Multi-service securities firms have a high risk of insider trading as information can seep through to other departments. The antifraud provisions of the federal securities laws restricts all persons from trading based on material non-public information. Therefore, multi-service securities firms such as those that offer investment banking, corporate counseling, and retail broker-dealer services must take the necessary steps to prevent the interdepartmental flows of material non-public information about corporate clients. To prevent such occurrences, it is required that firms build an internal Chinese Wall.
A Chinese Wall is the policies and procedures that a firm establishes to ensure that price-sensitive information available to certain departments is not leaked to others within the firm. As determined by the Securities Exchange Commission, the minimum elements of a Chinese Wall includes:
- review of employee and proprietary trading;
- memorialization and documentation of firm procedures;
- substantive supervision of inter-departmental communication by the firm’s compliance department; and
- procedures concerning proprietary trading when the firm is in possession of material, non-public information.
Once the firm obtains material non-public information, it should determine whether there are any securities that should be added to the watch list or restricted list. A restricted list is a list of securities in which persons of the firm are prohibited from buying or selling. A watch list is a list of securities in which the firm is monitoring very closely and any trades will be heavily scrutinized. The firm’s procedures should address why securities are placed on the list. The procedures should also address when and how the securities are placed on the list. It is not enough to just monitor employees’ trading accounts that are held with the firm, but firms are also required to monitor employees’ outside brokerage accounts to review for trades on the watch and restricted list. To monitor outside brokerage accounts, firms should request duplicate account statements from the outside firm and require that a supervisory principal review the account statements and sign off for approval. Firms should maintain documentation evidencing supervisory review and that the firm’s procedures are being followed.
As mentioned, the supervision of inter-departmental communication is vital in establishing an effective Chinese Wall. This supervision entails:
- the physical separation of the trading and sales departments;
- other restrictions to access, such as separate record-keeping and support systems for sensitive departments; and
- supervision of inter-departmental communications involving material, non-public information.
In multi-service securities firms, there may be instances when employees will need to cross into other departments. Firms should have procedures in place regarding instances when employees come over the wall. Any time an employee comes over the wall, they must be treated as a temporary member of the investment banking department. Therefore, precautions should be taken to ensure that the employee is able to obtain the needed information without disclosing the purpose of the request and tipping the research or sales department. The firm’s procedures should require that the employee’s name, department, date, name of issuers involved, and the name of the person requesting that wall be crossed is documented.
Another important aspect of maintaining an effective Chinese Wall is the training of employees. All employees should understand the firm’s policies and procedures relating to material, non-public information. It is the firm’s responsibility to ensure that it has made the information available to employees. One way to document this is to require employees to sign attestations of their understanding of the requirements.
If you are a mutli-service securities firm, be aware that the Financial Industry Regulatory Authority (“FINRA”) has handed down heavy fines to firms for failing to establish an effective Chinese Wall. You should review your firms procedures and test whether they are adequately designed to prevent the interdeparmental flow of material non-public information.