ONPOINT / A legal update from Dechert's Financial Services Group
SEC Fines Broker-Dealer for Inadequate Information Barriers
The U.S. Securities and Exchange Commission (SEC) on February 13, 2017, issued a cease and desist order (Order) and imposed a $100,000 civil penalty against broker-dealer Sidoti & Company, LLC (Broker-Dealer), to settle charges for “failure … to establish, maintain, and enforce written policies and procedures to prevent the misuse of material nonpublic information (‘MNPI’)” by the Broker-Dealer in connection with the trading of a hedge fund (Fund) managed by the Broker-Dealer’s affiliated investment adviser (Adviser).1 The Broker-Dealer, the Fund and the Adviser were all controlled, through a holding company, by the Broker-Dealer’s founder and CEO, who also headed the Broker-Dealer’s research and investment banking operations and directed trading for the Fund.
While the Order stated that between November 2014 and May 2015 “there were 126 instances when the Fund traded in a stock that appeared on [the Broker-Dealer’s] Daily Restricted List,” the SEC did not charge the Broker-Dealer or any of its affiliates or associated persons with actual misuse of MNPI. Instead, the focus of the Order was on the absence of adequate procedures to prevent the misuse of MNPI. The Order also noted that the Broker-Dealer implemented changes to its information barriers in July 2015, but that the new policies and procedures failed “to prevent the misuse of MNPI by [the Broker-Dealer] or its associated persons.” As a result of these failures, the SEC found that the Broker-Dealer violated Section 15(g) of the Securities Exchange Act of 1934, which requires broker-dealers to establish, maintain and enforce supervisory procedures.2 Without admitting or denying the SEC’s allegations, the Broker-Dealer consented to the entry of the Order.
The Order noted that the Fund was managed by the CEO through his control of the Fund’s general partner and investment adviser. The SEC also noted that the Adviser was created to focus on investing in substantially the same securities of issuers covered by the Broker-Dealer’s research operations. While, according to the Order, the Fund generally operated pursuant to a “tiered arithmetic formula,” the CEO “had authority over investment decisions in the Fund, … was the manager of the Adviser, manager of the GP, head of sales at [the Broker-Dealer], and a point of contact for [the Broker-Dealer’s] investment banking activities.”
According to the Order, the Broker-Dealer had a Daily Restricted Securities list, which restricted its CEO and employees from personally trading in certain securities because the Broker-Dealer “was engaged in investment banking activities, marketing activities with the company, or publishing research on the security.” However, the Order indicated that “nothing in [the Broker-Dealer’s] written polices prevented [the CEO and the Broker-Dealer’s] associated persons from misusing MNPI obtained from these departments when making trading decisions for the Fund.”
The SEC noted in its Order that, in response to concerns raised in an SEC examination, the Broker-Dealer implemented written policies intended to prevent the misuse of MNPI by its associated persons in connection with the Fund’s operations. The new policies addressed the misuse of MNPI by “explicitly restrict[ing] associated persons … from causing the Fund to trade in securities listed on the Daily Restricted List; requir[ing] physical separation between the different divisions, institute[ing] email monitoring, and prohibit[ing] employees from participating in both research and sales calls.” Yet, according to the SEC, while the new policies attempted to address the CEO’s conflicting roles, the procedures did not ensure enforcement of the new information barriers.
The Order is a reminder to registered broker-dealers – as well as registered investment advisers – to consider their business models and organizational structures when designing and implementing information barriers and other procedures to prevent misuse of MNPI, and to take into account activities and responsibilities with respect to affiliated entities, although, notably, the SEC did not charge affiliates – or individuals – in this administrative proceeding.