SEC exams drill into expert networks, alternative data

SEC examiners looking to prevent the misuse of material non-public information (MNPI) are particularly interested in firms’ use of expert networks and alternative data, market players say.

In recent exams, private equity managers said SEC staff have scrutinized firms’ policies and procedures, as well as the internal controls in place to ensure that MNPI is not used for insider trading. The SEC has also asked private equity firms to provide a list of all research providers, including expert networks and logs of discussions with these providers.

“The SEC was particularly interested in our use of expert networks and information walls,” the chief executive of a retail-focused private equity firm said.

The co-founder of a real estate-focused private equity firm found during his recent exam that “the SEC is really cracking down on insider trading and MNPI. They’re asking a lot of questions to make sure that the firms have a good understanding of the rules and regulations surrounding MNPI.”

That executive added that the SEC wants assurance that firms understand the potential risks associated with insider trading and are taking the necessary steps to prevent insider trading and the misuse of MNPI.

Dan Campbell, a director at ACA Group, noted that he has also seen increased interest from the SEC staff on the risks associated with MNPI within the private markets.

“The SEC staff has observed an increasing use of alternative data, expert networks, and more instances where there’s interaction with public companies, so the SEC staff wants to see that managers have identified potential issues and risks and that they have instituted appropriate controls and procedures to prevent the misuse of MNPI by internal and external stakeholders.”

MNPI danger grows

Insider trading and the potential misuse of MNPI are perennial issues for the SEC.

Section 204A of the Advisers Act requires advisers to establish, maintain and enforce written policies and procedures to prevent the misuse of MNPI.

In its 2023 exam priorities, the SEC said it will focus on “policies and practices regarding the use of alternative data and compliance with Adviser Act Section 204A.”

Private funds managers are increasingly using alternative data, value-add customers of the firm (investors with the firm with expertise helpful to fund managers, such as industry trends, but that may expose them to MNPI) and expert networks, which the SEC said are potential sources of MNPI. Because of this, the SEC is increasingly looking at MNPI compliance policies and procedures during exams.

In April 2022, the SEC issued a risk alert highlighting common compliance deficiencies relating to MNPI.

The SEC’s enforcement staff has used Section 204A violations to bring enforcement actions focused on compliance violations, even without bringing insider trading charges.

As an example, in May 2020, Ares Management was charged with failing to implement and enforce P&Ps “reasonably designed” to prevent the misuse of MNPI, and hit with a $1 million penalty.

In February 2020, Cannell Capital settled with the commission for failing to establish, maintain and enforce written P&Ps reasonably designed to protect against insider training, and paid a $150,000 fine as a result.

Even without insider trading or fraud, Philip Moustakis, a partner at Seward & Kissel and former senior counsel in the SEC’s Enforcement Division, said the commission is going to make sure firms’ policies and procedures are suitable to its risk management.

He added that the regulator doesn’t want to see a “cookie cutter, off-the-shelf MNPI policy,” but one that is the product of a risk assessment, with “thought, care and consideration as to those risks and safeguards put in place to address those risks.”

Firms should also have clearly written policies and procedures regarding MNPI, keep a record of all training and testing, and have logs of all analysis and conversations had with experts and independent analysts.

But no matter how robust a firm’s P&Ps are when it comes to MNPI, Moustakis said the efforts may be for naught if there is no buy-in from senior management at the firm.

“I think any compliance begins with tone at the top and an empowered CCO with sufficient resources to do their work,” he concluded.

Practice tips

MNPI policies and procedures will – and should – be very different for every firm, but there are certain common elements of policies and procedures that firms should have, including training, monitoring and testing, and documentation.

Ken Joseph, a managing director and head of the Financial Services Compliance and Regulation practice for the Americas at Kroll, said that when it comes to training on MNPI P&Ps, it is helpful to include definitions of what MNPI includes, training on recent SEC examinations and enforcement cases and deficiencies and guidance on what the Commission has found to be objectionable.

“Training should also cover the various scenarios personnel could encounter, what to do in these situations and who they have to notify if they find themselves in any of the scenarios described,” Joseph advised.

Martin Weinstein, a partner at Cadwalader Wickersham & Taft, noted that education should be first and foremost when it comes to MNPI policies and procedures.

“People need to understand what is material non-public information so they can recognize it. Then you need to have policies and procedures around what to do if someone thinks or has material non-public information,” he said.

Joseph said testing should include personal trading done by certain individuals within the firm. Creating and managing a “restricted” list and a “watch” list for companies where someone at the firm has come into or is coming into material non-public information. The firm and its employees cannot trade public shares of any company on the restricted list, where those on the watch list require approval from compliance before trading. Firms should also have a calendar and deck list outlining who will be speaking with company officials or expert networks, so compliance is aware of those scenarios, he added.

When it comes to monitoring, firms should be mapping where and when material non-public information came into the firm’s hands, Joseph said.

“Firms should monitor email correspondence to determine whether personnel are receiving, but not necessarily reporting, such encounters or receiving material non-public information. You would then check all those scenarios against actual trading, both at the firm level personal trading, for any questionable activity,” he explained.

Weinstein suggested doing spot checks of company computers, emails and other communications for possible MNPI and whether the information has been conveyed to others. He also said firms should prohibit the use of ephemeral messaging apps, such as WhatsApp, where the information is not traceable.