How investment managers can offset insider trading risk

March 14, 2014

Originally published by Thomson Reuters

The recent prosecutions of former portfolio managers at SAC Capital Advisors is a reminder, if one were needed, that insider trading cases can devastate the reputations and futures of firms as well as individuals.

One relatively unusual feature of the case was the U.S. Securities and Exchange Commission (SEC)'s action for "failure to supervise", in this instance two portfolio managers who have themselves separately been found guilty of insider trading charges. In a settlement yet to be confirmed, the firm has agreed to pay a $1.2 billion penalty to resolve outstanding charges, and to stop managing money for outside investors.

Leaving aside the specifics of that case, the question arises whether firms, or their senior executives, could be charged under UK legislation for failure to have proper insider trading controls, which might potentially be an easier case to prove than insider trading itself. This article compares United States and UK regulation in this area, identifies some of the high-risk areas for hedge fund managers and considers some practical steps to offset this risk.

U.S. v UK

The SEC's Rule 204A-1 (under the Investment Advisers Act, 1940) requires registered investment advisers to establish and maintain policies and procedures reasonably designed to prevent the misuse of material non-public information (itself a critical aspect of U.S. insider trading law).

Although there is no exact equivalent in UK regulation, the Senior Management Arrangements, Systems and Controls (SYSC)section of the Financial Conduct Authority (FCA) Handbook requires firms to "establish implement and maintain adequate policies and procedures sufficient … for countering the risk that the firm might be used to further financial crime". The definition of financial crime includes "misconduct, or misuse of information relating to, a financial market".

This approach would be consistent with recent FCA enforcement actions in the area of money laundering. Firms (notably several large banks) have been fined heavily, not for actual involvement in money laundering offences, but for having inadequate systems and controls to prevent it. Arguably, this lesser offence is easier for a prosecutor to prove, although without the extra deterrent that might come from a case against individual senior executives.

Insider trading controls

Insider trading controls must be tailored to the specific set-up of each firm, in particular its investment strategy and internal structure. If firms wish to reduce insider trading risk, under this analysis, they need to understand the critical information flows in their business, and hence identify the areas where they are most at risk. The following are typical examples of high-risk areas:

Research contacts with corporates

Although the days of wining and dining the finance director in the expectation of getting a "steer" on the next quarterly results are long gone, this is still an area fraught with danger. Playing devil’s advocate, why would anyone pay for this privilege unlessthey were getting something definite (and price-sensitive) in return or, one might say, "damned if you do, damned if you don’t". The FCA recently alluded to this in its Consultation Paper 13/17on the use of dealing commissions for corporate access, and has signalled that it plans to pay further attention to this issue.

Networks: formal and informal

Much attention has been paid to the so-called "expert" networks: consultancies which specialise in providing industry "experts" for background research. For the most part these firms now have rigorous controls in place, knowing that they are likely to be subject to regulatory scrutiny. Informal networks such as friends, colleagues and other contacts are now, arguably, the more dangerous sources of insider information, but are also inherently harder to monitor and control.

Private/public interface

Rather like the information barriers that have traditionally existed in investment banks between traders and corporate finance, many managers have begun to identify the need for internal barriers between private transaction teams (both equity and debt) and those who trade in public securities. Where correctly implemented, such barriers obviate the need for firm-wide restricted lists

Checklist to offset the risk of insider trading

The following is a checklist of measures that managers should be thinking about if they wish to offset the risk of insider trading:

  • Policies and procedures As well as describing the main insider trading and market abuse offences, these should be sensitive to the internal factors described above. They should describe the remit of the legal or compliance function, including the management of restricted lists, and the surveillance of trading activity and communications channels. They should also relate to personal account trading rules, typically including permitted transactions, pre-approval requirements and minimum holding periods.
  • Staff training Trading staff generally learn more effectively from discussing actual or imaginary cases, rather than being given a detailed exposition on the finer points of law. If nothing else, they must know who to ask (generally the compliance officer) when situations of doubt arise. How to handle market rumours is another critical issue that most traders will relate to, and learn from, personal experiences.
  • Recordkeeping As is the case in many areas of compliance, this is both an important ingredient of day-to-day monitoring and a defence in situations where abuse is suspected. Firms should build into their processes a requirement to record all research contacts, for example, as well as the reasoning behind all investment decisions.
  • Monitoring of transactions This should be conducted by the compliance function and may include screening of the most profitable or largest transactions within a period, and also an assessment of activity around major corporate announcements and sizeable share price movements. Monitoring of communications Although not universal, it is becoming increasingly common in buy-side firms to record phone calls, and also conversations on instant messaging services such as Bloomberg chat.
  • Suspicious transactions The FCA has reminded firms of their obligation to report suspicious transactions, and may eventually become suspicious if firms report nothing to them. Firms must at the very least have an established process for investigating dubious cases, and should document the reasons why they did or did not report.

Final thoughts

It is of course impossible to prevent a really determined employee from committing insider trading. Personal networks among market participants run wide and, in a financial centre like London, in close proximity. Can firms ever really control what is said in the proverbial local or at the children's Saturday morning football class?

The focus of this article has been corporate liability and how firms can offset the risks of being held to account for failing to manage financial crime risks. Of course, for the individual, the potential consequences of being caught are just as serious. At the very least, these would include a life ban from working in the UK financial sector for often modest gains.

The final word on this comes from Tracey McDermott, director of enforcement at the FCA, who was speaking at the conclusion of a recent case which ended in a jail sentence:

"His personal greed will have cost him his reputation, his career and his liberty. Those who think there is easy money to bemade from insider dealing should think again."


Martin Lovick is a compliance consultant with ACA Compliance (Europe) Ltd, the compliance consultancy firm for wholesale financial services companies with a client focus of hedge fund managers, private equity managers and institutional brokers. He has worked in front line trading and asset management roles in the City for over three decades. The views expressed are his own