by Michael C. Neus

In light of the recent unanimous Supreme Court decision in Salman v. United States (PDF: 101 KB), savvy investors can assume that the Securities and Exchange Commission, as well as the Department of Justice, will continue to seek out cases of insider trading.  Much has been written about whether or not Salman dramatically changed the jurisprudence existing prior to the Second Circuit’s opinion in United States v. Newman.  Whether or not the landscape has changed in the wake of the Salman decision, how can in-house counsel and compliance officers manage and avoid potential insider trading issues?

When defending an insider trading allegation, one would use every opportunity to demonstrate that the trader was not aware of a personal benefit, that the personal benefit was not sufficient to impose liability, and any manner of additional defenses.  By definition, investment advisors engage in fundamental research in order to discover factual information that is unknown to the market.  Indeed, such investors have a fiduciary duty to profitably (and legally) trade for their clients.   Notwithstanding this obligation to conduct in-depth securities research, no self-respecting trader would willingly court an SEC, or worse yet a DOJ, investigation into whether their research pushed them over the edge into illegal behavior.  When counselling traders on avoiding insider trading investigations, it is best to establish clear, easily understood, bright line rules of engagement.  To that end, every investment advisor utilizing fundamental research should have an effective insider trading compliance regime comprising a three phase approach:  training, procedural safeguards, and post-trade analytics.

TRAINING. 

The vast majority of traders want to stay on the right side of the law, but training is essential as insider trading prohibitions can appear counter-intuitive.  On the first day on the job, every investment advisory employee should sit through a formal training session which clearly identifies the firm’s insider trading procedures.  By scheduling a training session on the first day, it conveys the firm’s priorities, prohibits employees from claiming that they didn’t know the rules, and permits the firm to counteract any “bad habits” from previous employers.  The firm should make clear that if there is any question about whether some particular information could lead to a trading restriction, each employee has an obligation to consult with the legal/compliance department.  Since insider trading is essentially a fraud-based prohibition, consultation with in-house counsel significantly minimizes an insider trading claim; conversely, failing to consult could imply an intent to deceive.  The firm should periodically reinforce this message, for example, whenever a significant insider trading case is in the news.  At least annually, all investment professionals should be retrained in a dedicated session, potentially with outside counsel, former prosecutors, or others who can captivate employees with real “war stories.”  All employees should manually sign an annual confirmation that they have attended the training session.

PROCEDURES. 

Investment advisors must have compliance procedures tailored to the risks inherent in their individual business.  Having off the shelf procedures purchased from a consultant or downloaded from a law firm’s precedent library are unlikely to provide any real protection.  There is no “one size fits all” protection—a firm with one decision maker who executes his own trades will require significantly different procedures than a multi-billion-dollar firm with dozens of individual portfolio managers each of whom have investment discretion.  Some of the procedures that investment advisors should consider include:

1. maintaining a restricted list of securities that only a compliance officer can add to or remove;
2. authorizing only a compliance officer to execute confidentiality or consulting agreements that may result in material, non-public information;
3. creating a blocked security list in the firm’s order management system which only a compliance officer can lift;
4. ensuring that research vendors represent and warrant that they will not provide material, non-public information to the firm’ s analysts without pre-approval from a compliance officer first;
5. requiring every research vendor invoice to be approved by a compliance officer before payment;
6. prior to higher risk conversations, requiring analysts to read a disclaimer that the analyst does not want to receive material, non-public information;
7. counselling analysts to keep detailed notes and documents validating the mosaic theory of individual investment theses; and
8. given the increased risk of obtaining impermissible material, non-public information from the use of expert networks, investment advisors should have additional procedures which may include:
   1. all consultants must be pre-screened;
   2. employees are not permitted to speak with consultants who anytime in the previous six months have been an employee, director or consultant for a public company;
   3. consultant must prove that their employers have approved their participation in a paid expert network program;
   4. a compliance officer may periodically chaperone calls unannounced;
   5. all expert network consultations must be scheduled through a compliance officer, or in accordance with a protocol approved by a compliance officer; and
   6. after five consultations with the same consultant within 12 months, any additional consultation must be pre-approved by a compliance officer and the reasons for approval noted.

POST-TRADE ANALYTICS. 

Every investment advisor should analyze whether insider trading procedures are effective.  For example, daily tests could include reviewing trading records against the firm’s restricted list, expert network consultations, and same day/same way or same day/opposite way trades.  Monthly tests should include a list of the firm’s most profitable trades analyzed in light of market-moving public reports, communication with expert network consultants, contact with “value-added investors” such as firm investors who work for public companies, and other high risk information sources.

CONCLUSION. 

An efficient marketplace is a laudable public policy goal.  An issuer should not be the sole determinant of its stock price—in the extreme, no one wants a Bernie Ebbers to determine the price of a Worldcom until it implodes.  Without rigorous fundamental research, security prices would be more volatile, exacerbating the boom/bust cycle.  Investment advisors conducting fundamental research have a fiduciary obligation to utilize the most effective research tools.  Banning expert networks, for example because they require more oversight by the legal/compliance department, could well be viewed as an abrogation of the advisor’s fiduciary duty.  However, given regulatory focus on insider trading, it is imperative that advisors have a well-thought out regime to prevent unlawful trading.

Michael C. Neus is a frequent lecturer on securities, compliance, hedge fund and private equity topics at industry events and for global regulators.  Until recently, Mike was responsible for all legal, compliance, human resource and administrative matters as Managing Partner and General Counsel of Perry Capital, LLC.  Prior to joining Perry Capital in 2005, Mike was the Chief Operating Officer and General Counsel at RHG Capital, L.P., Chief General Counsel at Andor Capital Management, L.L.C., and General Counsel of Soros Private Funds Management LLC. Mike began his professional career as an associate at the law firm Coudert Brothers, in both the Singapore and New York offices.  Mike is a Senior Fellow of the Regulatory Compliance Association, and was formerly a director, chairman of the Investment Advisory Subcommittee, and member of the Executive Committee of the Managed Funds Association.  Mike received his J.D. from Columbia University School of Law, where he was a Harlan Fiske Stone Scholar, and his B.A. cum laude from the University of Notre Dame.

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