The Importance of Insider Trading Controls for Private Markets
A significant portion of the private markets fund manager industry has long subscribed to the erroneous notion that insider trading risks are low to non-existent in this industry. Many private markets fund managers believe that because they never (or rarely) trade in the public markets, they do not need to have the types of insider trading prevention controls that exist at hedge funds and other types of investment managers who routinely trade in public securities. These managers fail to realize they could have a fair bit of insider trading risk exposure even when they only invest in privately-held companies.
This risk exposure has intensified over the past several years as the intersections between private markets fund managers and public companies have significantly increased. For example, far more private markets fund managers interact with expert networks and public company executives than was the case five years ago. There are numerous reasons for these increased interactions, including:
- The desire to get public company comparable data to better inform and bring more objectivity to the valuation processes for privately-held portfolio companies (a trend that has intensified since the onset of the COVID-19 pandemic)
- An increase in transactions involving taking public companies private
- Evaluating prospective add-on targets for existing portfolio companies (including add-ons that may themselves be public companies or affiliated with public companies)
Even in the case of private markets fund-of-funds managers, we are increasingly seeing such managers exposed to material non-public information (MNPI)/potential MNPI – usually by virtue of an underlying fund manager inappropriately sharing MNPI with their limited partners (LPs), such as disclosing they have just signed an exclusive deal to take a public company private and identifying the potential target company or disclosing ongoing negotiations with a public company seeking to acquire one of their fund portfolio companies.
Irrespective of the drivers behind these increased interactions, there is no doubt that the average private markets fund manager is, intentionally or unintentionally, significantly more likely to receive MNPI about one or more public companies today and share such information with various non-employees (such as operating partners and strategic/senior advisers) who are increasingly involved in such a manager’s investment process, and potentially deal advisers (including law firms, investment banks, and valuation and consulting firms). At many private markets fund managers, such MNPI inflow and outflow increases often have not resulted in a corresponding increase in controls designed to: (i) prevent such inflows (where appropriate) and (ii) monitor and/or prevent misuse of such sensitive information by internal and external stakeholders.
Increasing SEC Scrutiny
The U.S. Securities and Exchange Commission (SEC) has taken notice of these risks and issued at least one notable enforcement action in the private markets fund manager space recently for alleged failure to implement adequately robust controls to periodically monitor for MNPI inflows and manage related risks. In addition, the SEC has also taken similar enforcement actions outside of the investment manager space, which holds important lessons for private markets fund managers. For additional details on such enforcement activity, please refer to our earlier discussion here as well as in our Q3 2021 Private Markets Update.
More recently, we have started to see SEC examiners probe private markets fund managers’ insider trading controls more deeply and expansively than in the past – even in relation to fund managers who do not engage in any public markets trading. The focus thus far seems primarily centered around controls relating to interactions with expert networks, other investment consultants, and public company insiders. In multiple recent examinations of private markets fund managers, we have seen the SEC request the following information relating to MNPI controls (to the extent relevant to a firm’s operations):
- Logs of communications with independent research service providers (such as expert networks and investment consultants) detailing relevant details such as participants involved and topics and companies discussed
ACA notes that these types of logs are customarily maintained by virtually all of the well-known expert networks and available upon request. Firms should request and receive these logs periodically and ensure they are up-to-date, and to the extent required, confirm that any pre-approval and/or reporting obligations were followed. Similarly, in relation to interactions with other types of investment consultants that do not routinely maintain such logs as part of their business, private markets fund managers should internally track these interactions carefully (at a minimum).
- Training materials relating to employee training around MNPI receipt and controls
- Written policies and procedures governing meetings or other communications between a firm’s investment personnel and personnel of publicly-traded issuers
- Documentation regarding any exceptions granted in relation to the firm’s MNPI control-related policies and procedures and the rationale for such exceptions
- All compliance calendars or other information tracking meetings or other communications between a firm’s investment personnel and personnel of publicly-traded issuers
- Records (if any) of chaperoning or other compliance oversight of the communications with expert networks and personnel of public-trader issuers
- A description of any program (along with an Excel download of data maintained in such program) used, such as A2 Access or Markit Calendar to assist in tracking communications between a firm’s investment professionals and outside persons who may be in possession of MNPI
- A schedule of all securities on the Restricted, Watch, or similar lists with notes reflecting why the company was placed on and removed from those lists
ACA notes that many private markets firms do not include any notes explaining why an issuer was added or removed from a restrict list (or other similar list used to monitor MNPI inflows) and should consider enhancing their processes in this area where necessary. Additionally, many private markets firms consolidate lists designed to track where they have MNPI with lists designed to ensure non-disclosure agreement (NDA) compliance relating to confidentiality and/or trading restrictions (irrespective of whether any MNPI was received pursuant to any such NDAs). Such firms may want to either maintain such lists separately or clearly distinguish where an issuer was added due to MNPI receipt versus another reason (such as NDA compliance monitoring). Finally, we highly recommend scrubbing restricted lists periodically (at least annually) to remove securities where a firm no longer possesses MNPI. This will reduce the risk of personal trading violations involving restricted securities as we as help avoid a potential deficiency finding in a SEC exam around stale restricted lists.
- As noted earlier, private markets fund managers are increasingly receiving MNPI (or potential MNPI) relating to public companies from multiple sources (either intentionally or unintentionally). Such information is almost always obtained pursuant to a duty of confidentiality and obligation and not to misuse the information for personal or client gains.
Against this backdrop, private markets fund managers should, to the extent not already done, undertake a comprehensive analysis of the various ways in which MNPI can flow into their respective firms (e.g., via discussions with public company executives and/or expert networks, or in the context of a transaction (or evaluating a proposed transaction) involving a public company). Private markets fund managers should also carefully reevaluate how to: (i) prevent such information from flowing into their firms (where there is no legitimate business reason to access such information), (ii) adequately ring-fence such information upon receipt, and (iii) monitor the activities of individuals and firms who have accessed such information to mitigate the risk of misuse.
- In connection with engaging the services of individuals who may not be employees (such as operating partners and senior/strategic advisers), private markets fund managers should periodically evaluate the nature of these services and whether such individuals are materially involved in these managers’ investment processes (and thereby potentially in a position to receive MNPI). In the latter instance, SEC-registered investment managers should carefully evaluate whether such individuals should be subject to the managers’ compliance programs (or at least their code of ethics). In the case of investment managers not registered with the SEC, such individuals should at the very least be subject to such investment managers’ insider trading prevention policies and procedures). Additionally, any individuals who are likely to be exposed to MNPI or other types of sensitive investment-related information in connection with providing services to a private markets fund manager should be subject to contractual restrictions prohibiting them from misusing MNPI and/or other sensitive information.
ACA notes that in instances where such individuals are subject to private markets fund managers’ compliance programs (including personal trading-relating reporting and preclearance requirements), ACA has uncovered an increasing number of occurrences where these individuals have traded in public companies for their personal accounts in a potentially problematic way. For example, a non-employee may have traded (even if only due to oversight) in a public company on a private markets fund manager’s restricted list. Fortunately, in most instances, such an employee and/or the manager was not actually in possession of active MNPI at the time of the trade in question. Nevertheless, these trends further reinforce the need to closely monitor and appropriately restrict the personal trading activities of employees and non-employees who may be in a position to, intentionally or unintentionally, misuse MNPI.
Further, in instances where the foregoing types of individuals provide similar services to other private markets fund managers (especially those deploying similar investment strategies), private markets fund managers should ensure they have implemented adequate measures to reduce the risk of such individuals sharing MNPI or other sensitive information with other managers.
- In instances where employees of a private markets fund manager want to utilize the services of an expert network (e.g., to incorporate objective data inputs into the valuation processes for fund portfolio companies whose business is similar to that of the foregoing public company), the private markets fund manager should, as a preliminary matter, properly vet the expert network to ensure they have adequate controls (including conducting training) to prevent experts on their network from sharing MNPI.
Such controls should prohibit an expert from engaging in any discussion relating to public companies he/she was associated with within six months (or other appropriate “cool out” period) of such discussion. While chaperoning each and every interaction with an expert on a network previously approved may be overkill at most private markets fund managers, obtaining relevant details relating to such conversations (e.g., topic and purpose of discussion, and companies discussed) from either employees or the expert network itself (virtually all seasoned networks will collect and provide such information to their customers) is important, and something we see the SEC frequently asking for in examinations of private markets fund managers.
- In instances where employees wish to talk to executives, or other insiders at public companies (outside of a transactional context), many private markets fund managers have a false sense of confidence that because such traditional insiders are subject to Regulation FD, which prohibits them from sharing MNPI selectively, such managers do not need to monitor interactions between their employees and such insiders for inappropriate MNPI sharing. A rare SEC enforcement action brought against a public company and certain of its executives for inappropriate MNPI sharing earlier this year, and summarized in ACA’s Q3 2021 Private Markets Update, should cause private markets fund managers to take these risks seriously.
ACA notes that at an increasing number of private fund managers, employees are frequently engaging in such interactions without being subject to any chaperoning or other controls. Apart from managing MNPI risks, failure to, at a minimum, track such interactions may prove troublesome when asked to produce such information at short notice during the course of a SEC examination.
- While having policies and procedures to prevent the risk of MNPI abuse are important, they are not sufficient on their own. Consequently, private markets fund managers should revisit how they are periodically monitoring such risks. We list a non-exclusive list of some of the practical steps private markets fund managers can take to effectively manage and monitor such risks:
- Periodic email reviews can (and often do) help firms detect potential improper sharing of MNPI by employees and non-employees via firm-issued email accounts and/or misuse of personal or unapproved messaging platforms for such business communications.
- Assessing the robustness of MNPI controls in place at deal advisers (such as law firms and valuation and M&A advisers) to mitigate misuse of MNPI their employees have obtained (or are likely to obtain) during the course of transaction related or other advisory services provided to a private markets fund manager. Similarly, in the context of deal related data rooms set up and managed by a private markets fund manager, limiting access to only those personnel who need such access to perform their duties is critical. Such access rights should also be periodically reviewed to ensure no employees of an adviser has access to the data room longer than needed.
- Regular review of access rights to data rooms to ensure that those who no longer need access have had their rights terminated.
- Requesting that third-parties who have received sensitive information from a private markets fund manager destroy such information (and receive confirmation of such destruction) once it is determined that such persons no longer have a legitimate need to possess this information.
How we help
Firms that use our ComplianceAlpha® regulatory technology (RegTech) solution have an advantage when monitoring for MNPI.
- The Control Room feature manages multiple restricted lists, including historical records, as companies move across restricted and grey lists for a firm and uncover information including the type of conflicted activity, linked companies, and linked employees.
- Our Market Abuse Surveillance Solution helps clients identify potential misconduct and insider trading risk. It tests portfolios after meetings with expert networks or issuers and drills down into your firm’s trading activity when compared to corporate actions, significant price movements, and important events such as expert network meetings or issuers or political intelligence research. ComplianceAlpha has a specific tool to track and log expert network meetings to meet the SEC’s requirements.
- Our eComms Surveillance Solution is an integrated natural language processing surveillance and investigations platform that ingests eComms, messaging, mobile traffic, and voice calls to provide firms with a complete view of potential high-risk activities and behavior across their organization. By reducing false positives and delivering more precise, meaningful alerts, our solution increases the effectiveness and efficiency of an eComms surveillance operation while reducing the time needed for teams to review electronic and voice communications.
In addition to our RegTech solutions, we also offer Expert Network Consultation Chaperoning. Our team is available to listen to consultations, document observed inconsistencies with policies and procedures, and provide a report of any findings after the meeting.
If you have any questions about the use of MNPI in Private Markets Fund Managers, or would like to learn more about our surveillance solutions, please reach out to your ACA consultant or contact us.