Insider vigilance

Recent charges from US Justice Department of 14 people in connection with alleged insider trading on private equity deals has highlighted the importance for GPs to enforce clear personal trading policies.
 
However, while more US firms will have to put such policies in place as they become registered investment advisers with the SEC, even non-registered managers must overcome their resistance to the additional disclosures.

The spotlight comes after Zvi Goffer, a former employee of hedge fund Galleon Group, was charged with leading a network that allegedly made $20 million trading on insider information about private equity deals including Hellman & Friedman’s buyout of Kronos and The Blackstone Group’s acquisition of Hilton Hotels in 2007. Goffer in 2008 established a trading firm as a vehicle for his illicit activities and employed several people including his brother Emanuel, who worked at hedge fund Spectrum Trading.

The resulting publicity from the arrests may cause the SEC to increase its focus on potential trading conflicts of interest as part of its audits for registered investment advisers. A partner at one such RIA, Oak Hill Capital’s John Malfettone, earlier this year outlined some of the things that the SEC looks for.

He said proper compliance means that firms must maintain a strict list of companies that investors cannot trade in, while any trade made by anyone at the firm as well as their spouse and children living at home has to be cleared in advance.

Elizabeth Fries, a partner in Goodwin Procter’s business law practice and head of its hedge funds practice, says personal trading information is not disclosed to clients, but is examined by the SEC. She noted that reporting and/or pre-clearance exceptions can be granted in various cases under most policies (for example, when an account is only mutual funds or an employee has no control or influence over an account managed by a third-party financial adviser).

Otherwise one of the main things firms need to look out for is potential conflicts of interest. “So if your brother works at the brokerage firm across the street, that’s the kind of thing you should disclose to your employer,” she said. “And if that brokerage firm is one that the adviser uses, and the brother may be earning commissions on those trades, the adviser would need to address the potential conflict and may need to disclose the potential conflict to clients as well, but disclosure is not mandatory and there are often other means to deal with the potential conflict.”

In order to keep track of such connections, a personal trading policy requires pre-clearance of IPOs and private placements, while once a year employees must inform the firm of securities accounts that they own, as well as provide quarterly statements of trading in those accounts.

“I think most firms look for circumstances when employees are trading in the same securities that are being traded in client accounts, because they do not want to be in a position where an employee is trading a small cap security, for example, at the same time that the firm is actively considering or perhaps has decided to buy the security for clients.” Fries said. “The firm’s expected purchase might be large enough to cause the price to go up. If an employee personally went into the market first and got it at the lower price, the price may go up as the clients are buying it.  That’s typically called “front running” the client and is a problem. Most firms look for situations involving unusual trading activity or trading in securities that are related to the firm’s portfolio in some way.”

More firms may have to deal with such considerations should some form of legislation working its way through Congress mandate SEC registration above a certain asset-under-management threshold. This could be a burden for private equity and venture capital firms that aren’t used to collecting such information, although companies such as Infraworks offer software that can make the process go more smoothly.

A bigger hurdle could be overcoming the cultural resistance at many firms to disclosing personal trading information. “Often people who have achieved a certain degree of wealth are not really interested in having their subordinates know how much that is or how they are investing it (or whether their choices are good or bad investments),” Fries said. “People are in the private fund business, not working at a large brokerage firm or investment bank, and based on their choice to work on the private side, they may be reluctant to submit to the type of detailed oversight of their personal activity that the SEC requires.”

This can lead to difficulties related to, for example, getting in the quarterly reports within 10 days after the end of the quarter, with late submissions sometimes resulting in a deficiency notice from the SEC. “It’s not uncommon to have a small number of people who were a couple of days late with their filings here and there, and to a certain extent you realize you need to tighten up but it is not a material compliance issue,” Fries said. “But if you have a large number people who are late or it is the same late reporters all the time, that can be a more serious compliance problem.”