A Practical Guide For Insider Trading Compliance

The Insider Trading Compliance Paradox

Recently, I had a chance to revisit the paradox of the best way for a broker-dealer or Registered Investment Advisor (RIA) to approach preventing insider trading. I frame this as a paradox, because it is incredibly difficult (and expensive) for firms to even identify that an insider trade has taken place, let alone put in place an effective means of preventing those trades while preserving the ability for firm clients and employees to trade in their accounts.

By way of example of this challenge, FINRA, on behalf of the Securities exchange Commission (SEC), attempts to monitor and investigate insider trading. FINRA reported in May of this year that in addition to top notch computer technology, Consolidated Audit trail (CAT) data, information sharing agreements and databases, they employ about 65 staff, including dedicated investigators whose sole role it is to investigate potential insider trading.

Broker-dealers and RIAs don’t have access to that same information, and I have not seen a firm that devotes that level of staffing or technology to this problem.

The Role of Regulators and Enforcement Bodies

There are a host of potential enforcement bodies (SEC, FINRA, State Regulators, International Regulators, DOJ, FBI, Courts finding civil liability) applying legal or regulatory iterations of the general concept that if one is in possession of relevant information about a business or security, not generally available to the public, that one shouldn’t trade on that information in a manner that might adversely impact others, or the market in general. As an example, FINRA has codified this in part via Rules such as 2010, 2020, 5270, and requires that broker-dealers put in place procedures reasonably designed to prevent such activities (Rule 3110(d)). These procedures in part rest upon the Securities Exchange Act of 1934, which is still cited in enforcement actions, today.

In weighing how to approach insider trading compliance, it is important to keep in mind that the need to prevent violations of the Exchange Act also apply to RIAs, and criminal liability frequently accompanies violations of these laws.

Challenges to Preventing Trades Based on Insider Information

Since insider trading requires relevant non-public information or Material Nonpublic Information (MNPI), and then trading that takes place based upon that, the simplest approach is to prevent the receipt of MNPI or trading in securities that are based on MNPI. While firms may be able to determine with some certainty whether their client or the firm employee is likely, through his/her job to come into contact with MNPI, it gets more difficult if that information comes to your client or employee through a third-party, like a friend or family member.

If firms have an imperfect ability to detect or prevent the receipt of MNPI, the other easy tool firms have is to prevent trading in relevant securities. Most firms are not willing to shut down brokerage accounts or only work with mutual funds or ETFs, so that isn’t necessarily a great option. Firms are similarly challenged if they attempt to just prevent trades that might be based on insider information. A technological approach to identifying such trades might be looking at a client’s or employee’s historical trading patterns, looking at entered (but not executed) trades for anomalies, and when identified, investigate the basis of the decision to trade in advance of processing that trade. Rarely would a firm have access to the relevant information to make such a decision, let alone quickly.

The Balanced Approach

In practice, firms resolve the paradox by balancing the need to take reasonable steps toward preventing insider trading while infringing the least on clients’ and employees’ ability to trade. The more a firm seeks to provide clients with the flexibility to trade and communicate, the more it needs to spend on technology, staffing and compliance.

Step 1: Information Collection

Most firms collect enough information about their clients or employees to make an educated guess as to the likelihood that individual or his or her family members might have access to insider information.

• When collecting this information, firms should establish a procedure that helps supervisors determine when that client or employee is sufficiently likely to come into contact with information so that further trading review should be put in place.
• If the firm determines that the likeliness threshold is met, then they should flag any other accounts in the same household (could be for a spouse, child, parent, or entity).
• For long-standing clients or employees, it is important to update this analysis whenever an employer or job duties change.

Step 2: Determining Impacted Securities

If a firm determines there is sufficient likelihood of insider information access, then the firm should determine what securities would be impacted by that potential information. Such securities could often include employer stocks or options, complementary company stocks or options and competitor company stocks or options.

With certain companies, it is important to revisit the list of competitors or complementary companies periodically.

Step 3: Mapping Accounts to Relevant Securities

Firms should create a list of clients or employees, and associates of those people from Step 1, and map them to the relevant securities from Step 2. Trades in these securities, by these people, are those that firms want to concentrate on.    

If firms are looking to minimize their expense, then the simplest solution is to prohibit the trading of these securities by these individuals.

A middle-of-the-road approach which preserves a bit more flexibility for firm clients or employees, is to hold those trades until the firm can investigate the providence and then approve or decline the transaction.

Another approach that I’ve seen is a combination of educating staff on this issue (which is a great idea, generally), and screening for anomalous trades before they execute. The advantage of this approach, in addition to or in lieu of the above, is it may also catch insider trading, senior abuse, or unsuitable trades in situations where you didn’t have special reason to suspect the trader would have inside information.

Step 4: Documentation and Training

Ultimately, firm clients or employees who regularly have access to inside information, won’t be surprised at their restricted trading. However, firms may want to spend some extra effort on educating clients or employees on the issue and market protection benefits where the individual is less likely to have prior awareness of the sensitivity. For whatever approach your firm takes, you will want to document it as a procedure and train your staff to follow it.

Trade Reporting and Compliance Support

Technology advancements are driving faster trading environments and regulators are intensifying their focus on compliance. From trade reporting to ensuring compliance, staying ahead of the curve requires expert guidance.  Oyster consulting’s experts conduct comprehensive reviews of trade processes, controls, and operations procedures to identify areas for improvement. Our regulatory compliance consultants will assist your firm with establishing, updating, or maintaining an insider trading prevention program tailored to your firm’s needs.