Tom Hardin will be presenting at NICE Actimize's ENGAGE Client Forum on November 7 in New York City as part of the event's Financial Markets Compliance track.
As someone who was charged for insider trading in 2009 and sentenced in 2015, I subsequently made it my life's mission to assist compliance officers in the training of investment staff. More than just "scaring them straight," my goal is to educate them on what exactly I was thinking as a young analyst – by exposing the extremely faulty rationalizations I made and then showing how compliance professionals today can keep their investment staff and employers from suffering the same fate as I did.
Dirks v SEC case laid out "tipper-tippee" liability in 1983, insider trading has been the bread and butter of the SEC's enforcement program. More recently, the regulator has invested resources into being more proactive about detecting suspicious trading. Today, the Market Abuse Unit's Analysis and Detection Center uses data analysis tools to detect suspicious patterns such as "improbably" successful trading across different securities over time. Behavioral analytics is growing quickly as a tool in assisting many firms in uncovering activities that could potentially lead to a range of trading illegalities.
Below are some of the insights gathered from my own experience as a former analyst that can serve as "best practices" toward thwarting potential "insider trading" activities for hedge funds and other securities traders.
Investment staff who think they may be in possession of material non-public information (MNPI) must escalate their questions/concerns to compliance without fail. They must never think they are wise enough to draw the line when they think they might have MNPI. You never want your analysts to be thinking about whether their relationship to the tipper is sufficiently close or whether the value received by the person who tipped you was significant enough to form the basis of a claim.
All of these facts will be assessed in hindsight in a political and judicial environment they can't control. If it is determined that they are in possession of MNPI, trading in the particular security is restricted until the MNPI becomes public. It's also important not to make an analyst feel guilty for going to compliance officials with their concerns regarding MNPI. You do not want the analyst to close down and avoid going to compliance in the future.
2) The current "hot areas" of enforcement for investment managers are always changing. The market may appear to be three steps ahead of enforcement, but that is actually to the analyst's detriment. Keep in mind that, regardless of the decisions in
Martoma, there's also the SEC, which has a much lower burden of proof – requiring only a preponderance of evidence to prove insider trading.
Just because someone is within the lines of what is considered current "good law" in terms of "gift" or "knowledge of benefit", he or she could still be subject to an enforcement action by the SEC. If that enforcement action is brought, the manager's assets under management are going to be threatened or disappear altogether.
Today, there are a lot of potential issues with respect to data sets and data scraping, where firms are coming into possession of semi-private data in the research process. Whether that information is obtained in breach of a duty can be a tough call. From what I've seen, compliance is frequently under pressure from analysts to permit a data source on the basis that other firms are using that source.
These data sources and providers often involve numerous areas of law, including computer privacy, securities law, even Federal Aviation Administration laws (e.g., if a manager is engaging a drone operator). I would recommend that any CCO analyzing these service providers take a closer look and bring in outside experts when needed.
3) Place limits on expert networks such as limiting the number of calls per expert to a handful. After a number of calls, an analyst will have established a relationship with the expert, and the risk of receiving MNPI increases. A way to limit the risks inherent to expert networks is to chaperone calls. I feel that unannounced chaperoning is good, although some will debate this. Even if you don't know whether compliance is on the call, always be above board. Compliance should work with its investment staff to rank the highest risk sources of MNPI.
4) Investment firms need to have specific policies in place that apply to consulting firms. A firm's policies and procedures for engaging outside consultants should not be focused solely on expert network firms. From my former seat analyzing the telecom sector, I can say with certainty that research calls with political consultants often venture into gray areas. For example, the former government employees will comment on whether they think a certain commissioner or staff will act a certain way. They love being "right," so it's up to the analyst to judge whether it's a prediction based on
past behavior or at risk of
On the criminal side, the prosecution has also expanded its menu of fraud statutes when targeting investment firm professionals in these cases. In addition to filing charges alleging securities fraud, prosecutors are also including charges under wire fraud and stealing property of the U.S. government (18 U.S. Code § 641). Consequently, while they may not prevail in a case for securities fraud, they've hedged themselves to a degree with these other fraud statutes.
5) Analysts should be very thoughtful when wording emails. I've observed that some firms are better than others about training their employees to consider how an email would look out of context. Regulators have the benefit of hindsight when bringing investigations.
We've also recently seen an increased focused of the
SEC's OCIE in understanding how investment advisers use various electronic communication mediums. Even if you're not doing anything illicit, using locker room language in an email could be a red flag during a later regulatory examination.
I've also found it quite effective during training sessions for the CCO to highlight poor examples of emails and/or IMs sent from their investment staff.
It is important to stress that every member of your firm is on the compliance team. Compliance can't be everywhere all of the time with the investment team. Your traders and analysts are responsible for being vigilant. Also stress if they make a mistake, own it before it gets worse –the cover-up is always worse than the crime.
On the behavior side, making investment staff aware of some of the rationalizations and psychological traps that pull people over the line – into unethical or even illegal activity – can be helpful. Examples of psychological traps include (i) small steps, (ii) reduction words and the idea of (iii) faceless victims.
With me, I received MNPI from another investor and then placed four small trades where I told myself these positions were "immaterial" because of their size. The reduction word "immaterial" was my self-talk to try and minimize my illegal behavior. During training sessions, I believe a CCO should introduce the psychological traps that can ensnare even the most well-meaning employees
7) Each quarter, take one or two analysts aside and go through their biggest positions. Who are they talking to? How are they getting information? Not only does it get the compliance officer comfortable with the positions and have the potential to ferret out important information, it also acclimates the investment staff to speaking about their positions. During presence exams, the SEC will often speak directly with investment staff, so it is important that analysts, staff and management are all comfortable speaking about their positions and that they're not doing it for the first time during an exam.
This may be even more important now that we know one SEC regional office is conducting unannounced visits to investment managers, not giving them time to prep analysts before the questions start.
8) The prohibition on trading while in possession of MNPI effectively shuts down the possibility of using the original analysis until after the MNPI has become public. One of my past clients shared with me the story of a young analyst and his largest position in the portfolio. He had his five thesis points, airtight analysis and then received MNPI on an unchaperoned research call with an industry contact. Instead of going to the CCO, he chose to ignore the MNPI as he rationalized it wasn't part of his original thesis. This all came to light after an inquiry from the regulator and the analyst is now on leave from the firm.
I believe it is situations like these that are most common and of highest concern. The analyst most likely did not have any intent to break the law, but engaged here in "isolated decision making" and ultimately put the firm and himself in harm's way. Analysts must own up if a mistake is made so that they are protected and the firm is protected.
Through the investment research process, a thorough analyst will come into possession of MNPI multiple times in their careers. It is not time to panic, ignore, rationalize or "cover up" in these situations. A well-trained analyst will know exactly what to do.
Thank you again for the opportunity to turn past career-ending decisions into an opportunity today to add a voice to the behaviorial aspects of a compliance discussion.