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The SEC demands more action on MNPI from hedge funds

Aug 28, 2018

Topics: Compliance | MNPI |

The US Securities and Exchange Commission (SEC) is escalating its focus on advisers’ policies and procedures to prevent the misuse of material non-public information (MNPI) during exams and issuing more deficiencies in exit letters to hedge funds for sub-optimal practices. To avoid receiving a deficiency letter, hedge funds will need to be sure they implement a broader range of policies and procedures than they may have previously used.

SEC cracks down on firms

The crackdown on hedge funds can be evidenced by enforcement actions we have seen recently, such as a recent settlement by a hedge fund with the SEC in May 2017. In July 2010, the regulator said that the hedge fund manager abused his position as a shareholder in a natural gas company to learn confidential information from a company executive about the sale of a gas-processing facility which the firm traded on. According to the SEC, the hedge fund brought in around $4 million in profits as a result of the trades, though in the final settlement, the hedge fund had to pay $5 million in fines. The firm was also ordered to retain an independent compliance consultant on staff until 2022, perform monthly MNPI certifications, and outsource the firm’s beneficial ownership program to a third-party deemed acceptable by the SEC. Ultimately, the hedge fund manager decided to convert the firm into a family office, effectively exiting the hedge fund business in July 2018.

An investment bank was also recently the subject of SEC enforcement proceedings when the regulator announced the firm would be paying a $1.25 million penalty in July 2018. In this case, MNPI about stock buybacks by the bank’s issuer customers was being passed between different trading desks as well as directly to hedge fund clients. The bank changed its policies and procedures in the wake of the SEC’s original investigation.

Hedge funds must boost MNPI efforts

It makes sense that the SEC is increasing its exam focus on the treatment of MNPI by hedge funds as a result of these and other cases. According to a poll conducted at the Cordium Regulatory Summit in New York, only one out of five investment firms were undertaking the sort of logging of contacts and testing that the regulator seems to expect today. Most firms, more than 47%, were only logging MNPI contacts without taking further steps. Another one-fifth were logging and performing some form of testing, but this is still not enough to meet SEC expectations on MNPI management, as evidenced in deficiencies issued.

In the past, many hedge fund executives believed they could rely on the fact that C-level executives at public companies were themselves constrained from disclosing inappropriate MNPI by Reg FD, however, the SEC has made it clear that this is not acceptable. Hedge funds, and other firms, must have an active and robust MNPI program in place.

Firms should consider the following practices well before they receive notice of an exam:

  1. Awareness of meetings – The regulator wants to see that CCOs have a central list of all meetings and phone calls with public companies that are attended by employees. This list can be provided as a spreadsheet, an Outlook calendar, or a dedicated software solution.
  2. Testing around the meetings – In addition to the list, CCOs should be chaperoning a sample of in-person meetings and telephone calls with public company executives.
  3. Documentation of the testing – The regulator also wants to see documentation around the CCO’s attendance or chaperoning of those meetings and phone calls. Compliance officers should keep documentation to evidence any supervision and any observation notes.
  4. Conducting surveillance – Firms should be conducting surveillance related to any meetings that may appear concerning given the firm’s trading activity. For example, CCOs can compare the log of public company meetings and phone calls against the firm’s trade blotter on a periodic basis. In instances where a meeting or phone call was followed by a trade in that company, a more thorough review of those activities should be conducted. Firms may consider the following:
    • Reviewing electronic communications – The CCO may want to review electronic communications around meetings and/or transactions that have been flagged through surveillance or other means. This review should include email and other forms of electronic communications that firms use, such as trading platform messaging, text messaging, and social media.
    • Looking over research platform notes – Many firms now use research management software (RMS) or other internal systems (such as OneNote), in which analysts can keep their notes and update their thesis information. A CCO reviewing a transaction should review the firm’s RMS content to see if notes could contain potential MNPI.
    • Checking personal trading – CCOs should also look for personal trading that was conducted by employees in the wake of any meetings with public companies.

By the time the SEC knocks on the door to conduct an exam, it’s too late to rectify MNPI policies and procedures. Even those firms that have historically tracked meetings with public companies and chaperoned a sample of these meetings have received deficiencies related to the failure to implement policies and procedures to prevent the misuse of MNPI. Deficiency letters for sub-standard approaches are bad enough, however the SEC is also escalating its overall approach to insider trading enforcement through the use of technology to identify suspicious transactions. A number of insider trading cases that were identified through the SEC’s new approach have already been prosecuted. CCOs should be vigilant about MNPI as a potential flag for illegal activities and be ahead of the regulator. The reputational damage from an insider trading case can ruin a firm.

Overall, it’s clear that MNPI is now a significant focus for SEC examiners when they are working with hedge funds. Firms need to be prepared by putting in place an adequate compliance framework around MNPI, including the appropriate policies and procedures as well as e-communications reviews, research reviews and personal trade monitoring.