues that could not be traded."
• An entry that’s a mystery. "No one remembers why a company or security was on the list, who put it on the list, and when," said Kanter, who has seen this occur when a restricted list has not been thoroughly reviewed for some time. "The solution is, for each entry on the list, to place a note as to when it went on, why it was put on, who brought the name to the list, and when it might be able to be removed."
• Failing to report a new instance of MNPI. An individual might forget to report MNPI that has recently come into his or her possession to the CCO, said Brown. The possible result is that securities for that company are traded while the advisory firm is in possession of MNPI.
• Failure to pre-clear individual securities. This may result in an advisory firm employee trading securities that appear on the restricted list, said Brown.
• Clearance errors. When pre-clearance is required, sometimes the compliance department will fail to detect when an employee is trading in the listed security, Alberstadt said. Compliance officers must monitor employee trading to ensure that the restricted list is being followed.
• Not circulating the restricted list to all parties that need it. If the trading desk does not have the most current version of the list, it may allow trading in a restricted security or company, said Kanter, and similarly, personnel may place trades in their personal accounts if they don’t know what’s on the list.