Prediction Markets Trading Must Be Part of Compliance Policies

Over the past year, a series of suspiciously well-timed trades on prediction markets has raised novel questions for an industry that now sees billions of dollars in weekly trading volume. Trading based on confidential information has become a fast-developing area of legal exposure for the individuals who place such trades.

It is also an emerging compliance risk for the organizations whose confidential information may be at issue. This doesn’t just include financial services firms; even public companies, pharmaceutical and technology companies, political organizations, and professional sports leagues face risks.

Organizations across these sectors should consider adopting certain compliance frameworks to reduce the risk of their employees misusing confidential information to place prediction market trades, as well as the potential risk of insiders seeking to manipulate corporate events.

Key Risk Sectors

The insider trading cases brought by the US Attorney’s Office for the Southern District of New York and the Commodity Futures Trading Commission involved a US soldier who traded in event contracts on the basis of classified government information. But the government’s legal theories can apply much more broadly to other cases involving trading based on misappropriated confidential information.

Companies can face litigation and regulatory exposure from misuse of confidential information by their employees, consultants, and agents. Potential exposure includes inquiries by state and federal regulators, False Claims Act exposure where federal payments or contracts are involved, and potential reputational damage.

Financial services firms face a distinct set of risks because they handle significant amounts of confidential, event outcome-related information and because event contracts are beginning to migrate into more traditional investment channels, including brokerage/advisory platforms and proposed fund products. For example, two dozen prediction-market ETFs are currently awaiting US regulatory clearance and traditional brokerages have launched their own prediction market platforms.

As prediction-market trading becomes part of these products and services, firms risk employees being able to obtain confidential information through the firm’s business and use that information to trade event contracts for personal, proprietary, client, or fund accounts. An analyst, for example, might use nonpublic information to position fund or client trades ahead of public disclosure—potentially without the client’s knowledge.

In that situation, the individual employee faces liability. Regulators also may scrutinize whether the firm’s material nonpublic information—or MNPI—personal trading, code-of-ethics, and supervisory controls were reasonably designed and enforced to address misuse of confidential information through commodity interests.

Although these theories are largely untested under the Commodity Exchange Act, and this type of entity-level enforcement may be less likely than actions against the individual trader, the consequences for a regulated financial-services firm could be severe. Firms should evaluate and address the risk early by updating existing compliance frameworks to fit the current moment.

The pharmaceutical, technology, and digital asset sectors face organizational risks. These sectors are particularly exposed because some of their most sensitive information concerns discrete operational milestones—such as trial results, FDA decisions, product launches, or token listings—that can become the subject of prediction-market contracts. The relevant insider may not only possess nonpublic information about the milestone, but in some cases may also be positioned to affect the event on which the contract turns.

A pharmaceutical company employee could, for example, seek to manipulate the timing, design, or reported results of a clinical trial to align with an open event contract position.

A technology company employee could try to delay or accelerate a product launch, security disclosure, or regulatory filing to drive an event market in a profitable direction. An employee of a crypto venture or platform could time a token listing or protocol change with the same intent.

Companies that deal with such conduct face potential regulatory enforcement based on inadequate internal accounting or disclosure controls, securities class actions, derivative claims, and for government contractors, potential False Claims Act liability.

Sports leagues also hold a vast amount of information that can easily be misused to place profitable bets, significantly undermining the public trust on which these organizations depend. For example, information on player injuries, trades, signings, and coaching changes are all highly material information in the context of prediction markets.

Risk Mitigation

To address risks, companies should consider incorporating prediction markets into their MNPI and personal trading policies, as well as their firm-wide codes of conduct. Policies that address the misuse of MNPI solely in connection with securities trading should be expanded to cover event contracts.

Because event contracts aren’t classified as securities, they may fall outside the scope of policies that prohibit the misuse of MNPI solely in connection with securities trading. Companies should consider expanding insider trading policies to cover the use of MNPI in connection with event contracts and other non-securities instruments, explicitly referencing prediction markets and other trading platforms.

Companies should also consider using their codes of conduct—which typically apply firmwide rather than only to designated covered persons—to prohibit misuse of confidential information regardless of the market or instrument used to monetize that information. Employees with access to sensitive information should receive training on these expectations, and employee certifications can be a valuable enforcement mechanism.

Companies may want to require employees to disclose personal prediction market accounts and account statements and consider whether to permit personal prediction markets trading with pre-clearance. They may also want to prohibit certain types of trading involving certain types of event contracts—or to prohibit such trading altogether.

Public companies should consider whether existing blackout periods and pre-clearance requirements should apply to trades on prediction markets—or whether heightened restrictions or prohibitions should apply to employees with access to earnings information, mergers and acquisitions intelligence, regulatory or policy information, operational incident data, or other advance knowledge that could move an event market.

The legal frameworks deployed in recent prediction-market insider trading actions are well-established, but their application to event contracts remains fast-developing and, in important respects, untested. To stay ahead, organizations should evaluate their existing policies, training, and surveillance frameworks now.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Eric T. Juergens is a corporate partner at Debevoise & Plimpton and a member of the firm’s capital markets, public company advisory, insurance, and private equity groups.

Douglas S. Zolkind is a litigation partner at Debevoise & Plimpton and a member of the firm’s white collar and regulatory defense group and national security practice.

Nicholas Folly is a litigation counsel in Debevoise & Plimpton’s San Francisco office and a member of the firm’s white collar and regulatory defense group.

Gary Murphy, Emma Chessen, and Monisha Trousdale contributed to this article.

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