Insider trading and the potential misuse of material nonpublic information (MNPI) have long been areas of intense focus of the U.S. Securities and Exchange Commission’s (the SEC) examination and enforcement programs. Recent SEC actions reflect a trend toward increased scrutiny of the potential for investment advisers to receive — and possibly to misuse — MNPI as a result of frequent interactions with the issuers in their investment portfolios, even where there is no evidence of misuse. Even in instances where the SEC does not allege that insider trading actually occurred, these actions reflect that investment advisers may face challenging regulatory examinations, enforcement actions and civil money penalties if the SEC alleges that an investment adviser’s policies and procedures were not adequately and effectively designed, implemented and enforced to address the potential for such misconduct. Accordingly, we suggest best practices with respect to the design and implementation of policies and procedures relating to the treatment of MNPI.
Recent MNPI actions involving investment advisers. The SEC has recently brought a number of MNPI-related enforcement actions, including these:
- an order alleging that an investment adviser’s policies and procedures did not adequately address the risks posed by its business model, which involved, among other things, entering into nondisclosure agreements with multiple issuers and engaging in confidentially offered transactions (e.g., secondary offerings and private investment in public equity (PIPE) transactions) with such issuers, notwithstanding that the SEC did not allege that the investment adviser or its employees had engaged in insider trading1
- an order alleging that an investment adviser to a private equity fund failed to implement and enforce policies and procedures reasonably designed to prevent the misuse of MNPI in view of the fact that the firm had representation on the board of one of its portfolio companies.2 Just based on purported policies and procedures violations, and without any finding that insider trading occurred, the adviser was censured and paid a significant civil money penalty. This action reflects the SEC’s attention to the heightened risk that an investment adviser may receive or misuse MNPI where its employee occupies a board seat in one of its sponsored fund’s portfolio companies or otherwise receives confidential information about an issuer.
These actions underscore the SEC staff’s focus on the specific risks posed by frequent interactions between investment advisers and the companies in which they invest even in the absence of evidence that any misuse of MNPI or insider trading actually occurred. Rather, the focus of these actions was access to potential MNPI and alleged failures to implement and enforce policies and procedures to sufficiently prevent and detect the misuse of MNPI.
Moreover, we note that for every enforcement proceeding the SEC staff publicizes, there are dozens of investment adviser examinations focusing on these issues that may not result in enforcement action but nevertheless can be distracting, burdensome and expensive if an adviser is not adequately prepared.
The broader MNPI enforcement landscape. The SEC has long warned of the risks of receiving MNPI from companies in which an individual or entity invests in other contexts. Notable MNPI-related actions in the past several years have included, for example, charges brought against an entrepreneur who was invited to participate in a confidential PIPE transaction (and who traded in shares of the company involved in the transaction on that basis)3 and an action brought against defendants including various employees of public companies who provided MNPI to an expert consulting firm, which then relayed the information to hedge fund clients who traded on it.4
While many of these actions focused on individual investors and hedge funds, the SEC has for years also alerted broker-dealers to the risks inherent in interacting with public companies. In September 2012, the staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) published a report summarizing trends and areas of concern identified in its examination of various broker-dealers.5 Specifically, the OCIE staff’s report focused on its review of broker-dealer compliance with regulatory requirements surrounding MNPI pursuant to Section 15(g) of the Securities Exchange Act of 1934 (Exchange Act), which requires that broker-dealers “establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such broker’s or dealer’s business, to prevent the misuse … of material, nonpublic information[.]”6 Among the risks highlighted by the OCIE staff was the potential for individuals and entities operating in the private equity space to receive MNPI through their interactions with portfolio companies:
With respect to Asset Management, Private Equity tends to have more frequent contacts with their portfolio companies as well as with corporations seeking potential investments.
As a holder of a substantial interest in a corporation, Investment Groups may receive confidential information, which at times may be MNPI, directly from the corporation. For example, the Investment Group may have an employee serving on the board of directors of the company or a shareholder committee. If a company has financial difficulty, a representative from the Investment Group may be invited to participate in bankruptcy or creditor committees of distressed companies (or even pre-bankruptcy committees).
Investment Groups may also obtain MNPI as part of the investment process. The information may be obtained by discussions between the employee and an insider of the company. For example, Investment Groups may be approached about investing in an offering that has not yet been publicly disclosed (e.g., a PIPE).7
As described, recent enforcement actions reflect that the SEC is increasingly focused on the potential misuse of MNPI by investment advisers in light of the close relationships such firms often maintain with the companies in which they invest. Indeed, annual reports published by the SEC’s Division of Enforcement reflect that for each of the last three years, cases involving (i) investment advisers/investment companies and (ii) insider trading have ranked among the top five types of enforcement actions the SEC has brought.8 The data also suggests that this trend will continue; for example, in fiscal year 2019, investment adviser and investment company issues accounted for 36 percent of all enforcement actions the SEC brought, an increase from 22 percent in fiscal year 2018.9
Best practices and key takeaways. The SEC’s approach with respect to policies and procedures and the potential misuse of MNPI — and the alleged deficiencies on which they focus — provide a roadmap for best practices for investment advisers that may have access to confidential information about their portfolio companies:
- DO implement and enforce a set of policies and procedures narrowly tailored to address the risks specific to your business. Simply maintaining written policies and procedures is not sufficient. Section 204A of the Advisers Act requires advisers to
- reasonably design MNPI policies and procedures, taking into consideration the nature of the adviser’s business in light of the totality of the facts and circumstances
- implement, monitor and enforce such policies and procedures
- periodically review and, as appropriate, modify those policies and procedures to prevent even the potential misuse of MNPI
- DO ensure that documentation of steps taken to confirm that relevant parties are not in possession of MNPI is substantive and consistent. The SEC staff has repeatedly underscored the importance of documenting, in sufficient detail, both the inquiry undertaken to confirm that relevant parties within the investment adviser are not in possession of MNPI and the results of that inquiry.
DO exercise great caution in relying on conclusions about the materiality of any potential MNPI. The determination of whether information is “material” will always be subject to second guessing, and advisers should expect that the SEC staff will assess such determination with the benefit of hindsight. In that regard, an adviser should maintain policies and procedures that require employees who suspect they may have obtained MNPI to consult internal and/or external legal counsel and/or the chief compliance officer to avoid making subjective determinations about the materiality of information they either do receive or may receive.
DO NOT rely on information barriers if they are difficult or impossible to enforce consistently in light of the nature and structure of your business. Many advisers choose to implement policies and procedures providing for the establishment of “ethical walls” or other information barriers; however, as a practical matter, such barriers may be difficult or impossible to enforce depending on the size and structure of the business. In establishing procedures, an adviser should consider the feasibility of implementing and enforcing such measures.
DO NOT rely exclusively on assurances from an issuer that the firm is not in possession of MNPI. An adviser should not rely on assurances from portfolio companies that such companies are not in possession of MNPI without undertaking its own independent review.
1 In the Matter of Cannell Capital, LLC, Inv. Adv. Act Rel. No. 5441 (Feb. 4, 2020), https://www.sec.gov/litigation/admin/2020/ia-5441.pdf.
2 Inv. Adv. Act Rel. No. 5510 (May 26, 2020), https://www.sec.gov/litigation/admin/2020/ia-5510.pdf.
3 SEC v. Cuban, No. 08-cv-2050 (N.D. Tex. Nov. 17, 2008), https://www.sec.gov/litigation/complaints/2008/comp20810.pdf.
4 SEC v. Longoria et al., No. 11-cv-0753 (JSR) (S.D.N.Y. Feb. 8, 2011), https://www.sec.gov/litigation/complaints/2011/comp-pr2011-40.pdf.
5 U.S. Sec. and Exch. Comm., Staff Summary Report on Examinations of Information Barriers: Broker-Dealer Practices Under Section 15(g) of the Securities Exchange Act of 1934 (Sept. 27, 2012), https://www.sec.gov/about/offices/ocie/informationbarriers.pdf.
6 The Investment Advisers Act of 1940 (Advisers Act) contains a substantially identical provision under Section 204A subjecting investment advisers to the same standard. See 15 U.S.C. § 80b-4a.
7 U.S. Sec. and Exch. Comm., Staff Summary Report on Examinations of Information Barriers: Broker-Dealer Practices Under Section 15(g) of the Securities Exchange Act of 1934 (Sept. 27, 2012), https://www.sec.gov/about/offices/ocie/informationbarriers.pdf.
8 U.S. Sec. and Exch. Comm., Division of Enforcement Annual Report (Nov. 6, 2019), https://www.sec.gov/files/enforcement-annual-report-2019.pdf; U.S. Sec. and Exch. Comm., Division of Enforcement Annual Report (Nov. 2, 2018), https://www.sec.gov/files/enforcement-annual-report-2018.pdf; U.S. Sec. and Exch. Comm., Division of Enforcement Annual Report (Nov. 15, 2017), https://www.sec.gov/files/enforcement-annual-report-2017.pdf.
9 U.S. Sec. and Exch. Comm., Division of Enforcement Annual Report (Nov. 6, 2019), https://www.sec.gov/files/enforcement-annual-report-2019.pdf; U.S. Sec. and Exch. Comm., Division of Enforcement Annual Report (Nov. 2, 2018), https://www.sec.gov/files/enforcement-annual-report-2018.pdf.