The Merger Tip in a Managed Account
Ms. Chen, 47, has a $600,000 discretionary managed account with a balanced mandate that permits equities, bonds, and ETFs but not options or margin. She is a partner at a law firm retained by a public company. On a Tuesday she emails her advisor: she cannot say why, but the advisor needs to buy XYZ before Friday, put 15% of the account into it, and buy call options, and she will sign whatever is needed. XYZ is a $4 billion TSX-listed company; its shares rose 6% on above-average volume the previous day. The account currently holds 15% in cash and 3% in XYZ. The advisor's firm has a policy against trading on client tips and requires pre-clearance for any discretionary trade over 5% of the account. Ms. Chen says that if the advisor refuses she will move the account.
1. What should the advisor do with the instruction?
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The advisor must not execute the trade. The client is a lawyer at a firm retained by XYZ, and her email strongly suggests she possesses material non-public information about a pending transaction. Trading on that information, or tipping others, would violate securities law and the firm's policy. Buying call options is also outside the account's mandate, which does not permit options or margin.
The advisor should not ask for details, should not trade, and should not share the information. The correct steps are to decline the instruction, explain briefly that the firm cannot act on information that may be confidential, escalate the matter to compliance immediately, and document the email, the call, and the actions taken. Compliance may restrict the account and determine whether a report is required. The advisor should avoid any appearance of trading ahead of the information, including for other clients or personal accounts.
2. How should the advisor handle the client's threat to transfer the account?
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The threat to transfer the account cannot influence the decision. The client has the right to move her account, but the advisor's obligation is to follow the law and firm policy. The advisor should remain professional, explain that the refusal is based on regulatory requirements rather than a judgment about her, and offer to continue managing the account within its mandate. All communications should be documented and reported to compliance.
If the client insists, the advisor should follow the normal transfer process once compliance clears it. Retaliation or a rushed trade to retain the account would compound the problem. The advisor should also avoid promising to revisit the decision after the news is public, which could create an implied agreement to trade on the information later.
3. What if the advisor is unsure whether the information is material and non-public?
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If the advisor is unsure whether the information is material and non-public, the safe course is still not to trade. The test is whether a reasonable investor would consider the information important and whether it has been disclosed to the market. The source is a lawyer working on the matter, and the timing, a purchase before Friday after a 6% rise on heavy volume, increases the risk. The advisor should consult compliance before any action and should not attempt to verify the tip through outside channels. The firm may apply a restricted list.
Documentation should show the basis for the decision. The advisor should also consider whether any previous trades in XYZ or related securities raise questions, and should not discuss the tip with colleagues outside the compliance process.