SEC Issues Rule Requiring All Registered Investment Advisers To Adopt Codes Of Ethics
July 14, 2004
I. Introduction
The U.S. Securities and Exchange Commission (the "SEC") has adopted new Rule 204A-1 (the "Rule") and related rule amendments under the Investment Advisers Act of 1940 (the "Advisers Act") and the Investment Company Act of 1940 (the "Investment Company Act") that require every registered investment adviser to adopt a code of ethics.[1] The codes of ethics must set forth standards of conduct expected of advisory personnel, safeguard material nonpublic information about client transactions, and address conflicts that arise from personal trading by advisory personnel. Among other things, the Rule requires certain persons associated with an investment adviser to report their personal securities transactions, including transactions in any mutual fund managed by the adviser. The purpose of the Rule is to prevent fraud by reinforcing fiduciary principles that must govern the conduct of advisory firms and their personnel.
The effective date of the Rule and related amendments is August 31, 2004. Advisers must be in compliance by January 7, 2005.
II. Background
Recently, the SEC has brought actions against advisory personnel who divulged portfolio information about their mutual funds, permitting favored clients to exploit the funds' investors, against an adviser who allegedly failed to take adequate steps to detect and deter its portfolio managers' short-term trading in affiliated funds, and against many other advisers or their personnel alleging violations of their fiduciary obligations to their clients.
Under the Rule, each registered investment adviser's code of ethics must establish procedures for employees to follow so that the adviser may determine whether the employee is complying with the firm's principles. Furthermore, the procedures laid out in a code of ethics should offer employees guidance and certainty as to whether certain actions are, or are not, permissible. Codes of ethics will ultimately protect the interests of both clients and advisers by demanding that advisory personnel perform their duties with complete propriety and do not take advantage of their positions.
Every adviser's code of ethics is required to (i) set forth the standards of conduct expected of it "supervised persons" (including compliance with the federal securities laws[2]), (ii) safeguard material nonpublic information against misuse, and (iii) require advisers' "access persons" to report their personal securities transactions, including transactions in any mutual fund managed by the adviser.
The code of ethics also requires access persons to obtain the adviser's approval before investing in an initial public offering ("IPO") or private placement. The code of ethics requires prompt reporting, to the adviser's chief compliance officer or another person designated in the code of ethics, of any violations of the code. In addition, the code of ethics must provide that the adviser supply each supervised person with a copy of the code and any amendments, and require the supervised persons to acknowledge, in writing, their receipt of these copies. The term "supervised person" is defined in the Advisers Act to include all of an adviser's employees, its partners, officers and directors (or other persons occupying a similar status or performing similar functions), and any other persons who provide advice on behalf of the adviser and are subject to the adviser's supervision and control.
The requirements of Rule 204A-1 are modeled largely on Rule 17j-1 under the Investment Company Act, with which investment advisers to registered investment companies are already required to comply. The two rules are not, however, identical.
III. Access Persons
An "access person" is a supervised person who:
· has access to nonpublic information regarding a client's purchase or sale of securities,
· has access to information regarding the portfolio holdings of any "reportable fund" (see, Reporting of Investment Company Shares, below),
· is involved in making securities recommendations to clients, or
· has access to such recommendations that are nonpublic.
Access persons include all portfolio management personnel. In some organizations, they would also include client service representatives who communicate investment advice to clients. These employees have information about investment recommendations whose effect may not yet be felt in the marketplace. As such, they may be in a position to exploit their inside knowledge.
Administrative, technical and clerical personnel may also be access persons if their functions or duties make them privy to nonpublic information. Organizations where employees have broad responsibilities, and where information barriers are few, may see a larger percentage of their staff subject to the reporting requirements. In contrast, organizations that keep strict controls on sensitive information may have fewer access persons.
If providing investment advice is an adviser's primary business, then all of its directors, officers and partners are presumed to be access persons.
IV. Code of Ethics
A. Standards of Conduct and Compliance with Laws
The Rule does not require the adviser to adopt a particular standard of business conduct, but the standard chosen must reflect the adviser's fiduciary obligations and those of its supervised persons, and must require compliance with the federal securities laws. The code of ethics should be more than a compliance manual. Rather, the code should set out ideals for ethical conduct premised on fundamental principals of openness, integrity, honesty and trust. According to the SEC, a good code of ethics should effectively convey to employees the value the advisory firm places on ethical conduct, and should challenge employees to live up not only to the letter of the law, but also to the ideals of the organization.
B. Protection of Material Nonpublic Information
The Rule does not require that the code of ethics include provisions designed to prevent access to material nonpublic information. However, advisers must maintain and enforce policies and procedures to prevent the misuse of material nonpublic information, which includes not only non public information about the issuers of securities but also material nonpublic information about the adviser's securities recommendations, and client securities holdings and transactions. An adviser's duty of care also requires that this sensitive information be safeguarded. Advisers should carefully consider how to control dissemination of sensitive information both within their organizations and outside them.
C. Personal Securities Trading
Investment advisers and their personnel face inherent conflicts of interest when they trade in securities for their own accounts because they have access to information about their clients' securities transactions, which they can exploit for their own benefit. Recently, several SEC enforcement cases have involved advisory personnel profiting unfairly through short-term trading in funds they managed, or alerting friends to do likewise.
To prevent advisers' personnel from harming clients by personal securities trading, every adviser's code of ethics must require an adviser's access persons - see "Access Persons" above - to periodically report their personal securities transactions and holdings to the adviser's chief compliance officer or other designated persons. However, the chief compliance officer is not required to personally review every report. Rather, advisers may designate another person within the firm to review personal securities reports submitted by the chief compliance officer.
There are exceptions to the personal securities trading reporting requirements. One such exception applies to an advisory firm that has only one access person (i.e., the adviser himself), so long as the advisory firm maintains records of the holdings and transactions that the Rule otherwise requires to be reported. Under the exception, the sole employee would not be required to make reports of personal securities transactions and holdings, but would be required to maintain records of his personal trades and provide them to SEC examiners upon request. In addition, such small advisers would also be excused from pre-clearing investments in IPOs and private placements. However, these small advisers are still subject to the other provisions of the Rule, including the requirements to adopt a code of ethics and safeguard material nonpublic client information. The second exception to the reporting requirements applies with respect to securities held in accounts over which the access person had no direct or indirect influence or control. The third exception applies with respect to transactions effected pursuant to an automatic investment plan.[3]
1. Personal Trading Procedures
The Rule seeks to provide advisers with flexibility to adopt codes of ethics appropriate for their businesses by not proposing specific provisions regarding personal trading, other than pre-clearance of certain investments as discussed below. Firms that have already adopted a code of ethics, however, commonly include in them many of the following elements, or address the following issues, which the SEC believes all advisers should consider in crafting their own procedures for employees' personal securities trading.
· Prior written approval before access persons can place a personal securities transaction ("pre-clearance").[4]
· Maintenance of "restricted lists" of issuers of securities that the advisory firm is analyzing or recommending for client transactions, and prohibitions on personal trading in securities of those issuers.
· "Blackout periods" when client securities trades are being placed or recommendations are being made and access persons are not permitted to place personal securities transactions.
· Reminders that investment opportunities must be offered first to clients before the adviser or its employees may act on them, and procedures to implement this principle.
· Prohibitions or restrictions on "short-swing" trading and market timing
· Requirements to trade only through certain brokers, or limitations on the number of brokerage accounts permitted.
· Requirements to provide the adviser with duplicate trade confirmations and account statements.
· Procedures for assigning new securities analyses to employees whose personal holdings do not present apparent conflicts of interest.
2. Access Persons Subject to the Reporting Requirements
An adviser's code of ethics must require access persons to report their personal securities transactions and holdings. A supervised person who has access to nonpublic information regarding the portfolio holdings of affiliated mutual funds is also an access person.[5]
Persons who are not supervised persons of the investment adviser would not be access persons. Thus, employees of other organizations, including affiliated organizations such as broker-dealers, custodians, and banks that may acquire information about client securities transactions in the course of their duties, would not be subject to reporting requirements. It would be impractical to apply the adviser's code of ethics to these persons, who may in any event be subject to ethical restrictions imposed by their own employers.
Whether directors and partners of an adviser have access to client securities information may vary significantly among organizations. If the firm's primary business is providing investment advice, then all of its directors, officers and partners are presumed to be access persons. If the firm has another primary business, then whether a director, officer or partner is an access person would turn on whether the individual has access to nonpublic client information.
While the definition of "access person" does not require all employees of all registered advisers to submit personal securities transaction reports, some firms may elect to require reporting from all personnel. This approach, while not required, offers certainty as to whether reports are required from a given individual.
3. Reportable Securities and Beneficial Ownership
Reports of holdings and transactions in "reportable securities" in which an access person has, or acquires, any direct or indirect beneficial ownership are mandatory.
As a general principle, all securities are reportable securities. Five exceptions exclude securities that appear to present little opportunity for the type of improper trading that the access person reports are designed to uncover.[6] Money market instruments - bankers' acceptances, bank certificates of deposit, commercial paper, repurchase agreements and other high quality short-term debt instruments - and direct obligations of the Government of the United States are exempt from the reporting requirements of the Rule. Shares of money market mutual funds are also exempt. Transactions and holdings in shares of other types of mutual funds are not required to be reported either unless the adviser or a control affiliate acts as the investment adviser or principal underwriter for the fund.[7] In addition, transactions in units of a unit investment trust are also exempt, provided that the unit investment trust is invested exclusively in unaffiliated mutual funds.[8]
Beneficial ownership should be determined in the same manner as for purposes of Rule 16a-1(a)(2) under the Securities Exchange Act of 1934 (the "Exchange Act") Under Rule 16(a)(2), any person who, directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, has or shares a direct or indirect pecuniary interest in a security is deemed to be the beneficial owner of that security. An access person is also presumed to be the beneficial owner of securities that are held by his or her immediate family members sharing the access person's household.
4. Reporting of Investment Company Shares
Rule 17j-1 does not currently require access persons of investment companies to report personal securities trades in mutual funds they manage. The exclusion of mutual funds reflected an assumption that trading in mutual fund shares posed little risk of abuse, because those shares are priced at net asset value daily. Recent enforcement actions against fund managers who have allegedly engaged in market timing abuses based upon their knowledge that portfolio securities were mispriced indicates that the SEC's assumption was false. Therefore, the Rule requires every adviser's code of ethics to require access persons to report their holdings and transactions in shares of investment companies managed by the adviser or a control affiliate ("reportable funds"[9]).
5. Initial and Annual Holdings Reports
A code of ethics must require every access person to submit a complete report of his or her securities holdings at the time the person becomes an access person and at least annually thereafter to the chief compliance officer or another designated person. The holdings reports must be current as of a date not more than 45 days prior to the individual becoming an access person (initial report) or the date the report is submitted (annual report). Each holdings report must contain, at a minimum:
(A) The title and type of security, and as applicable the exchange ticker symbol or CUSIP number, number of shares, and principal amount of each reportable security in which the access person has any direct or indirect beneficial ownership;
(B) The name of any broker, dealer or bank with which the access person maintains an account in which any securities are held for the access person's direct or indirect benefit; and
(C) The date the access person submits the report.
As under current Rule 17j-1, an access person can satisfy the initial and annual holdings report requirement by filing and dating copies of his or her securities account statements listing all securities holdings as long as all of the required information is presented. If the adviser maintains a composite record of the information required to be disclosed in the holdings reports and the quarterly reports described below, an access person can satisfy his or her holdings report requirements by simply confirming in writing (which writing may be electronic) the accuracy of the adviser's record. However, an access person cannot avoid filing holdings reports simply because all information has been provided over a period of time in various transaction reports unless the adviser maintains the requisite composite record. The policy behind the requirement of a holdings report is so that the adviser's compliance personnel and SEC examiners have ready access to a "snapshot" of the access person's holdings and are not required to piece the information together from transaction reports.
6. Quarterly Transactions Reports
The code of ethics must require quarterly reports covering access persons' personal securities transactions to be submitted no later than 30 days after the close of each calendar quarter. Each transactions report must contain, at a minimum, the following information about each transaction involving a reportable security in which the access person had, or as a result of the transaction acquired, any direct or indirect beneficial ownership:
(A) The date of the transaction, the title, and as applicable the exchange ticker symbol or CUSIP number, interest rate and maturity date, number of shares, and principal amount of each reportable security involved;
(B) The nature of the transaction (i.e., purchase, sale or any other type of acquisition or disposition);
(C) The price of the security at which the transaction was effected;
(D) The name of the broker, dealer or bank with or through which the transaction was effected; and
(E) The date the access person submits the report.
Access persons that had no personal securities transactions during a quarter do not have to submit a report confirming the absence of transactions.
Many advisory firms already receive copies of their employees' trade confirmations or account statements covering personal securities transactions. The code of ethics may excuse access persons from submitting transaction reports that would duplicate information contained in trade confirmations or account statements that the adviser holds in its records, provided the adviser has received those confirmations or statements not later than 30 days after the close of the calendar quarter in which the transactions take place. Furthermore, the Rule does not require all of the information required in a transaction report to appear in the duplicate trade confirmation or account statement. Some of the required information could appear in the confirm or statement, and the remainder could appear elsewhere in the adviser's records.
D. Initial Public Offerings and Private Placements
Every code of ethics must require access persons to obtain the adviser's approval before investing in an initial public offering ("IPO") or private placement. Because most individuals rarely have the opportunity to invest in these types of securities, an access person's IPO or private placement purchase may raise questions as to whether the employee is misappropriating an investment opportunity that should first be offered to eligible clients, or whether a portfolio manager is receiving a personal benefit for directing client business or brokerage. Advisory firms with only one access person and those that elect to completely prohibit such investments by access persons are not required to maintain a pre-clearance mechanism.
Codes of ethics must also require prompt internal reporting of any violations. Reports may come from violators themselves, as would be likely in the case of inadvertent and some technical violations of the code of ethics, or may come from others within the firm who learn of a fellow employee's inappropriate actions.
Reports of violations must be made to the adviser's chief compliance officer or to another person designated in the code of ethics. If an advisory firm designates someone other than the chief compliance officer to receive reports of code violations from supervised persons, procedures requiring that the chief compliance officer also receives periodic reports of all violations must be in place.
The SEC has admonished advisers to create an environment that encourages and protects supervised persons who report violations. Advisers should consider how they can best prevent retaliation against an employee who reports a violation. Many advisers may choose to permit anonymous reporting, while others may decide that retaliation constitutes a further violation of the code, and still others may find other methods to encourage employees to speak freely.
F. Acknowledged Receipt of Code of Ethics
A code of ethics must require the adviser to provide each supervised person with a copy of the code of ethics and any amendments, and requires each supervised person to acknowledge, in writing, receipt of those copies. An investment adviser's procedures for informing its employees about its code of ethics are, according to the SEC, critical to obtaining good compliance and avoiding inadvertent violations of the code.
G. Other Code of Ethics Provisions
As discussed above, advisers that have adopted a code of ethics often include a variety of provisions designed to guard against impropriety and conflict, and ensure that the firm can implement the code it has adopted. Other provisions that may be included in the code of ethics include:
· Limitations on acceptance of gifts.
· Limitations on the circumstances under which an access person may serve as a director of a publicly traded company.
· Detailed identification of who is considered an access person within the organization.
· Procedures for the firm and its compliance personnel to review periodically the code of ethics as well as to review reports made pursuant to it.
H. Educating Employees About the Code of Ethics
An investment adviser's procedures for informing its employees about its code of ethics are critical to obtaining good compliance and avoiding inadvertent violations of the code. Although the Rule does not require employee education as an element of a code of ethics, the SEC expects that most advisory firms will ensure that their employees have received adequate training on the principles and procedures of their codes. Many firms that have already implemented codes of ethics hold periodic orientation or training sessions with new and existing employees to remind them of their obligations under the code; others may require employees to certify that they have read and understood the code of ethics, and require annual recertification that the employee has re-read, understands and has complied with the code. The SEC has identified these as among the best practices for advisers.
I. Adviser Review and Enforcement
The Rule requires that advisers maintain and enforce the provisions of their codes of ethics. Enforcement of the code of ethics must include reviewing the securities holdings and transaction reports of the adviser's access persons. Responsibility for enforcing the adviser's code of ethics will lie substantially with the adviser's chief compliance officer, to whom personal trading reports must be submitted.
Review of personal securities holding and transaction reports should include not only an assessment of whether the access person followed any required internal procedures, such as pre-clearance, but should also compare the personal trading to any restricted lists and blackout periods. Furthermore, the firm should assess whether the access person is trading for his own account in the same securities he is trading for clients, and if so, whether the clients are receiving terms as favorable as the access person takes for himself. The review should include periodic analyses of the access person's trading for patterns that may indicate abuse, including market timing and an investigation into any substantial disparities between the quality of performance the access person achieves for his own account and that he achieves for clients. The firm should also investigate any substantial disparities between the percentage of trades that are profitable when the access person trades for his own account and the percentage that are profitable when he places trades for clients.
J. Recordkeeping
The SEC has amended Rule 204-2 under the Advisers Act to reflect the fact that advisers must adopt codes of ethics under the Rule. As amended, Rule 204-2(a)(12) requires advisers to keep copies of their codes of ethics, records of violations of the code and actions taken as a result of the violations, and copies of their supervised persons' written acknowledgments of receipt of the code. Rule 204-2(a)(13), as amended, covers records of access persons' personal trading and requires advisers to keep a record of the names of their access persons, the holdings and transaction reports made by access persons, and records of decisions approving access persons' acquisition of securities in IPOs and limited offerings. In order not to discourage employees from reporting violations of the code of ethics, revised Rule 204-2 does not require investment advisers to keep records of whistleblower reports.
The standard retention period required for books and records under Rule 204-2 is five years in an easily accessible place, the first two years in an appropriate office of the investment adviser. Advisers must maintain the records required under amended Rule 204-2(a)(12) and (13) for this standard period, subject to special holding requirements for certain categories of records as specified in amended Rule 204-2(a)(12) and (13). Codes of ethics must be kept for five years after the last date they were in effect. Supervised person acknowledgements of the code must be kept for five years after the individual ceases to be a supervised person. Similarly, the list of access persons must include every person who was an access person at any time within the past five years, even if some of them are no longer access persons of the adviser.
Prior to adoption of the Rule, the SEC proposed that records of access persons' personal securities reports (and duplicate brokerage confirmations or account statements in lieu of those reports) be maintained electronically in an accessible computer database (subject to the special safeguards and other requirements for electronic storage contained in Rule 204-2(g) of the Advisers Act-See our Hedge Fund & Investment Managers Advisory, entitled Electronic Recordkeeping by Investment Companies and Investment Advisers, dated September 24, 2003). The Rule does not require electronic recordkeeping. Nonetheless, the SEC has strong expectations that most advisers will need to maintain these records electronically in order to meet their responsibilities to review these records and monitor compliance with their codes. In all but the smallest advisory organizations, it may be impractical for the adviser or SEC examiners to review paper trading reports for patterns that may indicate abuse. Electronic records need not be costly or burdensome to maintain. In a small firm, a spreadsheet may be sufficient. Larger firms may monitor employees' trading by opening up "client" accounts for each employee so that the firm's existing portfolio analysis programs can track the employees' trades.
K. Amendment to Form ADV
The SEC has also amended Item 9 of Part II of Form ADV to require advisers to describe their code of ethics to clients and, upon request, to furnish clients with a copy of the code of ethics.[10] This disclosure would help clients understand how the adviser controls sensitive information and what steps it has taken to prevent employees from misusing their inside positions at the expense of clients. Disclosure should serve to encourage advisers to implement more effective procedures.
L. Registered Investment Company Advisers
Many advisers registered with the SEC also advise registered investment companies and are therefore also subject to Rule 17j-1. Currently, access persons under Rule 17j-1 need not make a quarterly transaction reports under that Rule if "all of" the information in the report would duplicate information required to be recorded under Advisers Act Rules.
In order to avoid advisers being subject to conflicting responsibilities under Rule 17j-1 and the Rule and related rule amendments, the SEC has revised Rule 17j-1 to state that no report would be required "to the extent that" the report would duplicate information required under the Advisers Act recordkeeping rules. Because the reports required under the Advisers Act are not identical to those required under Rule 17j-1, this revision avoids unnecessary duplication.
To avoid duplicative reports, some advisers to investment companies may require their access persons to provide reports that cover all information required under Rule 17j-1 and all information required under the Advisers Act code of ethics. For example, an access person's quarterly report might include information on new securities accounts (required under the Rule 17j-1) as well as on transactions in affiliated mutual funds (required under Rule.
IV. Effective Date
The effective date of the Rule is August 31, 2004. All registered investment advisers must comply with the Rule and the related amendments by January 7, 2005. By that deadline advisers must have adopted codes of ethics, identified their access persons, provided a copy of the code to each supervised person and received their acknowledgements of receipts. Also, by January 7, 2005, each adviser must also have on file an initial holdings report from each of its access person, and must arrange for the submission of quarterly transaction reports. Access persons' personal securities transaction reports for the calendar quarter ended March 31, 2005 will be due no later than April 30, 2005. Until advisers begin to comply with the Rule and related amendments to Rule 204-2 and Form ADV Part II, they must continue to comply with the personal securities transaction recordkeeping requirements of the SEC's current Rule 204-2(a)(12) and (13).
If you would like to discuss issues relating to hedge funds and their investment managers, contact Howard A. Neuman at (212) 818-9200.
Copyright 2004 Satterlee Stephens Burke & Burke LLP. All Rights Reserved.
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