With all the recent attention on insider trading, I thought it would be useful to take a quick look at some of the basic concepts involved.

The term “insider trading” itself is not defined in the federal securities laws, but generally is used to refer to the use of material non-public information to trade in securities (whether or not one is an “insider”), or the communication of material non-public information to others.  Section 204A of the Investment Advisers Act requires that all investment managers adopt formal policies which forbid any member, officer, director or employee from “insider trading.”

Although not specifically defined, it is generally understood that the law prohibits:

• trading by an insider, while in possession of material non-public information;
• trading by a non-insider while in possession of material non-public information, where the information either was disclosed to the non-insider in violation of an insider’s duty to keep it confidential or was misappropriated; or
• communicating material non-public information to others in breach of a fiduciary duty.

Next we’ll examine a few steps that advisers can take in order to minimize the risks of insider trading.

Strong personal trading policies

The first line of defense for a Chief Compliance Officer is to have strong personal trading policies and a solid infrastructure and capability to monitor employee trades.  For SEC registered advisers,  Advisers Act Rule 204A-1 outlines the baseline requirements for code of ethics reporting, but many advisers go beyond that baseline to ensure that they have proper internal controls and procedures to look for any conflicts of interest and potential insider trading.  At a minimum, these policies should include:

• adoption of pre-clearance procedures
• having employees provide monthly and quarterly brokerage statements
• having employees periodically report their holdings
• having employees report any outside business activities that they participate in.

It is important that these reports and brokerage statements do not sit unopened, but rather are critically reviewed to ensure that no improper trades were made.  Automated systems, such as ComplianceTrak, can help advisers streamline this process.

Employee Training

Chief Compliance Officers should also evaluate whether they should provide periodic training to their staff on the issues surrounding insider trading.  All employees should be familiar with the basic concepts of insider trading and the steps that should be taken if they believe that they have come into material non-public information.  Every employee should be required to read and acknowledge a form of insider trading policy statement.

No investment adviser wants to get caught up in an insider trading scandal.   It should be the Chief Compliance Officer’s duty to ensure that the firms’ policy statement on insider trading is understood by everyone.