Code of Ethics Concerns and Best Practices in Times of Market Volatility

In the current environment created by the COVID-19 pandemic, financial services firms are dealing with a perfect storm of market disruption, volatility, remote working, and delayed public disclosure and filings.

Added to this, regulators globally have made it known that they remain committed to protecting investors and market integrity. In addition to targeted relief, regulators are focusing on fraud, material nonpublic information misuse, market surveillance and insider trading, market manipulation, and COVID-19 fraud schemes.

For example, the Co-Directors of the SEC’s Division of Enforcement issued a statement reminding firms of “the importance of maintaining market integrity and following corporate controls and procedures,” particularly around MNPI, disclosure controls and procedures, insider trading prohibitions, and codes of ethics.

In the UK, the FCA has similar views, stating “Firms should continue to take all steps to prevent market abuse risks. This could include enhanced monitoring or retrospective reviews. We will continue to monitor for market abuse and, if necessary, take action.”

With the “new normal” of remote work, firms should ensure their Code of Ethics program is adjusted to comprehensively monitor for the new employee risks brought about by this environment.

Increased Market Volatility Leads to Increased Employee Trading

Employee personal trading volumes have increased significantly due to the recent market volatility. Through ACA’s employee personal trading system, ACA’s surveillance team saw a 77% increase in employee personal trading activity during the second half of Q1 2020 compared to the first half of the quarter.

This activity correlates with the rest of the market, specifically the Dow Jones Industrial Average (“DJIA”):

• January 27-31 (the world was becoming more aware of COVID-19): Employee transactions increased by 149% from the prior week, compared to a 31% increase in the overall market. DJIA weekly price changed approximately ~-0.7%.
   
• February 24-28 (global stocks began to plummet): Employee transactions increased by 139% from the prior week, compared to a 175% increase in the overall market. DJIA weekly price changed approximately ~-8.78%.
   
• March 16-20 (COVID-19 was declared a national emergency in the U.S.): The largest volume of transactions on the DJIA occurred during this period.
   
• March 30-April 3: The largest volume of employee transactions occurred during this period.

Increased Employee Trading Leads to Increased Firm Risk

Significant market moves can lead to inappropriate trading behaviors. Employees may have personal portfolios that are significantly impacted. The temptation to use inside information, to take advantage of market liquidity issues to push a market, or otherwise manipulate or abuse a market for their own gain, will be at its highest as staff try to recuperate losses for both the portfolio and themselves personally.

For the period of March 16-20, this correlated with the largest increase of employee Items of Interest (IOI) in ComplianceAlpha, which included failure to pre-clear, lack of holding period rules, and transactions in securities on screening lists. ACA also saw firms hand out trading bans and/or terminations.

Employee trading risk is a major concern for firms. 32% of attendees of the recent ACA webcast Best Practices and Strategies for Managing Business Risks Due to COVID-19 Pandemic said employee supervision is their most significant compliance program challenge resulting from the COVID-19 pandemic.

And according to attendees of the recent ACA webcast Protect Your Firm Against Insider Trading and Other Misconduct Related to COVID-19, a breach of MNPI/insider trading was their largest code of ethics concern, followed closely by increased violations of personal trading rules.

Tuning Your Code of Ethics Program

Now is the time to revisit your firm’s Code of Ethics program and ensure it is properly tuned to account for the increased risks brought about by COVID-19. The following are our recommended best practices for code of ethics monitoring and surveillance.

More Electronic Surveillance, More Often

• Ensure broker feeds are well-established and all reportable accounts are established on a feed to avoid the burden of manual reviewing statements and/or confirmations
• Increase the cadence of personal trading reviews from quarterly to monthly or weekly
• Explore additional questionnaires/certifications/attestations
• Remind staff that compliance must remain at the forefront of their minds

Monitor in Real Time

• Set up alerts to be notified in real time of any potential breaches to your Code of Ethics. This includes personal trading and any flags submitted by employees on questionnaires/certifications/attestations (e.g., MNPI certifications or attestations, anything regarding managed accounts)
• Ensure security lists are updated and maintained
• Implement higher-touch monitoring of at-risk employees

Employ a Top-Down Approach

• Increase transparency with staff – let them know violations will be treated as violations, but also be friendly and open with employees and let them know that you are there for them. We have seen firms be successful in adopting this approach.
• Create a violation matrix and enforce violations timely to staff – e.g., if an employee violates a trading rule three times, a 10-day trading ban will be implemented. This provides transparency to staff and forces them to think about compliance before panic selling and trading potential restricted securities, MNPI, insider trading, etc.
• Explore hardship requests during this time
• Stay consistent

Make Adjustments/Enhancements

• Revisit your firm’s treatment of Managed Accounts – ACA has observed an increase in requests asking how to change account type.
  • Follow the 2015 SEC IM Guidance
  • Increase attestation cadence, such as from annual to quarterly.
  • Have account on the electronic feed for additional testing
  • Get those third-party letters! Obtain written confirmation from third-party managers that the account is managed and the employee has no direct or indirect control of the account.
• ACA recommends that Limit/Good ’Til Cancel Orders should be executed within the pre-clearance window. Remember that employees are pre-clearing to execute a transaction, and executions outside the pre-clearance window should be viewed as potential violations of your firm’s Code of Ethics.
• Consider adding additional personal trading rules in your Code of Ethics, e.g., Short-Swing Profit Rules (30-Day, 60-Day, 90-Day).

MNPI / Information Barriers

The remote working environment comes with its own set of conflicts of interest – for example, employees may have spouses or roommates who work for other RIAs, hedge funds, private equity funds, etc. Take stock of these conflicts of interest and determine how your firm will handle them from a Code of Ethics standpoint.

• Review your Conflicts of Interest Logs – identify at-risk employees
• Implement quarterly trainings or attestations on “remote work type” questions, for example, on the long-term information sharing risks of remote work
• Consider implementing a telecommunication policy, if you don’t already have one
• Provide privacy screens to employees who work in the same room as someone else
• Review confidentiality questions and reevaluate MNPI attestations (as part of certifications and/or pre-clearance requests)

Employee Messaging

Once you have identified the conflicts of interest that may arise from the remote working environment and how they will be handled in your firm’s Code of Ethics, you need to ensure reminders and concerns are communicated to employees. This can be done either through email and/or attestations.

• Remind staff of their obligations under the firm’s Code of Ethics and Privacy Policy and draw their attention to the firm’s policy to prevent insider trading within the Code. Stress that these obligations remain in full force even though staff are working remotely.
• Remind staff of best practices for working from home:
  • Establish segregated working space if possible
  • Do not leave computers on or logged in while away taking breaks
  • Use a headset if possible when speaking with clients and be mindful of their end of the conversation (to reduce the potential of overhearing MNPI)
  • Dispose of hard copies of confidential information by shredding them. If no shredder is available, lock them up or find another way of keeping them secure until a shredder can be accessed. If the firm has a data destruction policy, staff should be reminded that it too remains in full force.
• Remind staff to notify the CCO immediately if any breaches do occur.

Remaining Vigilant and Proactive to Protect Your Firm

The COVID-19 pandemic has significantly changed how firms conduct business. These changes have created a new set of risks and challenges for firms, particularly related to a firm's employees. From market volatility to cyber risks to staffing shortages, firms need to make sure they remain proactive and vigilant in monitoring risks related to their employees during this unprecedented time.

How We Help

ACA provides a range of solutions designed to help firms to effectively and efficiently manage their code of ethics administration and monitoring. From our outsourced managed service offering to our employee personal trading compliance software, we can help reduce the burden of managing your firm's code of ethics while helping your firm meet its regulatory obligations and adhere to industry best practices.

To learn more about our code of ethics administration managed service, download our tear sheet.

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To learn more about our employee personal trading compliance software, request a demo or meeting.

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Watch the Webcast Replay

ACA recently hosted the live webcast Protect Your Firm Against Insider Trading and Other Misconduct Related to COVID-19. During the webcast, ACA's Carlo di Florio, Michael Lehman, and ACA's surveillance specialists discussed the employee risks related to the current environment and best practices for managing your firm’s monitoring and surveillance of personal and firm-wide trading, e-communications, and code of ethics. Click below to access the webcast on demand.

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ACA’s COVID-19 Resources

ACA is actively monitoring the developments related to COVID-19 and producing resources to help your firm address operational challenges created by this pandemic. Visit our COVID-19 Resources page to access all of the resources we've developed that may help you navigate through the restrictions in place to curb the pandemic.

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About the Author

Jay Petraitis joined ACA in September 2016. Today, as a Senior Consultant with the Analysis and Review Center (ARC), Jay leads and supervises the Code of Ethics team. In this role, he provides oversight for all things COE related especially focused on employee personal trading. Prior to joining ACA, Jay worked as a surveillance investigator for the New York Stock Exchange’s regulation department (NYSER). At NYSER, he helped initiate trade surveillance procedures for a compliance program that was responsible for monitoring activities on NYSE’s markets. Prior to NYSER, he worked as a fraud analyst and a compliance examiner for FINRA. Jay earned his Bachelor of Science degree in Energy, Business, and Finance from Pennsylvania State University.