A High Priority: Insider Trading Compliance
With all the writing and blog space filled with anti-corruption focus, companies need to take a deep breath and prioritize their compliance efforts. Anti-corruption, antitrust and export controls remain at the top of the list. But companies need to add insider trading compliance programs.
The recent high-profile investigations and prosecutions stand as a constant reminder for companies. The SEC and DOJ have shown they are willing to use all available tools to prosecute insider trading violations. The Galleon and Primary Global Research cases also show that law enforcement is focusing its efforts on the interactions between investment managers and expert networks.
An “expert network” provides investment managers and others with access to various industry experts within a given field. There is nothing wrong with such information. The tricky issue is when the experts are current or former employees of a publicly-traded company who may be in possession of material non-public information, the disclosure of which could cause a violation of securities laws. The focus on expert networks and investment managers should cause companies to revisit their own expert networking arrangements.
Insider Trading Liability
Federal courts have developed two theories of liability for insider trading—the classic theory and the misappropriation theory. Under the classic theory, a corporate insider or a temporary insider (such as an
accountant, lawyer or consultant), who obtains material non-public information breaches a duty of trust and confidence owed to the corporation’s shareholders by trading in securities on the basis of the confidential information. The misappropriation theory applies when a corporate “outsider” trades on the basis of material non-public information, in violation of a duty of confidentiality owed by the outsider to the source of the information.
Section 204A of the Investment Advisers Act of 1940 requires registered advisers to establish, maintain and enforce written policies and procedures reasonably designed to prevent the misuse of material non-public information by the adviser and associated persons.
There is no bright-line test for assessing materiality. Information is “material” if there is substantial likelihood
that a reasonable investor would consider the information important in making his or her investment decision. The information does not need to cause a reasonable investor to change his or her investment decision to be material, but instead would need to be viewed by such investor as significantly altering the “total mix” of available information.
Among the factors to be weighed in assessing materiality are (i) the specificity of the information, (ii) the significance attached to the information by those who knew it, (iii) whether the information diverges from analysts’ expectations, (iv) the probability that the events that are the subject of the information will occur and (v) the anticipated magnitude of such event in light of a company’s activity.
Material information covers a number of obvious events and/or topics such as earnings, stock splits, dividends, mergers and acquisitions, new products, discontinuation of existing products, major investment occurrences, government investigations, and major litigation.
Expert Networks and the Mosaic Liability
The mosaic defense is often asserted by an expert network defendant. Essentially, the defense claims that investment professionals often rely on publicly available information and specific amounts of information which is by itself immaterial, but when pieced together by an expert and combined with the expert’s knowledge of the industry, would be a lawful piece of information fitting into the overall mosaic of knowledge.
A Compliance Program Responsive to the Expert Network Risk
Investment advisers should implement compliance controls to reduce the risk of material non-public information being included in the adviser’s mosaic. Advisers should apply standard compliance program review protocols to:
— Review insider trading policies annually;
— Modify policies to reflect new developments in the law and enforcement
— Review information barriers and controls to ensure that access to information is restricted to those who need to know such information
— Maintain records and controls for access to such information
— Impose trading blackout times during scheduled disclosure or preparation of important material information
— Education and training of officers and employees on insider trading law
— Disciplinary program which responds to improper access to, or use of, important information
— Annual certifications by employees of compliance training and overall compliance with corporate policies
Due Diligence and Monitoring Interactions
With respect to expert networks or sources, companies should conduct a due diligence review of the proposed relationship. The due diligence should include an assessment of the expert network’s insider trading policy, the network’s processes for checking and approving experts and the representations of the network’s experts with respect to the use of material nonpublic information. The contract with the expert network service should include contract representations and warranties to ensure compliance, audit rights and the right to terminate the contract if a violation occurs.
In each interaction with the expert service, adviser and representatives need to confirm representations concerning compliance with the insider trading laws and the use of nonpublic material information.
An adviser’s chief compliance officer should pre-approve any discussion between an adviser’s employee and
an expert. The chief compliance officer also should consider whether to monitorinteractions between employees and experts. The content of all conversations should be documented and retained by the adviser. Further, the adviser’s chief compliance officer should monitor trades by such employees and test such trades against the release of material information.