As a business law major, one of the first things I was taught is that ignorance of the law is no excuse for breaking it. The securities laws surrounding insider trading are intentionally opaque to avoid investors from getting even close to the line. Insider trading is considered illegal when a company’s employees or representatives provide material, nonpublic information. Note that it is not necessary to actually trade on the information to violate the law.
There are a number of things that the leadership of investment firms can and should do to avoid ever being in the crosshairs of an ugly insider trading investigation. These investigations, even if they do not 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.
While the recent McKinsey insider trading scandal is an egregious case motivated by greed, many instances of insider trading are due to entirely preventable negligence.
Here are my top ten recommendations to avoid ever 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 getting even close to the line of insider trading. This is the mindset that needs to be adopted by every employee at the firm. In other words, this mindset needs to become intertwined with 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 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 is detected, the firm and any individual are likely in big trouble. So, you never want to get there. This requires a proactive mindset by the compliance, trading, and investment teams, 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. First of all, in this day and 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 that there will be a TEST based on the presentation is a good idea! The team may settle in for obligatory training, but once it’s announced that there will be a test on the information, that will get the attendees to perk up and listen! Make the announcement that the scores will be posted for all to see, which will get them to pay attention even more. Further, it will invoke their competitive juices.
Another way to ensure that employees are listening is to very clearly educate them on the consequences of insider trading, not only to the firm, but to them individually as well. 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 the 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. Find out who the experts would be to contact, communication to LPs, etc.
This is a tricky area of law, and I have found that 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 experts in the industry to be sure that 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…”).
We have found that an effective training process 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 and encourage feedback and participation. The hypotheticals will also test to ensure that the team is paying attention to the presentation. People tend to learn better when there are analogies to real-life situations.
Any serious compliance plan will 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 is clearly explained that this monitoring is necessary to protect the firm as well as the 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 that can be 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 is 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.
A frequently overlooked aspect of a firm’s compliance policy and procedures is the fact that the firm is also responsible for third-party consultant “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 testing to see that they are actually being adhered to. 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
While the recent McKinsey insider trading scandal is an egregious case motivated by greed, many instances of insider trading are due to entirely preventable negligence. Getting caught up in an insider trading investigation is no fun and can have serious consequences. It is important that the leadership of the firm takes a proactive approach to do whatever it takes to prevent this from happening. There is a LOT that can be done to reduce the risk, and it should be apparent that this is a wise investment of time.
Which of these tips do you think may be 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 consultation with us.
Do any of these tips stand out to you to be the most effective to prevent insider trading? Do you have any others? Let us know in the comments below!
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