Finding the Balance on Personal Securities Compliance
Who’ll Be Number 80?
On February 6, 2014, Matthew Martoma, a former trader at SAC Capital Advisers, a hedge fund founded by billionaire Steve Cohen, was found guilty in federal court for illegally trading on material nonpublic information. His former firm had only months earlier agreed to pay nearly $2 billion in settlements relating to insider trading by its employees. Meanwhile, the SEC is seeking to ban Mr. Cohen from the securities industry altogether for failing to supervise employees in connection with illegal trading activity. These highly publicized headlines are just the tip of the iceberg. Martoma, now facing the very real possibility of several decades in prison, is the 79th person to be convicted or plead guilty to charges of insider trading since a legal and regulatory offensive on the practice was initiated in 2009. The 80th is likely already waiting in the wings.
While no outsider can know for certain what Mr. Cohen may or may not have known, or when he knew it, with respect to trades placed at his firm on the basis of inside information, the SEC’s allegation that he failed to supervise employees demonstrates that where there is a duty to know, ignorance is not bliss. Investment companies and adviser’s fiduciary duty requires the adoption and implementation of written policies and procedures and other controls reasonably designed to ensure compliance with federal securities laws and to supervise employees with a view to preventing violations and averting compliance failures. Additionally, advisers are obligated to report any significant violations or sanctions to fund boards at least annually. A well-designed compliance program often results in a steady stream of spreadsheets, checklists, reports and other output. Increasingly, advisers of investment companies are finding that the vast amounts of paper and information generated from their compliance efforts are both a blessing and a curse.
“To whom much is given, much is expected.”
The old axiom is as true today as it ever was. If the reams of information produced by an adviser’s compliance program are gathering dust on the CCO’s desk, languishing in a database or an email inbox without effective, well-documented review, and the risks that the firm’s controls were meant to address materialize, the adviser is left with no excuse. As demonstrated in recent news headlines, nowhere is this gamble more clearly exemplified than in the areas of insider trading and personal trading practices. Increasingly, advisers and/or sub-advisers are turning to compliance software to fill the gap, control their risks and competently fulfill their compliance obligations. But, as helpful as these solutions can be - and they are - they can only inform the process of compliance. That is, an effective compliance regime results from regular reviews of data outputs. Without an investment of “man hours” to monitor and address compliance issues or patterns revealed by technology, these helpful solutions are nothing more than digital filing cabinets. And yet, who has that kind of time for constant review?
Insider Trading: Increased Scrutiny, Surveillance and Violations
In congressional testimony provided in March 2009, then-SEC commissioner Elisse Walter announced the development and deployment by the Commission of technological tools to identify trading patterns that may signify illegal trading activity by advisers, hedge funds and other financial industry participants and their staff. Then in October 2009, one of the largest hedge fund insider trading cases in history was filed by the SEC in a Manhattan federal court against California-based, Galleon Management, LP and its founder and chief executive, among others, sending shockwaves through the investment community. Speaking at a news conference shortly after the announcement of the Galleon case, Robert Khuzami, then-SEC Enforcement Director, stated his suspicion that insider trading was a systemic problem at many hedge fund managers and expressed the Commission’s determination to aggressively seek out and pursue those engaged in unlawful trading activities.
The Commission has been as good as its word. After peaking at 61 cases in 2008, the number of insider trading-related cases have steadily risen year-over-year from 37 in 2009 to 58 in 2012. In the 2014 Examination Priorities release of the National Examination Program (“NEP”) of the Office of Compliance Inspections and Examinations of the SEC, the Commission listed ferreting out fraudulent conduct as among the “most significant” initiatives across the program. In that release the Commission further specified that “…the NEP will continue to utilize and to enhance its quantitative and qualitative tools and techniques to seek to identify market participants engaged in fraudulent or unethical behavior.” All indications are that many more insider trading allegations will be levied in the coming months and years as a result of the Commission’s stepped- up efforts.
In response, mutual fund managers are examining the effectiveness of their own internal surveillance efforts to apply the lessons of insider trading cases to their operations and avert the firm-shuttering media attention allegations of wrong-doing can bring. Obviously, these advisers’ efforts include revisiting policies and procedures and scheduling mandatory staff training sessions. However, they continue to struggle with how best to use the information on-hand to identify potential abuse occurring right under their noses.
Personal Securities Trading and Code of Ethics
Personal trading practices of firm insiders have been an area of scrutiny by SEC examiners for years. This is because, when investment advisory personnel invest for their own accounts, conflicts of interest arise between the employee's interests and those of the adviser’s clients. Advisory personnel may, for example, usurp an investment opportunity that would have been appropriate for the firm’s clients. They may also abuse their positions with the firm by “frontrunning” client trades. When frontrunning, advisory personnel seek to personally benefit from the market effect of trades placed for the adviser’s fund clients. Even with the best efforts of the firm’s trade-desk, large trades placed for clients have the potential to affect the price of a security. This is true for both long positions and short positions, with long positions potentially driving up the price of a security and short positions potentially driving down the price. The possibility of driving the price of a security up or down before placing a trade in the same security for a personal account provides an opportunity for certain advisory personnel with knowledge of anticipated client trades to personally benefit from client trades. It almost goes without saying, but this is illegal.
When a fund’s portfolio manager invests in securities for his or her own account at the same time that he or she is trading the same securities for the fund’s portfolio, several conflicts of interest may occur. First, the portfolio manager may be tempted to purchase or sell securities for his or her personal account ahead of trades for the fund in order to receive a better price than the fund obtains. In addition, a portfolio manager might cause a fund to purchase a security already in the manager’s personal account in order to protect or improve the security’s market value. A manager could seek to do this, for example, in order to avoid a personal margin call. Similar practices can involve personal trading in securities related to securities held or to be purchased by the fund, such as options on common stock where the fund invests in the underlying stock. Other possible conflicts could arise when persons who wish to influence the price of a security may offer the portfolio manager an attractive investment opportunity to influence fund activity in that security.
Even if particular investment company personnel do not control a fund’s trading, advance knowledge of what securities are being considered for the fund’s portfolio could be used by those personnel for their own benefit and to the detriment of the fund. Furthermore, even where these kinds of misconduct do not occur, public confidence in a fund’s management can be undermined if investors believe that the fund does not have in place policies and procedures to prevent improper personal investing.
To address these and other issues, in 2004 the SEC adopted Rule 204A-1, the Code of Ethics Rule, under the Investment Advisers Act of 1940 (“Advisers Act”). In addition to requiring the adoption of a code of ethics, the Rule requires that firms monitor the personal trading activities of their supervised persons with access to certain information regarding client portfolio holdings, transactions or recommendations and identify improper trades or patterns of trading by those access persons. Section 17 (j) of the Investment Company Act of 1940 (“40 Act”) also requires that investment companies, their investment advisers and principal underwriters adopt and enforce Codes of Ethics reasonably designed to prevent Access Persons from defrauding the investment company with respect to purchases and sales of securities. In a 2008-issued Compliance Alert, the Commission warned advisers of the most common deficiencies found during examinations. Among these, they cited:
- Adviser’s code of ethics was incomplete.
- Adviser’s code of ethics was not followed
- Reporting requirements were not followed and/or monitoring was not performed.
- Disclosure (regarding the firm’s code of ethics provisions) was inaccurate.
For example, the Commission specifically noted, among other common deficiencies causing concern, that:
“Access persons did not submit, or did not submit in a timely manner, reports of their personal securities transactions or holdings consistent with applicable regulations or the adviser’s policies and procedures. Also, some advisers did not review reports of access persons’ personal trading for indications that trades were inconsistent with applicable regulations or the adviser’s policies and procedures.”
Unfortunately, far too many fund advisers view the Code of Ethics Rule provisions as mere recordkeeping requirements and fail to adequately scrutinize employee trades for the above-listed abuses, among others. Even then, they often don’t know if their records are complete. Others squander countless hours and resources manually comparing personal securities transaction reports to the firm’s trading activity, restricted lists and other written procedures, such as pre-clearance requirements, despite the fact that personal trading information can be effortlessly and effectively evaluated for these and other compliance breaches through appropriate software analysis.
A “Reasonable” Approach
There is a balance to be found for personal securities transactions monitoring. While software can manage the time- and resource-intensive comparisons and pinpoint the red flags, it cannot undertake the analysis of them once they’re identified. Nor can it ensure that a firm’s code of ethics is up to par. This is where “man power” can have the most impact. But even at this stage the volume of scrutiny required could be overwhelming for some compliance officers. A perfect balance can be achieved by engaging with consultants who are experts in compliance to:
- Align the firm’s code of ethics with compliance mandates
- Ensure the code of ethics is properly implemented in the software
- Monitor any exceptions noted by the system while processing personal trading activity
- Raise an alert when red flags are identified that require review and redress.
While it is true that no compliance officer, system or program will be able to identify and avert all problems all of the time, it is important to remember that reasonableness is the standard. Rule 206(4)-7 under the Advisers Act and Rule 38a-1 under the Company Act require that advisers and funds adopt policies and procedures reasonably designed to prevent, detect and correct violations of the respective Acts. In this day and age, it is simply not reasonable to allow compliance problems to arise that could have been averted through responsible utilization and review of data already compiled by the firm. However, these efforts must be appropriately integrated into a comprehensive compliance program and monitoring efforts tailored to the firm’s practice.
 In hindsight, the 2008 Compliance Alert appears to have been a prelude to the legal and regulatory offensive against trading abuses, such as insider trading, which was manifested in earnest beginning in 2009.