• Recent Regulatory Actions Focused on Policies and Procedures Designed to Safeguard Material, Non-Public Information
  • July 25, 2011 | Authors: W. Hardy Callcott; Jason Lane; John R. Snyder
  • Law Firms: Bingham McCutchen LLP - San Francisco Office ; Bingham McCutchen LLP - New York Office ; Bingham McCutchen LLP - Boston Office
  • Both the U.S. Securities and Exchange Commission (“SEC”) and FINRA have recently brought actions against broker-dealers alleging their failure to establish and enforce policies and procedures to prevent the misuse of material, non-public information (“MNPI”). These regulatory actions should serve as a reminder to firms to not only review their policies and procedures relating to safeguarding MNPI to ensure that they reflect the firm’s current business model, but also to take steps to ensure that supervisors understand and carry out their role in implementing and enforcing those policies and procedures.

    Recent Regulatory Actions Alleging Failure to Safeguard MNPI

    In an action brought by the SEC, the Staff alleged that the firm failed to adequately establish, maintain and enforce procedures reasonably designed to prevent the misuse of MNPI.1 Specifically, the Staff found that the firm failed to adhere to its policies and procedures relating to chaperoning meetings between research analysts and investment bankers and failed to properly maintain and enforce its email communication firewall procedures designed to prevent communications between bankers and research analysts.

    The Staff further alleged that the firm failed to adequately monitor trading in the securities of firms on its watch list; permitted a compliance employee to conduct supervisory reviews of pre-clearance trades without being a registered principal in contravention of firm policy; allowed investment bankers to execute trades without pre-clearance; failed to obtain initial and annual employee disclosure forms disclosing outside accounts in contravention of firm policy; failed to request and review account activity for outside accounts disclosed to the firm; and allowed a supervisor who lacked access to the firm’s watch list to review activity in outside accounts.

    The Staff alleged a violation of Section 15(g) of the Exchange Act, which requires brokers and dealers to establish, maintain and enforce policies and procedures reasonably designed, taking into consideration the nature of the firm’s business, to prevent the misuse of MNPI by the firm or any associated person. The firm agreed to be censured, paid a penalty, and is required to retain an independent consultant to review the firm’s MNPI policies and procedures.

    The FINRA Department of Enforcement (“Enforcement”) recently filed a disciplinary proceeding against a member firm alleging that the firm failed to have reasonable supervisory procedures or a reasonable system of supervision regarding information barriers, specifically as those information barriers relate to the firm’s role as a placement agent for PIPE transactions.2 Specifically, Enforcement alleged that the firm lacked written supervisory procedures addressing the creation or distribution of a watch list for a nearly three-year time period, and failed to maintain its restricted list in accordance with its own procedures, including failing to maintain proper documentation relating to the restricted list. Enforcement further alleged that the firm failed to adequately monitor outside accounts for trading in restricted securities, including that it failed to adequately obtain attestations from employees concerning the existence of outside accounts; failed to take adequate steps to ensure that the firm was receiving duplicate confirmations and statements for outside accounts; and failed to establish and maintain procedures designed to restrict the flow of MNPI (including sharing MNPI with unregistered individuals who were owners of the firm).

    Enforcement alleged that these actions constituted violations of NASD Rules 3010 and 2110. The firm submitted an Offer of Settlement, which was accepted by the National Adjudicatory Council, pursuant to which it was censured and assessed a fine.3

    Significance of Recent Regulatory Actions Relating to Safeguarding MNPI

    Although the recent regulatory and law enforcement spotlight has shined on insider trading with respect to hedge funds and expert networks, recent regulatory actions serve as a reminder that firms need to be ever-vigilant when it comes to safeguarding their own MNPI. In addition to the two cases described above, the Staff has also recently brought actions against two other firms where it alleged, in part, that the firms failed to establish and maintain controls reasonably designed to protect MNPI. These cases are significant in that they both focused on the information barriers between related entities.

    In November 2010, the Staff brought an action against a broker-dealer and a registered investment adviser subsidiary who shared office space, as well as the chief compliance officer (“CCO”) for both firms.4 The Staff alleged that the broker-dealer failed to follow its policies relating to the safeguarding of MNPI, and that the registered investment adviser’s policies and procedures were deficient and, in some cases, so unclear that employees were unaware of their responsibilities. The Staff was particularly focused on the relationship between the entities, the fact that the broker-dealer’s analysts were covering sectors in which the registered investment adviser was investing, the overlapping senior management between the two entities and their physical proximity.

    In January 2011, the Staff brought both an enforcement action and a civil action against a broker-dealer/transfer agent/registered investment adviser, an affiliated registered investment adviser, and an open-end management investment company.5 The Staff alleged, among other charges, that the broker-dealer and affiliated registered investment adviser both had policies and procedures which were not reasonably designed to prevent the misuse of MNPI by employees and related mutual funds regarding a separate fund managed by the registered investment adviser. The Staff noted that the policies and procedures in place governing fund redemptions by certain employees were insufficient (e.g., pre-clearance was limited to certain people such as the portfolio managers of the fund itself and redemptions by other personnel were not reviewed); there were no specific policies in place governing redemptions by portfolio managers who advised related funds of funds; nor were there appropriate information barriers in place to safeguard MNPI regarding the fund (e.g., information regarding redemption levels and plans to satisfy redemptions.)6

    This recent spate of enforcement actions demonstrates that regulators are clearly focused on both the quality of policies and procedures regarding the safeguarding of MNPI as well as the manner in which those policies and procedures are carried out. In fact, FINRA noted that information barriers were an area of ongoing concern and a focus for examinations in its Annual Regulatory and Examination Priorities letter for 2011.7

    Firms need to ensure that supervisors are adequately trained with respect to the firm’s policies and procedures concerning the safeguarding of MNPI. In addition, firms should take reasonable steps to ensure that when supervisors leave or transition into new roles and are replaced, the new supervisors are adequately trained on the policies and are consistent in the manner in which they both enforce and document the enforcement of the policies.

    Of particular significance in the November 2010 action, the Staff noted that the CCO had prepared a written response to the SEC examination staff in a previous exam stating that the firm would cure deficiencies relating to pre-approving and monitoring outside trading but failed to implement the remedial steps. The Staff also noted that the CCO was responsible for establishing all of the firm’s policies and procedures, including those relating to MNPI. The CCO was found to have willfully aided and abetted and caused the firms’ violations of Section 15(g) of the Exchange Act as well as Section 204A of the Advisers Act and was censured and fined. This should serve as a clear warning to firms that the regulators will potentially seek to hold individuals responsible for deficiencies relating to a firm’s policies and procedures for safeguarding MNPI.


    Section 15(g) of the Exchange Act does not specify which elements a broker-dealer must include in its written insider trading policies and procedures, but rather states that the policies and procedures must be “reasonably designed, taking into consideration the nature of such broker’s or dealer’s business,” to prevent the misuse of MNPI. Both the SEC and the SROs have subsequently issued guidance in this area.8

    As a starting point, firms should conduct a comprehensive review of their business in order to determine which units come into possession of MNPI. Firms should also take note of the manner in which employees from related entities interact with one another in order to identify areas where the potential to improperly share MNPI may exist. Once those tasks are complete, firms can then carefully review their policies and procedures relating to the safeguarding of MNPI.

    A firm’s failure to adequately maintain and implement policies and procedures relating to the safeguarding of MNPI may not only result in a substantial fine, but also the potential for charges to be brought against supervisory personnel. In addition, the resulting settlement may require the firm to retain an independent consultant to conduct a review of the firm’s policies and procedures with respect to safeguarding MNPI, a process which is generally costly and time-consuming. Firms would be better served by performing their own review and implementing any necessary changes.

    In addition to reviewing their policies and procedures to safeguard MNPI, firms should also review their training process to ensure that not only are employees aware of the relevant policies (i.e., where to find the policies and procedures, how changes are communicated to employees), but also that supervisors clearly understand their role in implementing and enforcing the policies and procedures. With the continuing regulatory focus in this area, firms would be wise to take the time to perform such a review before they are forced to do so under less than ideal circumstances.



    1 See Administrative Proceeding File No. 3-14459, Exchange Act Release No. 64855 (July 11, 2011).

    2 See Disciplinary Proceeding No. 2008012242901 (March 25, 2011).

    3 See Order Accepting Offer of Settlement, Disciplinary Proceeding No. 2008012242901 (June 28, 2011).

    4 See Exchange Act Release No. 63323 (Nov. 17, 2010).

    5 See Administrative Proceeding File No. 3-14184, Exchange Act Release No. 63693 (January 11, 2011), Litigation Release No. 21806 (January 11, 2011).

    6 It should also be noted that there is currently an SEC Enforcement sweep under way with respect to preferential redemptions, and Robert Khuzami, the Director of Enforcement at the SEC, has made note of the issue in recent public speeches.

    7Available at http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p122863.pdf.

    8 See Broker-Dealer Policies and Procedures Designed to Segment the Flow and Prevent the Misuse of Material Nonpublic Information, U.S. Securities and Exchange Commission Division of Market Regulation (March 1990); NASD/NYSE Joint Memo on Chinese Wall Policies and Procedures, NASD Notice to Members 91-45 (July 1991).