Philip H. Hilder
Paul L. Creech
Hilder & Associates, P.C.
819 Lovett Blvd.
Houston, TX 77006-3905
The Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA) created supervisory liability for the managers of asset management firms that requires the creation and enforcement of “written policies and procedures reasonably designed” prevent insider trading. ITSFEA amended the ’34 Exchange Act and the Investment Advisers Act of 1940 to add the requirement that firms put in place policies and procedures to prevent insider trading on registered brokers and dealers and investment advisors, respectively. Both additions are nearly identical:
Every [registered broker/dealer or investment advisor] shall establish, maintain, and enforce written policies and procedures reasonably designed, taking to in consideration the nature of such [registered broker/dealer or investment advisor]’s business to prevent the misuse in violation of [the Exchange Act], or the regulations thereunder, of material, nonpublic information by such [registered broker/dealer or investment advisor] or any person associated with such [registered broker/dealer or investment advisor]. The Commission, as it deems necessary or appropriate in the public interest or for the protection of investors, shall adopt rules or regulations to require specific policies or procedures reasonably designed to prevent misuse in violation of this [the Exchange Act] (or the rules and regulations thereunder) of material, nonpublic information. (Section 15(f) of the ’34 Act as codified in 15 USC Section 78o(f), and Section 204A of the IIA of 1940).
These policies and procedures are often referred to as ‘the wall’ or ‘Chinese wall.’
The National Association of Securities Dealers, Inc., the New York Stock Exchange, and a committee of the Securities Industry Association created a joint memorandum , reviewed by the Securities and Exchange Commission, which sets out the minimum policies and procedures for an adequate Chinese Wall pursuant to ITSFEA. These necessary elements include “review of employee and proprietary trading, memorialization and documentation of firm procedures, substantive supervision of inter-departmental communications by the firm’s compliance department, and procedures concerning proprietary trading when the firm is in possession of material, non-public information. ”
The policies and procedures must be formal, organized and incorporated into a firm’s policy manual. Further, the firm must maintain its analyses and investigations of employees and proprietary trading. Firms that engage in investment banking, research or arbitrage activities must create watch and restricted lists and conduct reviews of employee and proprietary trading of listed securities. Restricted lists are securities upon which there is an absolute prohibition in trading. The watch list holds those securities whose trading would draw close scrutiny by firm’s legal or compliance office. The restricted list should be updated and distributed regularly. Securities should be placed on or removed from these lists pursuant to reasonable written policies that explain the criteria used, the date and time of a placement or deletion, and the point of contact for that placement or deletion. The point of contact must be a person who can answer specific questions relating to the addition or deletion of a security from the list and the rationale for that decision and its timing.
Those policies must monitor employee trading outside of the firm by obtaining duplicate confirmations and account statements from the employee. Reviews of outside employee trading should be documented by noting the time period, frequency of the review, and who conducted it. Any trading, proprietary or employee, in restricted or watch list securities must be collected in a regular report, available for review by the SEC or SRO.
Firms must investigate possible insider trading by employees or for the firm’s proprietary accounts, particularly if the securities are listed on either the watch or restricted lists. The timing, nature, and amount of trades will determine the extent of investigation required. Such an investigation must not be abandoned simply because the employee’s department would not normally expose them to sensitive material. Investigations must be recorded to included 1) name of security, 2) date the investigation began, 3) amounts involved in the trades, 4) summary of the investigation disposition, including, investigation records, analyses, memoranda, and employee statements.
Rumor lists are not required but encouraged. Securities whose issuer becomes the subject of rumors of a significant impending third party deal are placed on this list.
Adequate Chinese walls must include policies and procedures reasonably designed to limit or contain the necessary flow of material, non-public information to just those employees with a “need-to-know.” These procedures must include 1) policy statements, 2) physical separation of trading and sales from those departments who regularly would have sensitive information, 3) restrictions to access to record-keeping and support systems, 4) supervision of inter-departmental communications involving material, non-public information.
When employees of another department are “brought over the wall” the firm must document the crossing, to include 1) the name of the employee, 2) employee’s department, 3) the date, 4) name of the securities’ issuer, 5) name of the person requesting the employee be brought over.
Employees should be made aware of policies and procedures relating to the wall and use of material non-public information upon hiring, at which time the employee should make a signed statement that they are aware of the policies and understand them. Annual training with annual attestation to the knowledge and awareness of policies are required, and again when the policies and procedures are updated.
Whether policies and procedures are adequate to meet requirements of ITSFEA depend upon the nature of the firm’s business, the scope of the services they provide, and the structure of the organization. The SEC enforces the Chinese Wall requirements through civil action.
See, SEC v. Haddad, 1992 U.S. Dist. Lexis 22086 (S.D.N.Y.). Liability results from a failure to take steps reasonably designed to prevent the misuse of material non-public information. The existence and enforcement of an effective Chinese wall is a defense akin to good faith against liability.
Philip H. Hilder is a former federal prosecutor and founder of Hilder & Associates, P.C., located in Houston, Texas. Mr. Hilder focuses on white-collar criminal defense matters. He is co-founder of the ABA National Institute on Securities Fraud. He had been the Attorney-in-Charge of the Organized Crime Strike Force, Houston Field Office, and was an assistant U.S. Attorney for the Southern District of Texas. Hilder & Associates, P.C., 819 Lovett Blvd., Houston, TX 77006-3905; (713) 655-9111;
Paul Creech is a
cum laude graduate of the South Texas College of Law, where he was a member of the Law Review. Mr. Creech is a former U.S. Marine.