Primer: Detecting and Preventing Insider Trading

Most everyone in the securities industry knows what insider trading is, at least the general outlines. Challenges arise when figuring out how to manage it internally from a compliance perspective, and how to detect (and avoid receiving) material non-public information (“MNPI”) in the first place. This primer sets out the basics briefly as a background but will focus on practical strategies to detect and prevent insider trading.

Managing Insider Trading Issues:

Investment advisers, fund managers, broker-dealers and other participants in the marketplace regardless of registration or exemption status, should have policies and procedures in place to prevent and detect insider trading. These can include, among other things:

  1. Clear agreements with research providers (especially expert networks) that contain representations to the effect that the firm is not engaging the provider for purposes of obtaining MNPI, and that the provider is aware of the laws pertaining to insider trading and will not transmit MNPI.
  2. Establish a policy prohibiting insider trading with the following supporting processes:
  • Employee training;
  • Emphasize that MNPI can be received in connection with the firm’s work or through other means. Receiving MNPI is still a risk to the firm even if the employee receives it separately from his or her work;
  • Periodic review of electronic communications;
  • At least quarterly reviews of employees’ personal securities transactions. More frequent reviews are always better and should be considered necessary to manage a high volume of activity and/or increased risk of receiving MNPI;
  • Real-time maintenance of restricted/watch lists;
  • Escalation of MNPI or a new risk area to Chief Compliance Officer; and
  • Restrict access to any MNPI that is in the firm’s possession.
  1. Analysts or other employees who may contact public companies in the course of their research, or who otherwise might access MNPI should receive additional and/or more frequent training on how to handle insider trading issues.
  2. Employees who think they have received MNPI must not share that information with anyone other than the Chief Compliance Officer and must not trade while in possession of that information (e., even if the MNPI is not a factor or is among other factors in a decision to trade).
  3. Identify areas in which a firm may be more likely to receive MNPI and implement additional policies if needed:
  • Issuers in a client portfolio that may be involved in M&A activity, tender offers and the like;
  • Activist strategies;
  • Confidentiality agreements with respect to information about a public company (e.g., for private equity funds, such an issuer might be in a position to acquire a portfolio company);
  • Use of expert networks; and
  • Employees/principals or their family members who have relationships with public companies (board/officer positions, employees, significant shareholders).

Background:

  1. Insiders. An “insider” includes officers, directors and employees of an issuer of securities. Additionally, anyone who has a confidential relationship with the issuer, such as its attorneys, accountants or other consultants is considered a “temporary insider.”
  2. Material Information. Information is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision, or if that information is reasonably certain to have a substantial effect on the price of an issuer’s securities. Material information can be positive or negative, and can relate to any aspect of a company’s business or to a type of security. While this definition is intentionally broad, common examples include:
  • Revenue and earnings information;
  • Projections and forward-looking information;
  • Mergers, acquisitions, tender offers, joint ventures, or changes in assets (even if preliminary);
  • New products;
  • Developments about customers or suppliers, such as the loss of a major contract;
  • Changes in control or management;
  • Events regarding the issuer’s securities, including defaults on strict securities; calls of securities for redemption; repurchase plans; stock splits; changes in dividends; changes to rights of securities holders; public or private sales of securities;
  • Change in auditors or audit report; and
  • Bankruptcies or receiverships.

 

  1. Non-public Information. Information is non-public until it has been effectively communicated to the marketplace. Practically speaking, this means that some fact will show that the information is available to the general public, e.g. through an SEC filing, a newspaper or online article, a quotation service such as Bloomberg, or a widely distributed communication by the issuer. Rumors or other information known to a smaller segment of the investment community is not considered public.

Types of Insider Trading:

  1. Classical Theory. Classic insider trading occurs when an officer, director, employee, or other insider trades on the basis of MNPI about the issuer for which s/he works, in breach of his/her duty to the issuer to refrain from such trading. The duty to refrain from trading extends to attorneys, accountants and other consultants who obtain information through their relationship as well as to “tippees,” if they are aware, or should have been aware, that they were given confidential information by an insider who has breached their duty to the issuer.
  2. Misappropriation Theory. This form of insider trading takes place between the source of the information and a third party who owes a duty to the source. If the third party steals or misappropriates information from the source and then trades on it, the third party is liable for insider trading. This is potentially broader than classical theory insider trading. In a 2013 case, the trader arguably did not receive MNPI as such, but had sufficient knowledge to make a correct, educated guess about an acquisition and traded accordingly. We discussed this case here; the SEC’s release and complaint are available on its website.

 

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