June 11, 2007
The Securities and Exchange Commission recently provided an important reminder of the need for effective information barriers and procedures to address potential conflicts of interest, including misuse of confidential information, that may exist given the multiple hats increasingly worn by broker-dealers, investment advisers, hedge funds, private equity funds, and other financial intermediaries. 1
At issue in the SEC’s complaint against Barclays Bank PLC and its proprietary distressed debt trader, Steven J. Landzberg, was the alleged misappropriation of material nonpublic information that Landzberg obtained as Barclays’ representative on six creditors committees. The SEC alleged, in particular, that Barclays’ senior management supervised Landzberg and authorized him to invest and trade the securities of the issuers on whose creditors committees he served. In addition, the Compliance Department allegedly knew that Landzberg’s desk possessed "Nonpublic Information" and was "Restricted" with respect to the securities of four issuers, but failed to impose information barriers or otherwise enforce policies and procedures to prevent Landzberg from trading the securities.
Of broader interest were the SEC’s allegations regarding Barclay’s alleged use of "big boy letters," a measure that some market participants have used in connection with the sale of securities to sophisticated investors in which the buyer disclaims the need for disclosure of material, nonpublic information that the seller may possess. Generally, "big boy" letters are a means by which sophisticated parties to a transaction waive any claims they have against a counterparty who may possess or obtain, but not disclose, material nonpublic information relevant to the transaction.2 The SEC alleged that the "big boy letters" that Landzberg used (the precise language of which is not in the complaint) to alert his trading counterparties that Barclays may have possessed material nonpublic information were ineffective to protect the defendants from insider trading liability. In no instance did defendants disclose to their counterparties the information they received through serving on official creditors committees, according to the SEC. This goes to the heart of Section 29(a) of the Securities Exchange Act of 1934, which provides that: "[a]ny condition, stipulation or provision binding any person to waive compliance with any provision of [the Exchange Act] or of any rule or regulation thereunder . . . shall be void.3
Barclays and Landzberg each consented, without admitting or denying the allegations in the complaint, to statutory injunctions. To settle the SEC’s insider trading charges, Barclays also consented to pay more than $10.94 million, including disgorgement, prejudgment interest and a civil money penalty. Landzberg consented to be permanently barred from participation on any creditors committee in any federal bankruptcy proceeding involving an issuer of securities and to pay a civil money penalty of $750,000.
The SEC has long recognized that financial institutions must often play multiple, and potentially conflicting, roles in the market and has stated that these entities will be immune from liability if they adopt, maintain and enforce polices and procedures reasonably designed to prevent the misuse of material, nonpublic information. Reflecting the lessons learned from the SEC’s recent enforcement action, the following considerations may be useful in evaluating and developing controls to manage these conflicts as well as the risk of potential insider trading violations.
Identifying and Tracking Conflicts. The first step in managing conflicts is identifying them, which requires an ongoing assessment of your various businesses most susceptible to conflicts.4 Certain scenarios involving multiple functions (e.g., investing on a proprietary basis side-by-side with clients, receiving confidential information from advisory clients while trading on behalf of other customers or itself, or providing fairness opinions in corporate control transactions in which the investment bank will receive financial advisory fees upon successful completion of the transaction)5 present potential conflicts that must be managed or, in certain cases, eliminated.
Information Barriers. The most important tools for addressing potential conflicts of interest are effective information barriers to restrict the flow of information regarding particular issuers, clients, and securities to assure that persons who may be making trading decisions or providing investment advice do not possess material nonpublic information. In addition to formal information barriers that satisfy certain regulatory requirements, consider whether further steps should be taken to prevent inadvertent disclosure of customers’ confidential information when providing market color or signaling the market or other traders about the size of material, impending transactions. Among other things, consider a policy such as only providing market color based on generic, post-execution information that has been publicly reported, and periodically review the effectiveness of any measures to separate customer and proprietary trading desks.
Insider Trading Policies and Procedures. A recent SEC review of hedge fund managers’ compliance policies and procedures relating to insider trading found deficiencies in preventing the use of nonpublic information to make investment decisions for fund and personal accounts.6 Periodic reviews of policies and procedures to confirm they reflect current business practices, coupled with periodic training of personnel with access to confidential information, or in a position to use such information, are important elements of an effective insider trading compliance program.
Appropriate Use of Disclosures and Disclaimers. While certain disclosures are required (e.g., acting as agent for both parties to a transaction, or receipt of compensation from an issuer of securities), the fact that disclosure is made may not in all cases be sufficient to protect an intermediary who traded while in possession of information not available to its client or the general market. Recent private party and SEC challenges to "big boy" letters call into question their effectiveness in protecting an intermediary with actual knowledge of specific material nonpublic information concerning a security or its issuer.7 Consideration should be given whether disclosures are intended to provide general notice that the intermediary may come into possession of information in other segments of its business that are effectively walled off from the client facing desk, or if they are intended to shield an actual conflict that might better be addressed by specific disclosure or, in certain circumstances, even declining a particular transaction or engagement.
Control and Track Outside Activities. In addition to following any applicable regulatory or self-regulatory organization’s procedural requirements relating to approving outside activities, consider the potential conflicts and reputational risks associated with employees’ activities that afford access to nonpublic information (e.g., participation on company boards or management committees). Similarly, evaluate requests to provide or accept gifts and entertainment with a view to the associated conflicts or appearance of conflicts.
Review Allocation Practices. Review your policies for allocating trades and investment opportunities to customer and firm accounts. Watch for delayed trade allocations that could give rise to temptations to afford preferential treatment to particular funds or customers.8 The SEC has recently expressed concerns about managers using allocation practices or trading strategies to favor particular hedge funds or accounts that are expected to be especially profitable.9
1. SEC v. Barclays Bank PLC and Steven J. Landzberg, 07-CV-04427 (S.D.N.Y.) (May 30, 2007), http://www.sec.gov/litigation/litreleases/2007/lr20132.htm
2. See, e.g., Harsco v. Segui, 91 F.3d 337, 343 (2d Cir. 1996).
4. Linda Chatman Thomsen, Dir., Div. of Enforcement, SEC, Remarks Before the IA Week and the Investment Adviser Association 9th Annual IA Compliance Best Practices Summit 2007 (Mar. 22, 2007), http://www.sec.gov/news/speech/2007/spch032207lct.htm.
5. See NASD Notice to Members 04-83 [PDF] (Nov. 2004),
6. Andrew J. Donohue, Dir., Div. of Inv. Mgmt., SEC, Remarks Before the 4th Annual Hedge Funds and Alternative Investments Conference (May 23, 2007),
http://www.sec.gov/news/speech/2007/spch052307ajd.htm
7. Id. See also R2 Investments v. Salomon Smith v. Barney, 1:01-CV-03598-JES (S.D.N.Y. Apr. 27, 2001).
8. See NYSE Hearing Panel Decision 04-93 (June 16, 2004), Karl Zachar, former Registered Representative, http://www.nyse.com/pdfs/04-093.pdf.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work or Barry R. Goldsmith (202-955-8580, [email protected]), John H. Sturc (202-955-8243, [email protected]), or
K. Susan Grafton (202-887-3554, [email protected])
in the firm’s Washington, D.C. office.
© 2007 Gibson, Dunn & Crutcher LLP
The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.