The SEC recently settled an enforcement action against a large private fund manager (the Sponsor) wherein the Sponsor was charged with violations of Sections 204A and 206(4) of the Investment Advisers Act of 1940 (the Advisers Act) and Rule 206(4)-7 thereunder in connection with its failure to implement and enforce policies and procedures reasonably designed to prevent the misuse of material nonpublic information (MNPI).
According to the SEC’s order, the Sponsor, a registered investment adviser, invested several hundred million dollars of client funds in the debt and equity of a portfolio company (the Portfolio Company). The debt investment included confidentiality provisions between the Sponsor and the Portfolio Company, and the equity investment gave the Sponsor the right to appoint two directors to the Portfolio Company’s board. The Sponsor appointed a senior member of its investment team responsible for the Portfolio Company investment (the Sponsor Representative) as one of its board members. Following the initial investment, the Sponsor Representative and other Sponsor employees received potential MNPI from the Portfolio Company.
During the period when the Sponsor Representative sat on the Portfolio Company’s board, the Sponsor (on behalf of its advisory clients) made additional investments consisting of more than 1 million shares of the Portfolio Company’s publicly-traded stock while in possession of information that could potentially be MNPI. The purchases were approved by the Sponsor’s compliance department and occurred during open trading windows at the Portfolio Company.
The Sponsor maintained written policies and procedures relating to the treatment of MNPI which contained circumstances under which securities should be subject to trading restrictions and tracked on a restricted list. Where the Sponsor had a representative on the board of directors of a publicly-listed company in its investment portfolio, the procedures required that that company’s stock be placed on the Sponsor’s restricted list and that any trades in the stock be preapproved by the Sponsor’s compliance staff. In such circumstances, the compliance staff was required to confirm with the subject company that any restrictive trading window applicable to directors was open, and to check with the director whether he or she had any potential MNPI. The procedures also provided for the optional establishment of information walls, regardless of whether a company’s stock was on the restricted list. However, the Sponsor did not routinely establish information walls with respect to publicly-listed companies in its investment portfolio on whose boards it had an employee-representative, and it did not have any walls regarding the Portfolio Company.
The SEC alleged that notwithstanding that the Sponsor placed the Portfolio Company’s stock on its restricted list, it did not sufficiently take into account the special circumstances presented by the Sponsor Representative’s dual role as both a member of the Portfolio Company’s board and a Sponsor employee who continued to participate in trading decisions concerning the Portfolio Company. Although the Sponsor’s compliance staff confirmed with the Portfolio Company that the relevant trading windows were open, the Sponsor’s policies and procedures did not provide specific requirements for compliance staff concerning the identification of relevant parties with whom to inquire regarding possession of potential MNPI and the manner and degree to which the staff should explore MNPI issues with these parties. Moreover, the Sponsor’s compliance staff failed, in numerous instances, to document sufficiently that they had inquired of the Sponsor Representative and the members of the investment team as to whether any of them had received potential MNPI from the Portfolio Company, or to apply a consistent practice to the inquiries made, resulting in ambiguity whether, or if, inquiries were made in certain instances.
In its order, the SEC appeared to be particularly concerned about the general nature of the Sponsor’s compliance policies and the amount of discretion it left to the compliance staff:
Any potential trades in securities on the restricted list were subject to a “hard stop,” which required that the trade first be reviewed and approved by compliance staff. [Sponsor’s] procedures required its compliance staff to provide “a reason for the approval in the… electronic order management system. Before making such a determination, compliance staff were instructed to “follow up with the relevant parties to gather additional information” and also to consider relevant factors, including but not limited to possession of MNPI by [Sponsor], whether or not an information wall was in place, and the circumstances of any pertinent confidentiality agreement. If [Sponsor] had a board seat on a publicly listed portfolio company, compliance staff were further required to confirm with the portfolio company that its trading window was open and to “check with [Sponsor’s] director for MNPI.” However, the specific manner in which these policies were to be implemented was left to the discretion of [Sponsor’s] compliance staff. The identification of relevant parties, the manner in which compliance staff followed up with them regarding possession of potential MNPI, and the thoroughness with which MNPI issues were explored with the relevant parties were all largely subject to compliance staff’s initiative, discretion, and interpretation. For example, [Sponsor’s] procedures directed compliance staff to check with the [Sponsor] director for potential MNPI but did not expressly require an assessment of whether the director shared information with others or confirmation of the full spectrum of [Sponsor] employees who could have acquired the potential MNPI. [Emphasis added]
The SEC stated that during the relevant time period, the Sponsor Representative regularly shared information he learned while serving as a Portfolio Company director with members of the investment team, as contemplated by the confidentiality provisions in place between the Sponsor and the Portfolio Company. However, the Sponsor’s policies and procedures did not address this situation and the Sponsor failed to enhance its policies and procedures despite being aware that the Portfolio Company regularly treated investment team members as generally bound by the same confidentiality obligations as the Sponsor Representative. As a result, the compliance staff failed to document properly whether they had assessed the extent to which the investment team members had any information that had the risk of being MNPI. Moreover, to the extent that compliance staff merely asked the Sponsor Representative or investment team members if they had potential MNPI, this called for these employees to self-evaluate whether particular information could be “material” within the context of the policies and for purposes of the federal securities laws.
The SEC also alleged that the Sponsor failed to comply with its written procedures regarding trades in restricted list securities by failing to provide entries in its order management system sufficiently documenting whether, prior to approving potential trades, compliance staff had inquired with the Sponsor Representative and members of the Portfolio Company investment team as to whether any one or more of them had received potential MNPI. Furthermore, the compliance staff’s order management system entries, to the extent that such entries were made, lacked consistency and detail. The Sponsor’s policies and procedures, as applied, did not require compliance staff to inquire sufficiently into whether the Sponsor Representative and members of the investment team were in possession of potential MNPI relating to the Portfolio Company. In some instances, there was insufficient documentation that the compliance staff inquired at all. As a result, the Sponsor did not properly assess the heightened risks presented by trading in the public markets in the securities of the Portfolio Company, whose shareholders were owed fiduciary duties by the Sponsor Representative in his role as a director of the Portfolio Company. Therefore, with respect to the Portfolio Company and the heightened risks presented by the Sponsor Representative’s dual role as a director of the Portfolio Company and as a Sponsor employee who participated in trading decisions concerning the Portfolio Company’s publicly-traded stock, the Sponsor failed to properly implement and enforce its policies and procedures relating to the treatment of MNPI, taking into consideration that it regularly received potential MNPI both by virtue of having confidentiality provisions in place with the Portfolio Company and by virtue of the Sponsor Representative’s seat on the board.
As part of its settlement with the SEC, the Sponsor agreed to pay a $1 million penalty and was censured. Additionally, the Sponsor voluntarily retained an outside consultant to review and evaluate the design and implementation of its compliance policies and procedures with respect to the acquisition and treatment of potential MNPI obtained in the context of public portfolio companies. The Sponsor also expanded the size and authority of its compliance teams, expanded and standardized compliance procedures for determining whether the Firm has access to MNPI, and enhanced training programs on MNPI issues, including enhancements specifically concerning situations where employees serve as directors of publicly-traded companies.
In light of this settlement, private fund sponsors, especially those who hold seats on boards of public companies, should review their policies and procedures regarding MNPI to seek to ensure that sufficient controls are in place to identify and police situations where the Firm may be at risk for acquiring and trading on MNPI. Importantly, these policies and procedures should address specific fact patterns tailored to the Firm’s investments and operations rather than simply relying on general policy statements about the use of potential MNPI.
- Section 204A requires a registered investment adviser to establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment adviser’s business, to prevent the misuse of MNPI by such investment adviser or any person associated with such investment adviser in violation of the Advisers Act, the Securities Exchange Act of 1934 or the rules or regulations thereunder. There is no requirement under Section 204A that an underlying insider trading violation be found to establish the basis for a violation predicated on deficient policies and procedures.↵
- Section 206(4) and Rule 206(4)-7 thereunder require registered investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder.↵
- The SEC order can be found here.↵
- The potential MNPI at issue included information related to the Portfolio Company’s: (i) potential changes to senior management; (ii) mid-quarter hedging adjustments; (iii) efforts to sell its passive interest in a specific asset; (iv) interest in selling equity and using the proceeds to retire certain debt that had been a source of market concern; and (v) decision to pay quarterly loan interest to the Sponsor “in kind” versus in cash.↵