September Surprise: SEC Finds Gaps in MNPI Controls for CLO Manager

In the SEC’s burst of settlements at the end of its fiscal year, one case about the potential misuse of material nonpublic inside information (“MNPI”) shows just how far down in the weeds it is willing to go to prevent insider trading.    

The case involves an investment adviser (the “Adviser”) that specializes in managing distressed debt for its private funds. The Adviser had routinely participated in creditors’ committees to explore “potential favorable debt restructuring opportunities” with issuers before bankruptcy or other reorganization. The Adviser had purchased bonds issued by an issuer (the “Issuer”), which found itself in financial distress. Some of the Issuer’s creditors formed an ad hoc creditors committee to discuss their options. This committee hired another adviser (the “Committee Adviser”) to help coordinate the restructuring discussions among the creditors. Employees of the Adviser participated in this committee.

The Committee Adviser signed a non-disclosure agreement (“NDA”) with the Issuer to receive MNPI.  The Committee Adviser provided information about the Issuer during calls and over email with all the committee members, including the Adviser’s employees. The Adviser’s employees understood that they could not trade on MNPI and told the Committee Adviser that they did not want to sign an NDA right away because they wanted to keep trading the Issuer’s securities.  Later in the process, the Adviser signed an NDA and stopped trading in the Issuer’s securities. The Committee Adviser then provided the Adviser with materials containing non-public information.

Seemingly both the Adviser and the Committee Adviser were following the appropriate procedures and meeting their obligations under Section 204A of the Advisers Act.  The Adviser told the Committee Adviser that it did not want to receive MNPI until it signed an NDA, and the Committee Adviser did not give the Adviser any MNPI until the NDA was signed.

Despite all this, the SEC found that the Adviser’s policies and procedures were “deficient” since they were “not reasonably designed to address the risks specifically related to the potential for receipt and misuse of MNPI resulting from participation on ad hoc creditors’ committees.” According to the Commission, the Adviser should have conducted due diligence on the Committee Adviser’s process for handling MNPI or, at a minimum, gotten a representation from the Committee Adviser that its MNPI policies and procedures were sufficient.  The Adviser was fined $1.5 million. 

Unlike insider trading cases, enforcement cases brought under Section 204A of the Advisers Act do not require the SEC to prove, or even allege, that an adviser engaged in insider trading. Instead, the SEC must simply prove that an adviser did not take adequate steps to prevent insider trading or other violations of the securities laws.   

The SEC has aggressively pursued advisers that misuse MNPI, focusing on potential sources of MNPI, starting with expert networks and moving on to alternative data service providers, and “value-add investors” defined as clients or fund investors that are corporate executives of financial professional investors who may have MNPI.  In this case, however, the focus is on the potential receipt of MNPI from another adviser, who supposedly should have the same duty of nondisclosure as the Adviser sanctioned by the SEC. Unfortunately, the SEC does not provide any details about the fate of the Committee Adviser. 

The lessons learned from this case include:

• Investment adviser employees, especially analysts and those involved in gathering data to make investment decisions should be trained in recognizing MNPI and what to do when they get access to it, including reporting to the compliance team and updating the firm’s restricted list.
• Firms that participate in issuers’ creditors’ committees have a much higher risk of being exposed to MNPI and should consider adding those issuers to their restricted lists. Consider whether compliance personnel should monitor communications with the creditors’ committees to help identify MNPI.
• Firms participating in creditors’ committees must address this activity in their insider trading policies and procedures. This could include prohibiting all trading in the relevant issuer’s securities by the firm and creating information barriers to prevent MNPI from being shared with other departments.
• Firms cannot rely on outside parties to determine whether shared information qualifies as MNPI. In the case discussed above, the SEC faulted the Adviser for not performing due diligence on the Committee Adviser. At a minimum, advisers should obtain representations from outsiders concerning their MNPI policies and procedures. 

The SEC appears to have a hair trigger when it comes to the potential misuse of MNPI. Firms should consider their information sources, evaluate whether they may gain access to MNPI, even inadvertently, and establish procedures to prevent its use.