Recent SEC Enforcement Actions Instruct That All Companies Should Review Their Insider Trading Compliance Programs

Broker dealers and investment advisers are required to have insider trading compliance programs. Generally, other companies are not. Nevertheless, it is prudent for all companies to carefully review their compliance programs in view of the nature of their business. This point is highlighted by a case settled yesterday by the SEC with Merrill Lynch and a report of an investigation issued last year regarding the Retirement System of Alabama.

The SEC filed a settled administrative proceeding against Merrill Lynch based on the failure of the firm to have adequate procedures regarding its “squawk box.” Specifically, the firm did not have adequate procedures to prevent day traders from overhearing and using material non-public information regarding unexecuted institutional orders that were being transmitted internally over the firm’s squawk box. This permitted those who overheard the order flow to trade ahead of the customer orders and in many instances to profit from the price movement following the execution of the customer orders. In the Matter of Merrill Lynch, Pierce, Fenner, & Smith Inc., Admin. Proc. File No. 3-13407 (March 11, 2009).

According to the Order for Proceedings, from 2002 to 2004 Merrill Lynch retail brokers at three branches permitted day traders to hear confidential non-public information regarding large unexecuted block orders of the firm’s institutional customers at three branches. One use of the squawk box system at Merrill is to allow position traders to communicate customer order information without identifying the customer to the sales force. The purpose is to determine if a member of the sales force might be able to assist in finding customers to complete potential trades.

Each day after the retail brokers obtained access to the squawk box they called the day trading firm. The phone was then put next to the squawk box for the entire day. This gave the day traders access to the unexecuted customer order information. The day traders used the information to trade ahead of Merrill customers and potentially benefit from later price movement of the security after the customer order is executed. The day traders compensated the brokers with kickbacks in the form of commissions and cash.

During the time period, Merrill Lynch had policies prohibiting insider trading, front running customer orders and the improper disclosure of information about customer orders. The firm did not, however, have written policies and procedures reasonably designed to prevent the misuse of customer order flow information. Specifically, the firm did not written policies and procedures: 1) limiting access to the squawk box; 2) to keep track of who had access to the squawk box; and 3) for branch managers in retail offices or compliance officers to monitor the use of the equity squawk box.

To resolve this matter, the Commission accepted the settlement offer of Merrill Lynch. Based on Merrill’s consent, the SEC directed the firm to cease and desist from committing any violation of Section 15(f) of the Exchange Act and Section 204A of the Advisers Act. Those Sections require, respectively, brokers and dealers and investment advisers to maintain and enforce policies and procedures reasonably designed in view of the broker’s and investment adviser’s business to prevent the misuse, in violation of the Exchange Act and Advisers Act, of material nonpublic information. Merrill was also censured and ordered to pay a civil penalty of $7 million. As part of the settlement Merrill, implemented a series of procedures. Those procedures are designed to restrict and maintain the confidentiality of client information transmitted over the squawk box.

The teaching of Merrill Lynch echoes those from Retirement System of Alabama last year. There, the SEC issued a report of an investigation, discussed here, which emphasized the necessity for proper procedures regarding material nonpublic information. Retirement System of Alabama, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934, SEC Release No. 57446 (Mar. 6, 2008), available here. With that report the SEC resolved an insider trading investigation regarding the Retirement System of Alabama by issuing a report rather than bringing an enforcement action in view of the fact that Retirement System adopted extensive procedures governing the use of material nonpublic information.

Read together, Retirement System of Alabama and Merrill Lynch suggest that the prudent approach for issuers is to carefully review the adequacy of their procedures for handling inside information. That review should be conducted in view of, and the procedures should be carefully tailored to, the specific business of the company.