Insider Trading: Recent SEC Charges Present Cautionary Lessons

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 fund and other types of investment managers who routinely trade in public securities. These managers fail to realize that they could have a fair bit of insider trading risk exposure even where they only invest in privately-held companies.

This risk exposure has intensified in 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: (i) 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) and (ii) an increase in transactions involving taking public companies private. The SEC has taken note of these risks and has taken at least one notable enforcement action in the private markets fund manager space in the recent past for alleged failure to implement adequately robust controls to periodically monitor material nonpublic information (MNPI) inflows and manage related risks.

Irrespective of the drivers behind these increased interactions, there is no doubt that the average private markets fund manager is significantly more likely to, intentionally or unintentionally, receive MNPI about one or more public companies today and share such information with various non-employees (such as operating partners and strategic/senior advisors) who are increasingly getting involved in such a manager’s investment process, as well as deal advisers (including law firms, investment banks, and valuation and consulting firms). At many private markets fund managers, such MNPI inflow and outflow increases have often 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.

Recent SEC charges in the insider trading area, while not involving private markets fund managers, involve the types of MNPI abuse risks that are increasingly becoming relevant to such managers. As such, these charges and the key takeaways from them should be taken seriously across the private markets fund industry.

SEC Charges Brought Against a Prominent Global Consulting Firm’s Partner and One of its Affiliates

In November 2021, the SEC brought parallel charges against the in-house investment advisory affiliate of a prominent global consulting firm (alleging a failure to implement adequate MNPI controls) and a partner of the foregoing consulting firm (alleging insider trading). These charges present significant lessons for private markets fund managers.

In the first set of charges (which are expected to be litigated), the SEC alleged that a prominent global consulting firm’s partner had illegally traded in advance of a corporate acquisition by one of the firm’s clients earlier in the year. More specifically, the SEC’s complaint alleges that in the course of providing consulting services to a large investment bank, the foregoing partner learned highly confidential information concerning the bank’s impending acquisition of a publicly-held FinTech firm.

According to the SEC’s complaint, in the days leading up to the acquisition announcement, the partner used this information to purchase and subsequently sell call options relating to the FinTech firm that were set to expire just days after the announcement. In doing so, the SEC alleged that the partner violated the contractual fiduciary duties he owed to his employer and client to keep the foregoing type of information confidential and not misuse it. The SEC’s complaint further alleges that the partner violated his employer’s policies by failing to pre-clear these options transactions.

In the second set of charges (which were settled with the payment of a $18 million fine), the SEC alleged inadequate MNPI controls at an SEC-registered investment advisory affiliate of the foregoing consulting firm that manages personal investments on behalf of current and former partners of the consulting firm.

Although the SEC did not allege any specific instance of insider trading or other improper use of MNPI, the SEC alleged that permitting active partners of the consulting firm to supervise and monitor the investment advisory affiliate’s investment decisions (via their seats on the investment committee of the investment advisory affiliate) presented an ongoing risk, which the investment advisory affiliate did not have adequate policies and procedures to mitigate.

The SEC specifically alleged that the foregoing active partners of the consulting firm had access to MNPI about public companies in which the investment advisory affiliate invested - due to the consulting services they provided such companies. This information included financial results, planned bankruptcy filings, material changes in senior management, and M&A activity.

The SEC found that the investment advisory affiliate had invested hundreds of millions of dollars in companies that the consulting firm had advised over a five year period.

The SEC alleged that the investment advisory affiliate’s written policies and procedures should have: (i) outlined how to identify investment committee members who, by virtue of their consulting services, may have MNPI relating to public companies in which the investment advisory affiliate had invested (or was looking to invest) and (ii) implemented recusal procedures reasonably designed to prevent misuse of MNPI by such partners (received via the course of their consulting services and/or their involvement with investments made/being considered by the investment advisory affiliate).

Key Takeaways 

• 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, 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 advisors), 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 in this area prohibiting them from misusing any such 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 that they have implemented adequate measures to reduce the risk of such individuals sharing MNPI or other sensitive information with such 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 at first glance the SEC’s enforcement action against the investment advisory affiliate of a consulting firm described above may not appear to hold any takeaways for private markets fund managers that rarely/never invest in public companies, upon closer consideration, we believe it illustrates the critical importance of obtaining and comprehensively evaluating information about the full gamut of outside business activities of employees and non-employees involved in such managers’ investment processes. Such issue spotting is particularly important as private fund managers increasingly employ or otherwise retain the services of individuals whose outside business activities may involve services to competing investment managers, services to and/or positions with public companies and/or otherwise pose significant MNPI-related risks.
• Finally, as these charges indicate, 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 third-parties who have received sensitive information from a private markets fund manager to destroy such information (and confirm such destruction) once it is determined that such persons no longer have a legitimate need to possess such information.

How we help

Our private markets consulting team can assist managers with building and assessing compliance and surveillance programs that monitor for the use of MNPI. Our managed service and RegTech solutions are customized to provide the appropriate amount of trade surveillance assistance to fit your firm's risk level.

Contact us if you have any questions about these exams or to find out how ACA can help you prepare.

Download our Private Markets Quarterly Update

This is just one of the many insightful articles included in our Q4 2021 Private Markets Quarterly Update. Download the full newsletter to learn about:

• Recent Remarks Signal SEC Desire for Comprehensive Reevaluation of Private Markets Regulation
• Best Practices for Building and Implementing a Private Markets Compliance Program
• Insider Trading Focus: Multiple Recent SEC Charges Present Cautionary Lessons for Private Markets Fund Managers
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• SEC’s Recent Sweep Enquiries Into Electronic Communications
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• Noteworthy SEC Enforcement Actions
• The UK National Security and Investment Act of 2021
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