The United States Securities and Exchange Commission (the SEC) and a New York–based registered investment adviser (the Adviser) recently agreed to a consent order (the Consent Order) to resolve an administrative proceeding relating to insider trading.

The SEC alleged that the Adviser, in violation of Section 204A of the Investment Advisers Act of 1940 (the Advisers Act), failed to "establish, maintain, and enforce written policies and procedures reasonably designed…to prevent the misuse…of material nonpublic information."

Background

The case originates from an investigation into the Adviser's relationship with one or more political intelligence consultants (collectively, the Consultant). It was alleged that the Consultant received tips from employees at the Centers for Medicare and Medicaid Services (CMS) regarding possible upcoming cuts to reimbursement rates for various healthcare products and services covered by Medicare and Medicaid. CMS is a federal agency that spends more than $1 trillion per year on healthcare products and services through Medicare and Medicaid. Decisions by CMS regarding payment rates and scope of coverage can often influence the stock price of publicly traded companies in related healthcare industries.

The Consent Order states that, on at least three separate occasions, the Consultant received tips from CMS employees regarding likely future rate cuts, and communicated this information to the Adviser. The Adviser subsequently used this material nonpublic information to make timely trades that resulted in profits of over $3.9 million for its hedge funds, once the rate cuts were publicly announced.

Violation of Advisers Act

Section 204A of the Advisers Act requires investment advisers to "establish, maintain, and enforce written policies and procedures reasonably designed…to prevent the misuse…of material nonpublic information." The Consent Order stipulated that the Adviser did not (a) establish procedures sufficient to prevent insider trading and (b) enforce the procedures it did have.

Establishment of Procedures

The Adviser's relevant compliance manual differentiated between information received from "experts" and information received from "research firms." Pursuant to the manual, experts were subjected to more rigorous procedures by the Adviser to prevent the receipt or misuse of material nonpublic information. First, before consulting, the Adviser was required to evaluate the expert's own internal controls designed to prevent the expert from providing material nonpublic information. Second, any consultation began with an oral reminder not to disclose material nonpublic information. Finally, each consultation with an expert was logged in a company database that was monitored by the Adviser's head of internal research.

"Research firms" were subjected to much less rigorous reviews. The Adviser only required these firms to demonstrate that they followed their own internal procedures to prevent the passing of material nonpublic information. The compliance manual was silent as to how this demonstration was made, how Adviser employees would make the determination, or how it could be refreshed over time. There was no requirement to give an oral warning about material nonpublic information, and meetings were not logged in the database.

These more lax procedures for research firms were deemed to be insufficient by the SEC because they placed the burden on individual employees to determine whether material nonpublic information was received and, if so, to report it to supervisors.

Enforcement of Procedures

The Consent Order also determined that the Adviser did not enforce the policies it did have. First, when red flags were raised regarding the procedures the Consultant used to prevent passing insider information to an analyst (the analyst was also the chief compliance officer), the Adviser did not cease the relationship. Second, the Consultant repeatedly passed material, nonpublic information to the Adviser. When this information was received by the Adviser's employees, they did not report it to supervisors, and instead they traded on it. When the information was received by senior management responsible for insider trading policies, they took no steps to prevent the information from being misused by the Adviser or to cease the relationship with the Consultant.

The Consent Order found a violation of Section 204A of the Advisers Act, censured the Adviser, and ordered the Adviser to pay over $4 million in fines.

Conclusion

This case highlights the government's heightened interest in the insider trading potential of "political intelligence" consulting firms. In addition to this administrative proceeding, the SEC brought a related civil suit against the Consultant, a CMS employee, and certain employees of the Adviser in the Southern District of New York, and the U.S. Attorney's Office for the Southern District of New York brought related criminal charges. These cases remain outstanding. Notably, this administrative proceeding provided the government another angle to penalize the Adviser's conflict. By relying on the Advisers Act's requirement that advisers "establish, maintain and enforce written policies and procedures" designed to prevent insider trading, the SEC was able to focus on showing the insufficiency of these procedures and did not have to actually prove insider trading, as likely would be the case in the related civil and criminal proceedings.

To read the Consent Order, click here.