The stories of high-profile firms and investment professionals getting charged with insider trading can be the jolt you need to implement more preventative measures at your firm. While it may seem insider trading incidents are clearly motivated by greed, you may be surprised to learn that not all instances of insider trading are. In fact, most aren’t. The primary cause of insider trading is actually negligence. Nearly 10% of daily trading volume is done illegally by insiders. When it is, you may not even be aware it’s happening at your firm due to negligence.
A long-standing legal principle is that ignorance of the law is no excuse for breaking it. The securities laws surrounding insider trading are intended to prevent investors from getting even close to the line. Any member of your firm who comes into possession of material, nonpublic information, regardless of the circumstances under which such information was received, must not use or disclose such information. Note that it’s not necessary to actually trade on the information to violate the law.
There are several things investment firm leadership can and should do to avoid ever being in the crosshairs of an ugly insider trading investigation. These investigations, even if they don’t result in a guilty verdict, can have the most drastic of consequences for your firm as well as for the individuals involved. The investigations themselves take up a tremendous amount of firm resources and are a huge distraction.
Here are 10 recommendations to minimize the risk of getting caught up in an insider trading investigation.
1. Tone at the top
The leadership of the firm needs to ensure that there is ZERO tolerance for coming even close to the line of insider trading, and every employee of the firm needs to adopt this mindset. In other words, this mindset needs to become intertwined within the culture of the firm. Encourage open lines of communication with the compliance and legal teams. Ensure that it’s a respectful experience and is not done with an accusatory tone.
You want the investment team to know you are on their side and not going to say “no” all the time. The safest thing to do is not trade at all. That obviously doesn’t make sense. These conversations are also the best type of training because they are real-life situations and that leads to the best type of learning.
2. Prevention vs. detection
While both prevention and detection are important, it stands to reason that significant resources should be invested in preventing any hint of insider trading behavior at the firm. Once it’s detected, the firm and any individual participants are likely in big trouble. So, you never want to get to that point. This requires your compliance, trading, and investment teams to take on a proactive mindset, rather than a reactive one. Focus on proactive prevention rather than reactive detection to set your firm up for success.
3. Training and testing
While most firms do have some sort of training, it usually is not taken as seriously as it should be without putting in some deep thought to make it so. Sitting through an hour-long presentation on the rules is just not enough. In today’s age of technology distraction, it’s hard to get your team to focus on any presentation, let alone a legal one with some very technical points.
That’s why letting the team know there will be a test based on the presentation is a good idea. The team may settle in for obligatory training, but once leadership announces that there will be a test on the information, attendees will perk up and listen. Make an announcement that the firm will be posting scores for all to see, which will compel them to pay even more attention. Further, it will invoke their competitive juices.
Another way to ensure that employees are listening is to clearly educate them on the consequences of insider trading, not only to the firm but to them individually. This includes both civil and criminal liability (i.e. jail time). Being embroiled in a messy insider trading case obviously isn’t the best thing for the firm or an individual’s reputation or career.
4. Contingency plan
If there is a detection of possible insider trading at the firm, be ready for it in advance. The time to start figuring out how to handle an emergency (and make no mistake about it, this is an emergency) is not when it happens, but before it happens. There should be a contingency plan in place, in checklist form. Identify the experts you should contact, how you will communicate to LPs, etc.
This is a tricky area of law, and even the top attorneys with expertise in this field of law often have different opinions. As such, it is prudent to “switch up” the training by utilizing different industry experts to be sure various angles and viewpoints are considered. This also helps to ensure that the participants of the training pay better attention. Otherwise, the team may not tune in (“I already heard this last year…”).
An effective training process often entails utilizing hypothetical examples. The best hypotheticals are those that are real-life and resonate with the team. These are more fun within a training session and encourage feedback and participation. The hypotheticals will also test your team to ensure they’re paying attention to the presentation. People tend to learn better when there are analogies to real-life situations.
Any serious compliance plan should include monitoring various things such as trades, emails, etc. In addition to random spot-checking, utilize technology by searching keywords. There shouldn’t be a “big brother is watching” fear if it’s clearly explained this monitoring is necessary to protect the firm as well as its employees.
8. Watch lists
There are trades and trading strategies that firms employ that impact the degree of insider trading risk. Firms that have a more short-term trading horizon with a high volume of trades clearly have a riskier profile than firms with a longer investment profile with a lower volume of trades. Either way, one procedure your firm can put in place is to monitor trades in securities that are close to earnings announcements, as that is likely the period of highest risk.
Traders can be alerted via watch lists, and the compliance department monitoring procedures can be on higher alert for these transactions. Ensure that there’s a clearly documented investment reason for the trades so that, in hindsight, it can be proven that the reason for the trade was legitimate research and not inside information.
9. Consultants and expert networks
A frequently overlooked aspect of a firm’s compliance policy and procedures is the fact that the firm is also responsible for third-party expert network “behavior” when it comes to insider trading. The SEC requires this. In other words, the consultant must adhere to the same policies and procedures.
10. Best practice reviews
Hiring an impartial outside firm to do a review of Insider Trading Prevention and Detection policies and procedures is always a good idea. This shouldn’t just be limited to revising the policies and procedures but also to testing that employees are actually adhering to the guidelines. The benefit of impartiality is that they aren’t subject to any politics of the firm and won’t be swayed by unintentional negligence or ignorance on the part of the team.
The Bottom Line
Many instances of insider trading are based on entirely preventable negligence. Getting caught up in an insider trading investigation is no fun and can have serious consequences on your firm’s future. It’s important that firm leadership takes a proactive approach to do whatever it takes to prevent this from happening. There’s a lot that can be done to reduce the risk, and it should be apparent this is a wise investment of time.
Do you think any of these tips are missing in your firm’s policies? We can work with you to devise sound policies and procedures to strengthen your focus on prevention. If you feel that your firm can be more diligent, book a no-obligation consultation with us.
Planning and preparation are the best ways to make sure things go your way. Download a free copy of our eBook, The 10 Step Arootah Success Formula, to help plan for success in the future.
Do any of these tips stand out to you as the most effective tool for preventing insider trading? Do you have any others? Let us know in the comments below!