Trade Pre-Clearance and Blackout Periods: Use Them Wisely
Trade pre-clearance and blackout periods are two reliable methods used by advisers seeking to avoid certain kinds of problems when trading securities or with personal trading. That’s not to say, of course, that these methods don’t carry their own problems if not done right.
It all really comes down to striking the right balance between setting restriction levels that do their job and not discouraging legitimate trading.
"It’s very easy to create a prohibition that overwhelms reasonable trading, and very easy to create an exception that overwhelms the protection," said Shearman & Sterling partner Russell Sacks, who advises financial institutions on issues including review of personal trading.
In deciding how broad to make trading restrictions, consider the facts and circumstances surrounding each client, as well as the trade strategy the firm pursues, and where any MNPI exposure may lie. Questions may involve the role of an employee or another person involved, or when a rumor is likely to become a fact.
Sacks suggested that chief compliance officers at advisory firms would be wise to seek advice from CCOs at other firms, as well as those at banks and broker-dealers, to see what they do in regard to trading restrictions, he said.
"The purpose of trade pre-clearance is to try to avoid either trading in MNPI or in material nonpublic market information," which may enable individuals to front run, or trade ahead, of the market, Sacks said.
The order management systems used by many firms have built-in controls that require trade pre-clearance when potential trading in certain securities is entered. On the client side, if a client doesn’t want certain trades, such as in derivatives, the firm enters that information into the trading software. The same system is not typically used for employee and firm trading. An order management system will actually prevent a trade on behalf of a client in a restricted list security, while personal trading software will alert the chief compliance officer to a request to trade a security that is on the restricted list, allowing the CCO to deny the employee’s request for trading.
Advisory firms that do not have trading software may perform trade pre-clearance manually, which means that they would need to require employees to physically send, or personally submit, such requests to the Compliance Department.
Stark & Stark attorney Max Schatzow suggested that advisers ask themselves some key questions before approving any trade pre-clearance requests:
What is our firm’s trading strategy?
What kind of inside information do we have?
What securities are we trading?
Before requiring trade pre-clearance, advisers should first decide "how wide they want to make each category of interest," said Sacks. They also need to ensure that they are complying with all relevant guidance and have necessary controls in place.
"Striking the balance is a business decision, really," Schatzow said. "Most investment advisers will choose a pretty restrictive stance."
Blackout periods are essentially what the name implies, creating a time frame when trades will not be allowed. In that sense, they are similar to restricted lists, which also impose moratoriums on trading in certain securities or firms, said Sacks. The similarity between the two methods is particularly pronounced when restricted lists are updated frequently, so that trade restrictions on certain securities may last only 30 or 60 days, much like blackout periods.
When prohibited trades are entered in the system, the trading software recognizes them and they are automatically restricted for the length of the blackout period.
Mistakes to avoid
Whether your firm uses trade pre-clearance, blackout periods or both, consider taking the following steps to prevent the following mistakes:
Don’t unnecessarily restrict clients. Trade restrictions that go too far may prevent clients from doing business. For instance, a firm may have distant satellite offices, the activities of which are not well-known at the home office. Those in the home office would have little reason to restrict client trades in securities exclusive to the satellite office. Advisers can make use of "information barriers" that prevent information from one unit from spreading to another.
Failure to make clear in policies and procedures the importance of trade pre-clearance. If a firm’s policies and procedures do not properly articulate its position in regard to when various kinds of trades require pre-clearance, then it should be no surprise when employees fail to do so, said Schatzow.
Failure to refresh lists. Whether these are lists for blackout periods or for pre-clearance – or, for that matter, just restricted lists – they need to be reviewed and updated fairly frequently, perhaps as often as once a month. Facts and circumstances will lie behind each decision of what to remove, but information that is six months old or more should be considered for removal.
Letting management or ownership of the advisory firm off the hook. It’s never easy to challenge the boss, but firm managers and owners need to follow the same rules involving trading restrictions as other employees, otherwise your policies and procedures lose credibility, said Schatzow. Failure of managers and owners to follow trading restrictions may also lead to problems with examiners or the SEC’s Division of Enforcement down the line.