{"id":43523,"date":"2014-08-13T10:53:50","date_gmt":"2014-08-13T14:53:50","guid":{"rendered":"http:\/\/www.hedgeco.net\/news\/?p=43523"},"modified":"2014-08-13T11:37:04","modified_gmt":"2014-08-13T15:37:04","slug":"finding-the-balance-on-personal-securities-compliance","status":"publish","type":"post","link":"https:\/\/hedgeco.net\/news\/08\/2014\/finding-the-balance-on-personal-securities-compliance.html","title":{"rendered":"Finding the Balance on Personal Securities Compliance"},"content":{"rendered":"

New York (HedgeCo.Net) \u2013 On February 6, 2014, Matthew Martoma, a former trader at SAC Capital Advisers, a hedge fund founded by billionaire Steve Cohen, was found guilty in federal court for illegally trading on material nonpublic information. His former firm had only months earlier agreed to pay nearly $2 billion in settlements relating to insider trading by its employees. Meanwhile, the SEC is seeking to ban Mr. Cohen from the securities industry altogether for failing to supervise employees in connection with illegal trading activity. These highly publicized headlines are just the tip of the iceberg. Martoma, now facing the very real possibility of several decades in prison, is the 79th person to be convicted or plead guilty to charges of insider trading since a legal and regulatory offensive on the practice was initiated in 2009. The 80th is likely already waiting in the wings.<\/p>\n

While no outsider can know for certain what Mr. Cohen may or may not have known, or when he knew it, with respect to trades placed at his firm on the basis of inside information, the SEC\u2019s allegation that he failed to supervise employees demonstrates that where there is a duty to know, ignorance is not bliss. An adviser\u2019s fiduciary duty requires the adoption and implementation of written policies and procedures and other controls reasonably designed to ensure compliance with federal securities laws and to supervise employees with a view to preventing violations and averting compliance failures. A well-designed compliance program often results in a steady stream of spreadsheets, checklists, reports and other output. Increasingly, private fund advisers are finding that the vast amounts of paper and information generated from their compliance efforts are both a blessing and a curse.<\/p>\n

\u201cTo whom much is given, much is expected.\u201d<\/strong>
\nThe old axiom is as true today as it ever was. If the reams of information produced by an adviser\u2019s compliance program are gathering dust on the CCO\u2019s desk, languishing in a database or an email inbox without effective, well-documented review, and the risks that the firm\u2019s controls were meant to address materialize, the adviser is left with no excuse. As demonstrated in recent news headlines, nowhere is this gamble more clearly exemplified than in the areas of insider trading and personal trading practices. Increasingly, advisers are turning to compliance software to fill the gap, control their risks and competently fulfill their compliance obligations. But, as helpful as these solutions can be \u2014 and they are \u2014 they can only inform the process of compliance. That is, an effective compliance regime results from regular reviews of data outputs. Without an investment of \u201cman hours\u201d to monitor and address compliance issues or patterns revealed by technology, these helpful solutions are nothing more than digital filing cabinets. And yet, who has that kind of time for constant review?<\/p>\n

Insider Trading: Increased Scrutiny, Surveillance and Violations<\/strong>
\nIn congressional testimony provided in March 2009, then-SEC commissioner Elisse Walter announced the development and deployment by the Commission of technological tools to identify trading patterns that may signify illegal trading activity by advisers, hedge funds and other financial industry participants and their staff. Then in October 2009, one of the largest hedge fund insider trading cases in history was filed by the SEC in a Manhattan federal court against California-based Galleon Management, LP and its founder and chief executive, among others, sending shockwaves through the investment community. Speaking at a news conference shortly after the announcement of the Galleon case, Robert Khuzami, then-SEC Enforcement Director, stated his suspicion that insider trading was a systemic problem at many hedge fund managers and expressed the Commission\u2019s determination to aggressively seek out and pursue those engaged in unlawful trading activities.<\/p>\n

The Commission has been as good as its word. After peaking at 61 cases in 2008, the number of insider trading-related cases have steadily risen year-over-year from 37 in 2009 to 58 in 2012. In the \u201c2014 Examination Priorities\u201d release of the National Examination Program (NEP) of the Office of Compliance Inspections and Examinations of the SEC, the Commission listed ferreting out fraudulent conduct as among the \u201cmost significant\u201d initiatives across the program. In that release the Commission further specified that \u201c\u2026 the NEP will continue to utilize and to enhance its quantitative and qualitative tools and techniques to seek to identify market participants engaged in fraudulent or unethical behavior.\u201d All indications are that many more insider trading allegations will be levied in the coming months and years as a result of the Commission\u2019s stepped-up efforts.<\/p>\n

In response, advisers and hedge fund managers are examining the effectiveness of their own internal surveillance efforts to apply the lessons of insider trading cases to their operations and avert the firm-shuttering media attention allegations of wrong-doing can bring. Obviously, these advisers\u2019 efforts include revisiting policies and procedures and scheduling mandatory staff training sessions. However, they continue to struggle with how best to use the information on-hand to identify potential abuse occurring right under their noses.<\/p>\n

Personal Securities Trading and Code of Ethics<\/strong>
\nPersonal trading practices of firm insiders have been an area of scrutiny by SEC examiners for years. This is because, when investment advisory personnel invest for their own accounts, conflicts of interest arise between the employee\u2019s interests and those of the adviser\u2019s clients. Advisory personnel may, for example, usurp an investment opportunity that would have been appropriate for the firm\u2019s clients. They may also abuse their positions with the firm by \u201cfrontrunning\u201d client trades. When frontrunning, advisory personnel seek to personally benefit from the market effect of trades placed for the adviser\u2019s clients. Even with the best efforts of the firm\u2019s trade-desk, large trades placed for clients have the potential to affect the price of a security. This is true for both long positions and short positions, with long positions potentially driving up the price of a security and short positions potentially driving down the price. The possibility of driving the price of a security up or down before placing a trade in the same security for a personal account provides an opportunity for certain advisory personnel with knowledge of anticipated client trades to personally benefit from client trades. It almost goes without saying, but this is illegal.<\/p>\n

To address these and other issues, in 2004 the SEC adopted Rule 204A-1, the Code of Ethics Rule, under the Investment Advisers Act of 1940 (Advisers Act). In addition to requiring the adoption of a code of ethics, the Rule requires that firms monitor the personal trading activities of their supervised persons with access to certain information regarding client portfolio holdings, transactions or recommendations and identify improper trades or patterns of trading by those access persons. In a 2008-issued \u201cCompliance Alert,\u201d the Commission warned advisers of the most common deficiencies found during examinations. Among these, they cited:<\/p>\n