How To Level Up Your Employee Trading Pre-Clearance Process

BY: ComplyLog|August 31, 2021|Employee Trade Monitoring

There are many occasions when investment companies and their employees will be in possession of inside information. The Market Abuse Regulation (MAR) prohibits the use of this information for gaining an “unfair advantage”. 

Another consideration for investment firms is Article 20 of MAR, which requires those who make recommendations on investments to declare any interests or conflicts of interest in the course of their work. To prevent both the use of inside information to someone’s advantage and conflicts of interest, you need a robust employee trading pre-clearance process. 

When you examine the cost of non-compliance, it becomes clear why it is so important to level up your pre-clearance protocols. The Market Abuse Regulation penalties for not disclosing potential conflicts of interest when making investment recommendations stand at up to €500,000 for a natural person and €1,000,000 for legal persons, whilst the fines for insider dealing can reach up to €5,000,000 for a person and up to €15,000,000 or 15% of the annual turnover from the last available accounts for a business. 


What is pre-clearance in employee trading? 

Pre-clearance, also known as pre-approval, is the process where employees request permission from their employers to purchase securities and other products. The employer will have a number of rules about what counts as a permissible trade for an employee and what should be prohibited. They will use these to decide on whether the employee can proceed. 

Reasons for prohibiting a trade include: 

  • when it would arise in a conflict of interest with a client
  • when it comes between agreeing to make a trade for a client and completing the transaction
  • when the employee is in possession of inside information relating to a party involved in the trade
  • when the trade could cause reputational damage to the employer. 

Companies will often restrict staff from investing in certain issuers or various types of financial products. There might also be different rules for different departments, if certain designated employee groups such as the board of directors are considered high risk, for example. 

Each business will have its own rules as to how the pre-clearance process works, but it might include making a formal request to the line manager. Often, once pre-approval is granted, the employee might also have to gain pre-approval from the chief compliance officer of the company before they make the transaction. 

What is the regulatory risk? 

In the EU and the UK, there are two main pieces of legislation of which companies should be aware relating to employee personal trading. Pre-clearance helps businesses comply with these regulations when the relevant restrictions are implemented as part of the company’s criteria for approving or declining potential employee trades. 

Regulation Rules
Markets in Financial Instruments Directive II (MiFID II) MiFID II demands that “an investment firm shall establish adequate policies and procedures sufficient to ensure compliance of the firm including its managers, employees and tied agents with its obligations under this Directive as well as appropriate rules governing personal transactions by such persons.”

MiFID II is linked with the Market Abuse Regulation, prohibiting any trades that would contravene the articles of MAR.

Some EU member states have imposed criminal sanctions on companies that breach the terms of MiFID II.

Market Abuse Regulation (MAR) MAR requires that anyone making investment recommendations must declare any conflict of interest. This would include employees dealing with clients when they own stock in the same issuer they are recommending to that client, for example.  

The regulation also prohibits the disclosure or misuse of inside information. This is defined as: 

“information of a precise nature which has not been made public, relates directly or indirectly relates to one or more issuers or financial instruments and, if it were made public, would be likely to have a significant effect on the prices of those financial instruments, or on the price of related derivative financial instruments.” 

There are large potential fines for making inside information public without following the process defined by MAR.


How to level up your pre-clearance process

The pre-clearance process is more complex than simply offering a ‘yes’ or ‘no’ to an employee over a trade. Compliance teams can level up their pre-clearance process to make it as frictionless as possible, allowing staff to make legitimate trades in good time whilst ensuring the company remains in accordance with the latest regulations. Here is how the process should work:

Capture the employee’s personal trades and holdings

Knowing employees’ current holdings, including the number of shares they own in various issuers, is essential for making accurate and compliant decisions over future trades, based on their known interests. It also helps you designate accounts to them, ensuring that a holding does not cause a conflict of interest. 

Compelling employees to report and attest to their earnings and holdings allows you to gain a real-time picture of their portfolio. Logging declarations made for pre-clearance also provides an audit trail to show that you have made a serious attempt to ensure compliance. 

In the EU, the UK and the US, investment firm employees are obliged to disclose their personal trading activity to their employer. One of the questions that immediately arises here is ‘How do you protect this data?’ You can keep it safe by choosing an employee trading pre-clearance platform that allows employees to apply directly to make their transactions.

Set pre-clearance rules

The rules that you set for your pre-clearance process are unique to your business and should be noted in your code of ethics, code of conduct or personal trading policy as well as when setting parameters in your compliance platform. 

Your pre-clearance rules might include the following: 

  • restricted list of companies on whom the employer has received or expects to receive inside information, or non-public information (MNPI). There is a risk of insider trading in these cases.
  • blackout period on trading certain securities, bonds, derivatives and more when simultaneously making or recommending trades in the same products to clients. These trading window closures protect both the buyer and seller from market manipulation.
  • restriction on the trading of certain types of securities of the company that employs the individual. For example, to prevent them from short-selling company stock.
  • preventing investment in a limited offering, where the employee’s personal account has access through their employment to products not generally available for clients and the public. An example would be for a newsworthy and popular IPO.

These rules can be inputted into your policies and used during the pre-clearance process to allow or deny a personal trade. 

Review employee trading activity against insider trading rules

We mentioned above that there are serious penalties for those companies that do not pay due regard, requiring investment firms to keep a close eye on compliance. That’s why, as part of pre-clearance, you should analyse potential employee trades for links with inside information.

Inside information is defined under Article 18 of MAR as information that:

  • relates to particular instruments or issuers
  • is of a precise nature
  • has not yet been made public
  • is likely to affect the price of those instruments if it were made public

Purchasing or selling stock, or cancelling an existing order based on inside information is against the law. That’s why you must compile an insider list to document all employees who gain access to price-sensitive information in the course of their work. This allows you to cross-reference insiders against employees attempting to make trades. If they are doing so whilst in possession of inside information, you should decline their application in pre-clearance.

Check employee trade activity for front-running and tailgating

Front-running, or tailgating, involves an employee holding off on making a big trade for a client until they have made a personal transaction in the same product. Usually, their expectation is that, when the client’s deal goes through, the price of the product will rise. 

To ensure proper pre-clearance of trade activity, you should make provisions in your rules to prevent this type of unethical activity from taking place. 

How to protect your firm from conduct risk

Automating the pre-clearance process takes away a lot of the time and effort involved in scrutinising potential employee trades. When software does most of the work, there is a smaller chance for human error and, so, a smaller conduct risk. 

When using an online system like TradeLog, employees can apply in minutes. The system will instantly match their request against the tailor-made rules and parameters designed for the specific company in order to accept, decline or escalate the application. 

TradeLog documents the requests, provides automated decisions and alerts you to violations of company policy in a streamlined, seamless and user-friendly manner.   

FAQ

Are you obliged to keep a pre-clearance list?

Investment companies are obliged to prevent their employees from contravening the regulations laid down by MAR and MiFID II. The preceding directive, MiFID, says “an investment firm shall establish adequate policies and procedures sufficient to ensure compliance of the firm including its managers, employees and tied agents with its obligations under this Directive as well as appropriate rules governing personal transactions by such persons.”

It also states that the employee, known as the ‘relevant person’ should inform the firm of their trade “promptly” and that the firm should keep a record of the transactions. 

Whilst a pre-clearance list isn’t mandatory, logging and analysing clearance requests for securities transactions and other deals is helpful in ensuring compliance with the regulations. Instigating disciplinary action for employees who do not disclose the purchase or sale of securities also helps you remain on the right side of the law. 


Conclusion

Pre-clearance is the best way to sift through potential employee personal trading transactions for compliance issues before the staff member makes their trade and potentially causes regulatory trouble. This is why it is so important to instil an effective employee trading pre-clearance process that you can tailor to your needs. 

If you include a software platform in this process, you will be able to instantly flag any violation issues, while also allowing employees to make legitimate trades more quickly than with an outdated manual system. If you want to find out how a pre-clearance platform can help your organisation, try TradeLog today

 

References and Further Reading

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