SEC Settlement Cites Trading Ahead of Research

June 27, 2017

There's no crying in baseball and there shouldn't be any tears shed on Wall Street when it comes to regulation. Frankly, much of what passes for regulating the industry seems to be a cost-benefits analysis of how much you can get away with versus what you would finally agree to pay via settlement. It all looks like checkbook regulation, which tends to favor the too-big-to-fail and disproportionately crushes the small market participants. 

In a recent SEC settlement, we have a quintessential small firm and its individual President cited for a number of violations involving trading and non-public information. In fairness to the federal regulator, it sets forth what's pretty much an air-tight case. In fairness to the respondents, you likely did yourself a service by settling. For industry participants, the SEC's presentation of the case provides a superb opportunity to consider whether your own policies and procedures will stand up to similar scrutiny. 

Case In Point

William S. Smith is the founder, majority owner, and President of Wm Smith & Co. ("WSC"), a broker-dealer since 1992 that provides equity research, trading, and investment banking services to institutional customers.  From the relevant period starting about January 2013 through December 2015, WSC employed between 6 to 14 associated persons, including two to three research analysts, who covered about 15 to 30 public companies at any given time. Smith supervised WSC's Research Department. 

WSC's Written Supervisory Procedures Manual ("WSP") included policies intended to protect against the misuse of material nonpublic information ("MNPI"), of which research reports pending dissemination were so characterized. Based upon an investigation, the Securities and Exchange Commission ("SEC") believed that WSC had failed to maintain and enforce various WSP policies and procedures (and failed to establish procedures reasonably designed) to prevent the misuse of MNPI. 


In anticipation of the institution of proceedings by the SEC but without admitting or denying the findings, Wm Smith & Co., And William S. Smith submitted an Offer of Settlement, which the federal regulator accepted.  In the Matter of Wm Smith & Co., And William S. Smith, Respondents (Order Instituting Administrative And Cease-And-Desist Proceedings, Making Findings, And Imposing Remedial Sanctions And A Cease-And-Desist Order; '34 Act Rel. No. 81025; Admin. Proc. File No. 3-18046 / June 26, 2017) (the "OIP").

April 2013 FINRA LOC

The OIP alleges that on April 18, 2013, the Financial Industry Regulatory Authority, Inc. ("FINRA") issued a Letter of Caution (the "LOC") to WSC asserting that in violation of its rules, Smith had personally placed four trades in companies covered by WSC's research analysts without his having obtained written pre-approval from compliance personnel.  In response to the letter, WSC assured that no employee would be allowed to place a personal trade without the prior, written approval from the Chief Compliance Officer ("CCO"). On December 20, 2013, WSC updated its WSP to incorporate that policy.

The OIP asserts that notwithstanding the April 2013 LOC and the firm's December 2013 WSP update, on numerous occasions from May 2013 through December 2015, Smith did not receive the CCO's written pre-approval. The OIP does not set forth the number of cited trades but characterizes Smith as having "engaged in active personal trading in securities."


The OIP further alleges that the WSP prohibited research personnel from disclosing "any non-public information about the timing and content of pending research publications to non-research personnel" and prohibited non-research personnel from reviewing pending research reports. Despite such policies, WSC research analysts and Smith allegedly disclosed to WSC sales and trading personnel the analysts' unpublished views and analyses that appeared in subsequent WSC research reports. As more fully detailed in the OIP:

a. On 25 separate occasions during the relevant period, a contract research analyst associated with WSC sent emails containing non-public research analysis, often including price targets, to members of the firm's sales and trading departments. In multiple instances, the contract research analyst sent full draft research reports to members of WSC's sales personnel. Smith was included on all 25 emails sent by the analyst and WSC's chief compliance officer was included on 23 of the 25 emails, but there is no record that the analyst faced any remedial action. 

b. On February 28, 2013, Smith forwarded an email from an analyst to two sales employees, indicating that the analyst was likely to initiate coverage on a new company and that the analyst expected "significant price appreciation" for the company's stock price. The email contained non-public research analysis regarding why the analyst expected the company's stock price to rise. 

c. On December 31, 2013, Smith emailed a sales employee a copy of a full draft research report from an analyst. The draft report contained non-public research analysis and price target information, as well as Smith's redline edits to the report. 

d. On July 1, 2014, Smith forwarded to a sales employee a full draft initiation research report from an analyst. Smith asked the sales employee for comments and edits, and the sales employee sent back a marked-up version of the draft report. On July 2, 2014, Smith forwarded a copy of the analyst's draft research report to another sales employee. C. WSC failed to enforce its policies prohibiting WSC personnel from disseminating MNPI to the public. 

Additionally, the OIP alleges that although the WSP's section titled "Firm Policy on Insider Trading," stated that "no personnel may communicate any material non-public information to anyone outside the Company." Apparently, this prohibition was not observed on multiple occasions by WSC sales and trading personnel. Pointedly, the OIP asserts that: 

a. On May 1, 2013, an analyst sent a firm-wide email containing non-public research analysis, including a projected price target, in connection with a public company that had recently made an earnings announcement. Later that day, two sales employees and a member of the firm's trading department forwarded the analyst's email to a total of 14 existing and prospective customers. Smith was copied on one of the emails sent by a sales employee. In response, Smith wrote "good follow" and suggested the name of another customer to whom the sales employee should forward the analyst's email. 

b. On May 7, 2014, an analyst sent two sales employees and others an email containing non-public research analysis, including a projected price target, in connection with a public company that had recently made an earnings announcement. Subsequently, the sales employees forwarded the analyst's email to a total of 10 existing and prospective customers. Smith received two of the emails sent to customers. 

Trading Ahead

Although the WSP prohibited WSC personnel from trading ahead of research reports, this policy was not fully enforced. Pointedly, the OIP asserts that: 

[O] May 1, 2013, a trading employee placed a trade for a customer account while in possession of non-public research analysis that was later contained in a research report that was published the following day. The trading employee placed the trade the day after the company at issue made a positive earnings announcement, and just hours after receiving an email from an analyst that contained non-public research analysis, including a projected price target, regarding the company. In an email to the customer informing him of the trade, the trading employee twice mentioned that the analyst had a "high conviction" in the company and referenced the specific price target that the analyst had included in his internal firm email from May 1, 2013. 

During the period from January 2013 through September 2015, the OIP alleges that from the time that a research analyst decided to initiate company coverage until the publication of said report, WSC did not prevent personnel from trading in the company. Pointedly, the OIP alleged that:

[O]n February 28, 2013, the firm's chief compliance officer pre-approved a sales employee's purchase of stock in a company on which a research analyst was preparing to initiate coverage. The chief compliance officer was unaware of the impending initiation at the time that the stock purchase was approved, and was further unaware that the sales employee had contacted the research analyst about that same company during the prior month. 

24. On September 4, 2015, following an on-site examination, the Commission's examination staff informed WSC of the issue outlined above. In response, on September 29, 2015, WSC instituted a Research Idea List to track companies on which analysts had begun research, but for which WSC had not yet published initiation reports. 


Based upon the alleged findings, the SEC deemed that WSC willfully violated Section 15(g) of the Exchange Act, and that Smith willfully aided and abetted and caused WSC's violations. In accordance with the terms of the OIP, the SEC ordered that Respondents WSC and Smith cease and desist from further securities violations and censured both of them. Respondent WSC was ordered to pay a $50,000 civil money penalty; and Respondent Smith was ordered to pay a $35,000 civil money penalty.  In determining to accept Respondents' Offers, the Commission considered remedial acts promptly undertaken by Respondents and cooperation afforded the Commission staff. 

Bill Singer's Comment

Overall, an excellent OIP replete with sufficient content and context as to make it both intelligible and educative.

That being said, we should not lose sight of the fact that WSC  is a small firm with no more than 14 associated persons during the relevant time and the firm services institutional customers. This is not a large retail broker-dealer and its customers are, in fact, sophisticated. None of which excuses the firm's porous WSPs but does offer important context.  

Based upon what I have read, I cannot justify the amount of fines imposed upon either the firm or its President. Given the circumstances, both sums strike me as excessive. Notwithstanding my opinion, I allow for the fact that the underlying numbers may be far worse than presented to us as a result of the SEC's concessions during the settlement process -- on the other hand, the numbers may also be far more benign but massaged by the SEC so as to justify the fines. Regardless of what may be under the viewable surface, I always acknowledge that the respondents opted to settle the charges and if they are satisfied with the findings and sanctions, it is not for me to second-guess them. As any veteran regulatory lawyer knows, a settlement is the bastard child of regulation.

One shortcoming in the OIP is its failure to clarify the extent of Smith's personal trading, which is, after all, a key aspect of the allegations. By way of example, consider this:

10. During the relevant period, Smith engaged in active personal trading in securities.

As characterized in the OIP, the "relevant period" is "from at least January 2013 through December 2015." The next reference to Smith's personal trading is:

11. On April 18, 2013, the Financial Industry Regulatory Authority, Inc. ("FINRA") issued a cautionary action letter to WSC based on its finding that Smith had placed four trades in 4 companies covered by WSC's research analysts without first receiving written pre-approval from the firm's compliance personnel, in apparent violation of certain FINRA rules.

The only other reference in the OIP to Smith's personal trading is:

14. WSC failed to enforce its trading pre-approval procedure with regard to Smith during the relevant period. From May 2013 through December 2015, Smith did not receive written pre-approval from the firm's chief compliance officer on numerous occasions. The firm's failure to enforce its pre-approval procedures limited WSC's ability to review adequately Smith's trading for the misuse of MNPI.

There are no other specific references in the OIP to Smith's personal trading. What the OIP has pointedly asserted is that from January 2013 to December 2015, a span of nearly three years, Smith was cited by FINRA for "four trades in 4 companies."  We are then asked to incorporate into the "active personal trading" characterization, the OIP's assertion the Smith traded without the CCO's pre-approval "on numerous occasions" from May 2013 through December 2015, which is a period of time subsumed in the OIP's "relevant period" of January 2013 through December 2015." Does the "numerous occasions" reference include the four trades covered in FINRA's LOC? If it does, isn't that a bit of a regulator double-dip? On the other hand, if the "numerous occasions" does not include the four FINRA cited trades (and, in a sense, gives Smith what amounts to regulatory credit for those transgressions) then how many additional trades took place after the April 2013 LOC? Frankly, the SEC should be a tad more careful when flinging around such nebulous characterizations as "active" and "numerous."