Insider trading continues to be one of the most heavily scrutinized areas in financial services. Practitioners in the industry serving in a fiduciary capacity such as investment advisers (“IAs”), broker dealers (“BDs”), private fund advisers, wealth managers and others face severe consequences for violations, intentional or not, such as regulatory and civil penalties, reputational damage, liability to harmed persons, and even criminal prosecution.
What Is Insider Trading?
Insider trading occurs when a person or firm violates Securities Exchange Act of 1934 — Section 10(b) and Rule 10b-5 which states:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.[1]
That is, insider trading occurs when a person trades security or tips others to do so with material and non-public information (“MNPI”) of the security.
It is important to note that anyone who receives MNPI and acts on it can face liability.
Regulatory Framework for IAs and BDs
In addition to the broader Securities Exchange Act of 1934 — Section 10(b) and Rule 10b-5, IAs and BDs are held under additional regulatory obligations in relation to insider trading.
SEC Regulation S-P requires firms to have strong policies protecting client data, and especially how MNPI is handled.
- SEC Rule 204A-1 (for IAs) requires registered investment advisers to adopt a written code of ethics that addresses personal trading and MNPI. It is the core statute that requires IAs to not only establish adequate policies, but to enforce them.
It is critical to note that the SEC can charge firms under Section 204A for lacking adequate written procedures alone, regardless of whether any actual trading misconduct occurred.[2]
- FINRA Rules 3110 and 4511 (for BDs) require supervisory procedures, recordkeeping, and controls over employee conduct, including personal trading.
- The Insider Trading Sanctions Act (1984) and Insider Trading and Securities Fraud Enforcement Act (1988) significantly increased civil and criminal penalties, and imposed liability on “controlling persons” including the firm, if adequate supervision is not implemented.
Proactive Best Practices
- Establish and Enforce an Information Barrier Policy
Firms should establish and enforce the use of information barriers which are stringent internal controls that stop MNPI from flowing between different parts of a firm that shouldn’t have access to it. Information barriers should be documented, communicated to all relevant staff, and tested regularly.
- Require Pre-Clearance for Personal Trading
All personnel, especially those privy to MNPI should be required to obtain prior approval before executing personal trades.
- Implement Surveillance and Monitoring
Automated trade surveillance tools can flag unusual trading patterns relative to known MNPI events, news releases, or corporate actions. This is a key supervisory mechanism for BDs under FINRA requirements and for IAs under the duty of supervisory oversight.
- Adopt a Robust Code of Ethics
Your written code of ethics should clearly define MNPI, outline prohibited conduct, set out employee obligations to report potential MNPI exposure, and specify consequences for violations. The code should be reviewed annually and acknowledged in writing by all covered employees.
Protecting Your Employees
Insider trading violations can be unintentional. It is important to protect employees, as well as the firm from inadvertent violations.
- Providing regular compliance training to help employees recognize potential violations. These should include real-life scenarios and immediate action steps.
- Creating a clear response policy can help employees know what to do in the event they receive an MNPI. This should include clear direction to cease trading, escalate to compliance and avoid discussing the information with colleagues.
- Providing an avenue to safely report potential violations encourages a protective culture around compliance.
Best Practices for When a Violation Occurs
If a potential insider trading issue is suspected or occurs, act promptly.
- Ready all relevant records including trading records, communications, and access logs.
- Involve legal counsel immediately and do not conduct informal investigations that could compromise privilege.
- Assess the scope of the situation and identify key factors like – who had access to the information, when, and what trades were made.
- Consider voluntary disclosure obligations, depending on the nature and severity of the issue.
- Cooperate fully with regulators if an inquiry arises as cooperation is consistently a mitigating factor in enforcement outcomes.
Regulators consider insider trading a priority and continue to ensure that firms have the right tools in place to prevent it.
Establishing strong internal controls can protect both the firm and personnel from violations as consequences remain dire even for situations where the violation was unintentional.
For assistance with strengthening your policies and procedures against insider trading violations, or if are faced with investigations or enforcement actions, please contact us at 619.298.2880 or email [email protected].
[1] https://www.ecfr.gov/current/title-17/chapter-II/part-240/subpart-A/subject-group-ECFRbda83517ce4377f/section-240.10b-5
[2] https://www.sec.gov/newsroom/press-releases/2024-106
