Running a financial advisory practice is no easy task. There are significant, inherent risks when you’re in this business, but there are two steps you can take to reduce these risks substantially. You need to:
- Educate yourself about these risks.
- Monitor yourself for any possible infractions.
Many advisors, particularly those hauled before a regulator for investigations of alleged infractions, ask me why their supervisors didn’t stop the trade or activity that led to the infraction. The assertion is accusatory, blaming the dealer and supervisor for failure to either have controls or follow processes. I respond with the same following points each time:
- Supervisory controls and processes are not perfect.
- If the supervisor didn’t follow protocols, he or she will likely be investigated and might be penalized as well.
- If the dealer firm didn’t have controls, or follow protocols, it might also be the subject of an investigation and penalized.
The focus for you as an advisor should be on why you didn’t self-monitor to ensure you didn’t commit an infraction. The reason is usually because you were unaware that your activity was an infraction, or that you were moving too quickly to consider or recognize the activity as an infraction.
This is either a failure to educate yourself, a failure to monitor yourself, or both. Dealers rely on the first line of defence: advisors themselves. Advisors are in better hands when they are self-reliant rather than dependant on supervisory controls and processes to catch the infractions.
You should know that just because you were not aware of the illegality of the activity, or that it could constitute an infraction, you will not get a free pass from the regulator. That’s the case even if this is your first infraction — and even if you have been in the industry for decades.
As an example, Moe, an advisor, hears from Bow, another advisor and good friend, about a company’s takeover that will be completed in the near future. Moe buys the stock for himself and for some of his clients based on this information. Moe actually didn’t give a second of thought to the source of the information, or whether this could constitute any type of infraction, including insider trading. As a result, Moe didn’t check to see if the information had been released to the public or make inquiries of the source of the information from Bow.
There are two notable issues that Moe didn’t consider in all this:
- Whether the information of the takeover had been disclosed generally. If the information has not been disclosed to the public and it is “material,” then that’s one element of the test for “insider trading.”
- Whether Bow was a “person in a special relationship with the issuer.” If you are tipped by someone in a long line of successive tippees, you may be considered a “person in a special relationship with an issuer” if you ought reasonably to have known that the information you received came from a person who was in a special relationship with the company.
So, let’s say there was a person in a close relationship with the company who told someone about the takeover, and then that second person told Bow that information. Although the information was not obtained directly from someone who is considered to be an “insider” and Moe trades on it, that could fulfil the second part of the test. As a result, both Moe and Bow would be guilty of insider trading and/or tipping. In other words, a person who is “tipped” and ought reasonably to know that the source of information is a “person in a special relationship with the issuer” also becomes a “person in a special relationship with the issuer.” This can continue down a long chain of successive tippees.
What if Moe says he didn’t know that he could be guilty of insider trading if he didn’t receive the information from the person with the direct relationship with the company (i.e. Moe was unaware of the law). And what if Moe also didn’t know that the information was indeed material, non-public information? The regulators might say, “Too bad.” Moe, as a professional advisor, ought to have known that if the information about the company’s takeover were true, it would likely be material. Furthermore, Moe didn’t check the source of Bow’s information to satisfy himself that it wasn’t from a person in a special relationship with the issuer.
The lesson to be learned from Moe’s situation is that advisors need to educate themselves and monitor their actions. If you fail to educate yourself of the relevant law or regulation, you may be investigated and ultimately penalized for an infraction, regardless if you knew that the trade was in violation of the law or regulation. You also need to self-monitor to ensure you’re compliant with the law or regulation. Don’t wait for your supervisor or compliance department to do this for you. This is part of your job and it will save you your reputation, licence and money.