By Bart Mallon, Esq. (www.colefrieman.com)
High Profile Case Highlights Issues for Hedge Fund Managers to Consider
Insider trading is now an operational issue for hedge fund managers. The high profile insider trading case involving RR and the Galleon hedge fund has put the spotlight directly on hedge funds again and has also sparked a debate of sorts on the subject. Given the potential severity of penalties for insider trading, it is surprising that we still periodically hear about such cases, but nevertheless it is something that is always going to be there – human nature is not going to change.
As such hedge fund managers need to be prepared to deal with this issue internally (through their compliance procedures) and also will need to be able to communicate how they have addressed this issue to both the regulators and institutional investors. While managers always need to be vigilant in their enforcement of compliance policies and procedures, during this time of heightened insider trading awareness, managers need to be even more vigilant about protecting themselves. As the Galleon liquidation too vividly shows, a lapse in operational oversight can and will take down an entire organization.
Insider Trading Overview and Penalties
We have discussed insider trading before, but as a general matter insider trading refers to the practice of trading securities based on material, non-public information. Whether information is material depends on case law. In general information will be material if “there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision (see TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). Information is non-public if it has not been disseminated in a manner making it available to investors generally. An insider is generally defined as officers, directors and employees of a company but it can also refer to a company’s business associates in certain circumstances (i.e. attorneys, accountants, consultants, and banks, and the employees of such organizations). Additionally, persons not considered to be insiders may nevertheless be charged with insider trading if they received tips from insiders – such persons generally are referred to as tippees and the insider is generally referred to as the tipper. [HFLB note: more information on insider trading generally can be found in the discussion of Regulation FD on the SEC website.]
The penalties for insider trading are potentially harsh – censures, cease and desist orders, fines, suspension and/or revocation of securities licenses are all potential penalties. Depending on the severity of the insider trading there may be criminal sanctions in addition to the listed civil penalties. Securities professionals (or other business professionals like an attorney or accountant) may jeopardize their ability to work in their industry if they are caught engaging in insider trading which, for most people, would be a large enough deterrent to engage in such activity.
Addressing Compliance Inside the Firm
Insider trading is usually addressed in the firm’s compliance policies and procedures. Indeed, Section 204A of the Investment Adviser Act of 1940 requires SEC registered investment advisers to maintainpolicies and procedures to detect against insider trading.
Usually such policies and procedures forbid employees from trading on material non-public information (as well as “tipping” others about material non-public information). Additionally, employees typically are required to disclose any non-public material information they receive to the chief compliance officer (“CCO”) of the firm. The employee is generally prohibited from discussing the matter with anyone inside or outside of the firm. The policies and procedures may require the CCO to take some sort of action on the matter. There are a number of different ways that the CCO can handle the situation including ordering a prohibition on trading in the security (including in options, rights and warrants on the security). The CCO may also initiate a review of the personal trading accounts of firm employees. Usually when the CCO is informed of such information the CCO would contact outside counsel to discuss the next course of action.
Dealing with Regulators
While many large hedge fund managers are registered as investment advisors with the SEC, many still remain unregistered in reliance on the exemption provided by Section 203(b)(3). With the Private Fund Investment Advisers Registration Act likely to be passed within the next year, managers with a certain amount of AUM (either $100 million or $150 million as it now stands) will be forced to register with the SEC. Of course, this means that such managers will be subject to examination by the SEC and insider trading will be one of the first issues that a manager will likely deal with in an examination.
As we discussed in an earlier insider trading article, the SEC has unabashedly proclaimed war against insider trading and they will be aggressively pursuing any leads which may implicate managers.
Some compliance professionals believe that the SEC comes in with a view that the manager is guilty until proven innocent. While I do not necessarily subscribe to this blanket viewpoint, I do believe that managers, as a best practice, should be able to show the SEC the steps they have taken to ensure that compliance with insider trading prohibitions is a top priority of the firm. The firm and CCO should be prepared to describe their policies and structures that are in place to deal with this issue.
Potentially more important than how a firm deals with the SEC, is how a firm describes their internal compliance procedures to institutional investors. The question then becomes, how are institutional investors going to address this risk with regard to the managers they allocate to – what will change?
Right now it appears a bit unclear. Over the past week I have talked with a number of different groups who are involved hedge fund compliance, hedge fund consulting, and hedge fund due diligence and I seem to get different answers. Some groups think that institutional investors will be focusing on this issue (as many managers know, one of the important issues for institutional investors is the avoidance of “headline risk”); other groups seem to think that this is an issue that institutional groups are not going to focus on because there are other aspects of a manager’s investment program and operations which deserve more attention.
We tend to agree more with the second opinion, but we still believe that robust insider trading compliance policies and procedures are vital to the long term success of any asset management company. We also encourage groups to discuss their current procedures with their compliance consultant or hedge fund attorney.
Outsourcing and Technology solutions
Many large managers have implemented compliance programs which have technology solutions designed to track employee trading. Presumably there will be technology programs developed to address this concern for manager. Although I do not currently know of any specific outsourced or technology solutions which address this issue, I anticipate discussing this in greater depth in the future – perhaps there is some data warehousing solution. [HFLB note: please contact us if you would like to discuss such a solution with us.]
The Galleon insider trading case could not have happened at a worse time for the hedge fund industry which is trying to put its best face forward as Congress determines its future regulatory fate. However, increased awareness of this issue will force managers to address it from an operational standpoint which will only help these managers down the road. While the full effect of this case will not be understood for a while, in the short term it is likely to cost managers in terms of time and cost to review and implement increased operational awareness and procedures.
Other related hedge fund law articles:
Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and the Series 79 exam website. He can be reached directly at 415-868-5345.