With the increase in the number of hedge fund and private equity managers starting or considering starting a credit fund, it is more important than ever to understand and address the challenges and risks as they relate to insider trading. Dan O’Connor and Matt McGinnis will discuss the state of play for insider trading law as applied to debt instruments and other assets often held by credit funds, including what to expect from the SEC in this space in the future. They will also discuss various tools and strategies managers can implement in order to mitigate the risks associated with trading in debt instruments, including developing bespoke and nimble policies and procedures, single-firm restricted lists, ethical walls, internal trainings and ongoing risk monitoring.

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Transcript:

Dan O’Connor: Hello, and welcome to this Ropes & Gray podcast. My name is Dan O'Connor, and I'm a partner in the litigation and enforcement practice, and I co-lead the firm's securities & futures enforcement group. I'm joined today by my partner, Matt McGinnis, who's also a partner in the litigation and enforcement group. Today's podcast is part of a series focusing on issues related to credit funds.

It's no secret that an increasing number of managers or private equity and hedge funds are starting or considering starting their own credit funds. Today we thought we would take a look at what credit fund managers need to think about as they're considering their challenges and risks in the insider trading area, and what they might need to do in terms of dealing with material non-public information that develops within the firm. First, we're going to provide some legal background about what the courts and the regulators have said with regards to how the rules and regulations are applied. Then we're going to talk about the current landscape – what is it the SEC is doing in terms of enforcement, and what you might expect to see on that front. Lastly, we'll talk about your own practices and policies and provide some practical insights and tips so that you can think about how to address these circumstances before they come up. Matt, help us set the stage here. Everyone knows that the insider trading laws typically focus on publicly traded stocks, but what about bank debt or other assets that aren't technically considered securities – what are we seeing in that regard

Matt McGinnis: Well, Dan, I think for that, we need to look at some history for what would probably qualify in this space as ancient history. Interests in bank debt typically have been considered not to constitute securities for purposes of the federal securities laws. Now this is all based on a Supreme Court case called Reves vs. Ernst & Young that came out in 1990. Generally speaking, the Reves test is designed to distinguish notes issued in the investment context, which the court considered securities for purposes of the statutes, from notes issued in a commercial or consumer context, which would be deemed not to be securities under the federal statutes. Now if you look at how Reves has been applied by other federal courts, that is also in large part ancient history. A key decision came out in 1992, and that was the Second Circuit's decision in a case called Banco Espanol. In Banco Espanol, the Second Circuit held that a loan participation agreement among sophisticated financial institutions did not constitute covered securities for purposes of the federal securities laws.

Dan O’Connor: Thanks, Matt. So that about sums up the key law on this issue. And as you noted, that Banco Espanol is old – it came out in 1992. A lot has changed since then, especially in the enforcement space and how regulators look at what will be considered a security, and especially as it relates to the securities that a credit fund manager will own and trade. So there's some good reasons to proceed with caution. And we often tell folks that you have to think about the current landscape and what we're seeing in this regard. So maybe, Matt, if you could give us a little bit of a sense of that. What are we seeing from the SEC? What is it we think that managers in this credit space should be thinking about when it comes to the enforcement landscape?

Matt McGinnis: Sure. So typically, the transactions that market participants in this space today participate in differ from the standard securities transactions that the Banco Espanol court and the Reves court were considering in the early '90s, and that they may not be over in exchange, but instead are between sophisticated parties who have access to diligence materials and other information. That said, a lot of these transactions still often do run through brokers, and there are markets, admittedly, of different levels of liquidity for a lot of the, you know, securities or other assets that are held in credit funds. Now the SEC is aware of the general test that applies to loan participations, but has shown a different take on how it interprets the laws as a regulator. The SEC views combating financial fraud as a key part of its charter and so it views insider trade, of any form, as the equivalent of fraud. So regardless of the analysis that it was employed in case law 20-plus years ago, the SEC may look for ways today to combat insider trading where it can including by expanding the scope of assets that it is focused on. And I think if you look back at the 1992 Banco Espanol decision, the SEC may even be able to find some support for its current views. If you look at that decision, the dissenting judge in a 2-1 decision noted that debt participations, even at that point in time, were in his view considered securities. And even the two-judge majority on that decision cautioned that, "the manner in which participations in the debt instrument are used, pooled or marketed, might establish that such participations are securities." So they left the door open, in the SEC's view, for modifications or adjustments or evolution in the future. And I don't think you have to look much further than 2007, about 15 years after the Banco Espanol decision, to get a sense of the SEC's evolving views in this area. In 2007, the SEC entered into a settlement with Barclays. That settlement was based on information that Barclays employees learned while serving on a creditors' committee in a bankruptcy. No classic securities were involved in that case, and instead it essentially involved trading and bonds. And although this is just a settlement between the SEC and Barclays, it is a helpful reminder of how the SEC approaches its jurisdiction in this space.

Dan O’Connor: That's a good point, Matt. I think you also have to consider that in the past several years, there's been press accounts of the SEC investigating potential insider trading issues associated with information gained by other parties while participating in creditors' committee and other distressed situations. I think what the SEC does is it looks at after the initial issue instances of these participations and sees how these, what they believe to be securities, are trading in the market with brokers, sending out bids, sending out asks, and telling the market that these things are available in the same way, although maybe with a bit different liquidity than they see things being traded with respect to securities. And you also have to remember that the SEC isn't the only regulator out there that's thinking about insider trading-type issues. The CFTC has also shown some interest in the insider trading area, and they've indicated that they consider certain bank debt to be derivative for purposes of their anti-fraud and manipulation rules, which were enacted shortly after Dodd-Frank. So Matt, what does all this mean in terms of a fund managers practices and policies? What are some practical things they can think about with regards to insider trading as they're approaching these issues?

Matt McGinnis: Well, Dan, I think that there are a couple of key things that I would focus or suggest that fund managers focus on, and you may have additional thoughts on this as well. First off, I'd suggest that fund managers take a look at their existing policies and consider whether any changes are appropriate today. There are many types of policies applicable to insider trading and the receipt in handling of non-public information that are appropriate and provide necessary information. But the specific content of those policies is typically specific to a firm's business, and that may need to evolve over time as the business evolves. So some things to keep in mind when you're looking at your existing policies is can you have one policy for the entire platform, or do you need to have different or modified policies or procedures for different aspects of the platform in order to address unique risks for the various business lines? Also, give thought to how you use expert networks both in connection with securities as well as potential other assets, and what level of involvement compliance has or should have in monitoring and approving interactions with issuers and other sources of data. The considerations that apply here both in terms of the administrative burden associated with implementing a policy as well as the underlying regulator and MNPI concerns may differ depending upon the assets that are at issue and the sort of information you're receiving. Also, think a little bit about whether you typically are, or may in the future, sit on creditor committees or similar defense groups. Participating in these groups gives you often access to certain information that poses additional considerations for your policies, and it's important to think proactively in advance of about how receipt of that information in connection with those responsibilities or those participations may affect your ability to trade or engage in other transactions. In addition, policies and procedures can approach restricted lists or information barriers in a variety of ways. Policies and procedures can range, for example, from a single-firm restricted list to an ethical wall or somewhere in between – a hybrid model. Any of those varieties essentially from one end of the spectrum to the other are possible and, in many cases, appropriate and defensible for a particular business. But it needs to be customized and thoughtful with respect to the business that you have today and in the future, not just the business that you had in the past. You know, in particular, we see some fund managers choose not to use an information barrier, but instead have an expanded monitoring program. Some, on the other hand, have the typical restricted list for prohibited securities that has circulated within a firm, but then add a second watch list or a gray list that is often not shared and that may be used by compliance to monitor potential investments that may or may not implicate MNPI concerns. Second point on this – think about how you're training your teams within your firm so that they understand the risks and know where to turn if issues arise. This is a complicated area, and providing training with real-world examples, not just based on the classic publicly traded stock examples of insider training, is important so that your teams are sensitive to the key issues as this continues to evolve into the future. This is, I think fair to say, a very complicated area and providing training with real-world examples and more importantly a clear path for escalation of issues to the legal or compliance department is key. Dan, any other further thoughts on things that fund managers should be thinking about today?

Dan O’Connor: Sure, Matt. I think the one last issue that you need to thinking about is how are you monitoring for these risks? Are you embedded with your teams? Do you have a good sense of what is driving the investment decisions? As you know, we've handled many insider trading inquiries for asset managers over the last few years, and one of the key elements of putting together a strong defense to help these issues go away as soon as they get raised is by being able to show that there was a diligent, informed investment process with contemporaneous documentation of the principle investment thesis and the rationales. This is obviously a backdrop that can't be created after the fact and can really make the difference. If it turns out there are some well-timed, or what looked like, suspiciously timed, but otherwise innocent and legitimate connections between a trading decision and some of the principles at the firm and people who might have or believe to have inside information. And it's the kind of thing that you really need to be doing on a consistent basis so that you have file, you have that data source that you can pull up and put on the table with the SEC and the regulators. Finally, one other issue that comes up oftentimes in the credit space is the use of big boy letters. Now big boy letters are a useful tool to help ensure that counter parties to a transaction understand that they may not be sharing full knowledge with each other and their positions, and therefore can be very helpful when those counter parties later have a dispute about a transaction. The SEC, however, has made clear that big boy letters should not be considered to be a get-out-of-jail-free card, and the fact that you're not selling these securities in the market but are selling them to another sophisticated party who's signed up to a big boy letter won't help you when there's an insider trading issue. The Barclays case made that clear – it won't insulate you from regulatory claims while it may help in regards to counter party claims. Now there's a way to use a big boy letter along with some additional disclosure and requirements that we've seen have some success for clients that are trying to avoid certain of the issues, but I think you just have to realize that those in and of themselves aren't going to make the regulators look the other way.

So that's all we have time for today. I want to thank everyone for listening. For more information, please visit our website at www.ropesgray.com. Stay tuned throughout the coming months for more podcasts on topics of interest related to credit funds. And of course, if we can help you navigate any of these challenges, please do not hesitate to get in touch. Thank you.