A hedge fund advisory firm (the “Adviser”) recently settled charges by the SEC that it failed to establish, maintain, and enforce policies and procedures reasonably designed to prevent the misuse of material, nonpublic information received from research firms, including those that specialize in political intelligence (collectively, “Research Firms”). According to the SEC’s order, during a three year period, the Adviser received material, nonpublic information from a political intelligence analyst regarding governmental decisions before those decisions were publicly announced. The Adviser’s analysts executed trades based on that information, which resulted in profits of more than $3.9 million for certain of the Adviser’s hedge funds.
The SEC found that, unlike its policies and procedures for expert networks, the Adviser’s policies and procedures were not reasonably designed to guard against the risk of receiving material, nonpublic information from Research Firms. The Adviser’s policies and procedures required experts and expert networks to undergo due diligence to evaluate their compliance controls. Additionally, employees were required to remind the expert network consultant at the beginning of each consultation not to disclose material, nonpublic information and enter a report of the discussion into the Adviser’s investment research database. The Adviser’s head of internal research was responsible for monitoring compliance with these requirements.
With respect to Research Firms, however, the Adviser’s sole requirement was for the Research Firms to demonstrate that they “observe policies and procedures to prevent the disclosure of material nonpublic information or any information in breach of a duty.” This demonstration was to be refreshed “from time to time.” However, the Adviser’s policies and procedures did not explain what these reviews should entail. Further, the Adviser relied on its employees to self-evaluate and self-report the potential receipt of material, nonpublic information from Research Firms, but did not adopt policies and procedures to ensure that its employees did so.
The SEC also found that the Adviser failed to enforce its policies and procedures for Research Firms. For example, the Adviser failed to review the policies and procedures of a Research Firm for multiple years and continued to retain the firm despite the red flag that the political intelligence analyst also served as the firm’s chief compliance officer. Moreover, the Adviser’s employees, including members of senior management responsible for enforcing the Adviser’s policies and procedures, received communications from a political intelligence analyst that contained material, nonpublic information, but no actions were taken to prevent the potential misuse of the information.
In settling the charges, the Adviser agreed to disgorge $714,110 in performance-based compensation, plus interest of $97,585 and pay a civil money penalty of $3,946,267.
S&K Observations
In view of this settlement, investment advisers are reminded to adopt and enforce policies and procedures to prevent insider trading that address the particular risks presented by its business. This enforcement action suggests that policies and procedures similar to those designed to prevent the misuse of material, nonpublic information received from expert network firms should be applied to Research Firms, including due diligence of the Research Firm’s compliance controls, an oral reminder read at the beginning of each research consultation not to disclose material, nonpublic information, and supervisory oversight of employee communications with Research Firm analysts.
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