This article appeared in the Journal of Investment Compliance, Vol. - PDF document

This article appeared in the Journal of Investment Compliance, Vol. 8, No. 3 (Sept. 2007), pp. 5-18. The SEC’s Enforcement of Procedures to Prevent Insider Trading by Brian A. Ochs When the Securities and Exchange Commission and other regulators filed enforcement actions against ten investment banks in 2003 for conflicts of interest that tainted their investment research, the settlements were the subject of a major media blitz, including a joint press release, a press conference, and separate statements by then SEC Chairman William Donaldson and the Commission. In March of this year, when Banc of America Securities (“BAS”) paid $20 million in disgorgement and penalties to settle a similar SEC action relating to conflicts of interest in research on three companies, the announcement took a distinct back seat in the Commission’s press release. Instead, the press release trumpeted the Commission’s finding that BAS failed to prevent its traders from gaining access to and trading on information in the firm’s research reports, including information about upgrades and downgrades, before the reports were made public – for which the SEC fined BAS an additional $6 million. 1 That the Commission chose to spotlight BAS’ “breakdown in its internal controls” (to quote the SEC) relating to the dissemination and use of material nonpublic information over the Commission’s findings that BAS issued misleading research was no accident. The SEC has made cracking down on insider trading and other misuses of confidential information by securities professionals an enforcement priority. 2 Earlier this year, the SEC’s examination staff initiated a broad inquiry of major broker-dealers to explore whether employees were leaking information about large trades to favored clients such as hedge funds in order to enable those clients to front-run the trades. 3 The examination staff has also recently identified deficiencies among hedge fund advisers with respect to insider trading policies and other compliance policies 1 See Press Release, “SEC Enforcement Action Against Banc of America Securities for Failing to Safeguard Nonpublic Research Information and Publishing Fraudulent Research; Firm to Pay $26 million” (Mar. 14, 2007 ), available at http://www.sec.gov/news/press/2007/2007-42.htm (“BAS Press Release”); Banc of America Securities LLC, Exchange Act Release No. 55466, 2007 SEC LEXIS 492 (Mar. 14, 2007). 2 See, e.g., SEC v. Barclays Bank PLC, et al., Litig. Release No. 20132, 2007 SEC LEXIS 1170 (May 30, 2007); Press Release, “SEC Charges Two Securities Professionals with Insider Trading” (May 10, 2007), available at http://www.sec.gov/news/press/2007/2007-93.htm; Press Release, “SEC Charges Credit Suisse Investment Banker with Insider Trading” (May 3, 2007), available at http://www.sec.gov/news/press/2007/2007-85.htm; Press Release, “SEC Charges 14 in Wall Street Insider Trading Ring” (March 1, 2007), available at http://www.sec.gov/news/press/2007/2007-28.htm. 3 See “SEC is Looking at Stock Trading” The New York Times (Feb. 6, 2007).

and procedures designed to address the use of nonpublic information to make investment decisions for fund and personal accounts. 4 As part of this focus, the SEC’s enforcement staff is scrutinizing with renewed vigor the roles and responsibilities of securities firms for the protection of confidential information. The BAS case was the third major action in less than a year in which the SEC faulted securities firms for lapses in their procedures designed to prevent trading on material nonpublic information. 5 The Director of the SEC’s Enforcement Division took the occasion of the settlement with BAS to emphasize that the Commission is “determined to plug the improper leak of information on Wall Street,” and that “firms must have appropriate safeguards on all their nonpublic information, including upcoming research reports.” 6 The SEC’s recent actions have been brought under section 15(f) of the Securities Exchange Act of 1934 (“Exchange Act”) and section 204A of the Investment Advisers Act of 1940 (“Advisers Act”), 7 companion provisions that require brokers, dealers, and investment advisers that are registered with the Commission to “establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such [broker, dealer, or investment adviser’s] business, to prevent the misuse” of material nonpublic information. These requirements are not new – they were enacted as part of the Insider Trading and Securities Fraud Enforcement Act of 1988 (“ITSFEA”), 8 and since the early 1990’s the SEC has brought a number of enforcement actions charging their violation. However, in the past, most of the cases brought under sections 15(f) and 204A sanctioned firms either for not having procedures at all, or for narrowly-focused failures in the implementation of existing procedures. In contrast, the SEC’s recent cases against BAS and Morgan Stanley illustrate the increasing willingness of the Enforcement staff to engage in both a broad and a deep examination of the information barriers, transaction reporting requirements, trading surveillance, and other processes by which a regulated firm is expected to safeguard material nonpublic information in its possession. Thus, in any case involving misuse of confidential information by employees of brokers, dealers, or investment advisers, the SEC is poised to look not only at the conduct of the 4 See Andrew J. Donohue, Director, Division of Investment Management, U.S. Sec. and Exch. Comm’n., “Remarks Before the 4 th Annual Hedge Funds and Alternative Investments Conference” (May 23, 2007), available at http://www.sec.gov/news/speech/2007/spch052307ajd.htm (“Donohue Remarks”). 5 See also Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., Exchange Act Release No. 54047, 2006 SEC LEXIS 1465 (June 27, 2006); SEC v. Friedman, Billings, Ramsey & Co., et al., Litig. Release No. 19950, 2006 SEC LEXIS 3009 (Dec. 20, 2006). 6 BAS Press Release, supra note 1. 7 15 U.S.C. §78o(f) (2006); 15 U.S.C §80b-4a (2006). 8 Pub. L. No. 100-704.

individual violators, but also at whether the firm took appropriate actions to protect the information. Indeed, actual misuse of information may not even be necessary to spur an enforcement investigation and possible sanctions; the SEC fined Morgan Stanley $10 million “due to a systemic breakdown in this critical compliance function” 9 in a case where “there was no evidence that material nonpublic information was misused as a result of that failure.” 10 Moreover, firms that fail to vigorously maintain and enforce reasonable procedures to protect against misuse of material nonpublic information may not only face stiff penalties, but may also lose the benefit of legal defenses to insider trading liability should employees engage in such conduct. Given the SEC’s current enforcement emphasis on this area, it is essential that brokers, dealers, and investment advisers look critically at whether they are taking adequate steps to protect the confidential information that they may handle on a daily basis. This article reviews the SEC’s implementation and enforcement of section 15(f) of the Exchange Act and section 204A of the Advisers Act. Part I discusses the legislative history of these provisions and reviews SEC and staff pronouncements relating to procedures for the protection of material nonpublic information. Although Congress granted the SEC authority to require brokers, dealers, and investment advisers to adopt specific policies or procedures to implement sections 15(f) and 204A, the SEC has largely refrained from doing so. Instead, the Commission and the staff have published general guidance on certain of the elements of effective procedures, while leaving firms with flexibility to adopt procedures that are appropriate to their particular business operations. The lack of regulation in this area makes it all the more important that brokers, dealers, and investment advisers understand and appreciate the Commission’s approach to enforcement of sections 15(f) and 204A because it is through enforcement actions that the Commission has in large part articulated it expectations for firm compliance. After a brief discussion in Part II of the potential consequences, from an enforcement perspective, of a firm’s failure to satisfy the requirements of section 15(f) or section 204A, Part III describes the SEC’s enforcement program in this area and distills guidance for securities firms from the SEC’s actions. As will be seen below, the fact that the Commission permits firms flexibility to adopt procedures that are best suited to their particular operations and risks does not equate with a lax view of a firm’s obligations under sections 15(f) and 204A. To the contrary, the SEC’s enforcement actions have made it abundantly clear that the Commission’s flexible approach to the statutory requirements also means that the Commission places high expectations on brokers, dealers, and investment advisers to design procedures that take into account the unique and myriad ways that information may be subject to abuse in the context of each firm’s particular business model. Further, the SEC places a high priority on firms not merely having adequate written policies and procedures, but, just as importantly, ensuring that their policies and procedures are vigorously enforced. 9 Exchange Act Release No. 54047, 2006 SEC LEXIS 1465 at *4. 10 Testimony of Linda Chatman Thomsen Concerning Insider Trading before the U.S. Senate Committee on the Judiciary (Sept. 26, 2006), available at http://www.sec.gov/news/testimony/ts092606lct.htm.