Every year FINRA sends hundreds of inquiries to firms that are not broker-dealers, including RIA firms, about suspicious trading. In such instances, FINRA likely has no authority to require the firms or directors of those firms who receive these letters to provide the information requested. Nevertheless, if you receive such a request, you will undoubtedly want to know why you received it and what, if anything, you should do to respond.
These inquiries are a systematic part of FINRA’s mandate to uncover insider trading. As such, you should not presume that you, your staff, or your clients did anything wrong. Conversely, you should avoid the risky presumption that the inquiry is merely routine. Most non broker-dealers voluntarily provide the information requested by FINRA. This article will explain the process and the issues you or your firm should consider in determining whether and how to respond.
Background on FINRA Investigations
In 2011, FINRA made more referrals (285) for insider trading to the SEC than ever before. The referrals came from FINRA’s Office of Fraud Detection and Market Intelligence, a specialized unit made up of over 50 analysts and attorneys who use sophisticated computer programs to comb through SEC filings, electronic trading data, press releases and the division’s own database of prior investigations to look for suspicious trading patterns. As a result of agreements between various regulators, FINRA has responsibility for monitoring insider trading across the U.S. securities markets.
FINRA and the SEC have developed detailed databases of trading activity that allow them to connect suspicious trades from different issuers, in different markets, and across years of trading. In recent years these efforts have uncovered rings of insider traders who went to great lengths to cover their tracks.
When FINRA has a lead that it desires to investigate, it follows a fairly standard investigatory protocol as it conducts it inquiry. Exactly what triggers a FINRA insider trading inquiry is a closely-guarded secret within FINRA, but inquiries are usually prompted by a spike in trading volume or extreme price movement in a public company’s stock prior to the public announcement of a material event. Such events might include a merger, a significant transaction or business development, or any event that could move the stock price, such as an earnings announcement. FINRA conducts between 200 and 400 insider trading investigations at a time.
FINRA begins its investigations by sending letters to various entities involved in these market-price-moving events. FINRA usually asks for a chronology of all events prior to the public announcement. It also asks the participant to identify all individuals who were aware of the event prior to the public announcement.
Usually, FINRA will send a second letter to companies involved in the event, providing a list of individuals and entities that traded in the security or had other connections to the event and requesting that the recipient ask employees, officers, directors, and others to identify any current or prior relationships with the individuals and entities on the list. This information is added to FINRA’s database.
Using their extensive databases of prior suspicious trades and investigative tools — wire taps, informants, and review of financial records and emails, for example — authorities have been able to crack schemes that used sophisticated techniques, such as the use of disposable cell phones and fake email trails, to try and hide their activities.
The SEC and the Department of Justice can apply significant sanctions against those found to be engaging in insider trading, whether as a tipper or tippee. Beyond jail sentences, insider traders can be forced to give up the profits obtained, or losses avoided, and pay penalties of up to three times the trading profits. Individuals associated with broker-dealers or investment advisors can also be barred from the industry.
Should My Firm Respond to the Inquiry? If So, How?
Most recipients of initial FINRA inquiry letters will either be broker-dealers directly regulated by FINRA or companies listed on exchanges which are required to respond to FINRA requests. However, FINRA also routinely sends inquiry letters to firms over which it does not have power to compel responses. Unlike the SEC or government agencies, FINRA does not have subpoena power. We believe that even though those firms may be under no legal obligation to respond, they are generally best served by responding to the request.
Many firms over which FINRA has no jurisdiction will respond to maintain a good relationship with another company that is involved in the event prompting the inquiry. Moreover, if the FINRA staff believes that they have a credible lead as to possible insider trading and a company or individual will not cooperate, the staff may simply turn the lead over to the SEC, inviting the SEC to either obtain information through its examination authority (if the entity is subject to the SEC’s regulatory jurisdiction) or to issue a subpoena for the information (and perhaps testimony under oath). The decision not to respond may cause negative impressions about the non-cooperating recipient. In our experience, responding to an SEC subpoena in this context is likely to be substantially more burdensome than complying with the FINRA inquiry.
Many companies responding to FINRA inquiries retain experienced counsel to assist them through the process. Counsel can guide the investigation to ensure that answers to questions are clear, based on a thorough investigation, and that necessary documents are gathered and preserved. Counsel can also advise when to follow up on incomplete answers and suspicious relationships. Insurance coverage may be available to pay the cost of retaining counsel.
The ultimate audience for the fruits of FINRA’s investigation is, at the end of the day, the SEC, which will decide whether to initiate an enforcement action. Most typically, FINRA takes several months before it determines whether to make a recommendation. Due to the confidential nature of the investigation and FINRA’s referrals, the recipient of an inquiry letter may never know what conclusion FINRA has reached.
A FINRA insider trading inquiry letter should be handled carefully. In most cases, even firms that are not directly or indirectly under compulsion should choose to cooperate. The process of crafting a response can be time-consuming and burdensome for most firms, but dealing with FINRA in a cooperative manner from the outset is typically more advantageous than the likely alternatives.
The authors are both partners in Foley & Lardner LLP’s Securities Enforcement and Litigation Practice Group, practicing in the Washington, D.C. office. Mr. Wallace is a former enforcement attorney with the United States Securities and Exchange Commission and former Chief Counsel of FINRA’s Division of Market Regulation.