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News September 11, 2006 Issue

Advisory Firm Executive Describes Code of Ethics Changes

When it comes to policies and procedures, donít complacently rely on the policies youíve always had.

Thatís the message delivered by a senior executive at a large East Coast advisory firm, who reported that his firm is in the process of making improvements to its personal trading code of ethics. The suggested changes, he said, were offered by the firmís compliance department. "They made a recommendation to the executive group," he said. "I thought they made a compelling case . . . . They said, ĎLook, the burdens are so great.í"

Among other things, the firm is adopting a new policy that specifies the brokerage firms where employees can hold brokerage accounts. The list of permissible brokers is comprised of firms that are able to provide automated data feeds into the adviserís personal trading system, CTI Examiner. While a number of well-known brokers are on the list, such as Schwab, Fidelity, TD Waterhouse, UBS, and Merrill Lynch, "some of the larger ones are conspicuously missing," noted the executive.

The policy change, he explained, is designed to allow his firm to automate personal trading surveillance and "eliminate the whole manual process of reviewing statements." Obtaining data feeds "is going to free up time to focus on more important compliance issues," he said. "Itís not that personal trading isnít important. It is." But, he added, "itís not rocket science. Itís just matching." In fact, an advisory firm doesnít even necessarily need a compliance expert to review personal trading reports. "You need someone who pays enough attention to detail . . . . itís ripe for automation." By requiring employees to have accounts at one of the specific firms, he said, his firm will "potentially get rid of 95 percent of the problem."

What if a firm employee wants to keep her brokerage account with her long-term broker who is not on the list? The executive explained that the new policy provides for limited exceptions where the situation warrants. "Maybe itís a trust account," where an employee says, "I have this trust account, this is the trustee, and this is where the assets are held, sorry itís not one of those places, but itís not easily changeable." Another example might be where an employee had a longstanding relationship with a particular broker. "In those handful of situations," he said, exceptions might be made.

The executive also reported that his firm is modifying certain trading windows where experience has shown that they are not working. Some blackout periods will be extended, while others are going to be shortened. "In some cases, we modified them to be more practical," he said.

In addition, certain reporting requirements were lifted "where it was determined that [the requirement] was not necessary because the information was already getting reported in some other means."

The executive said that his firm has not imposed very strict personal trading measures, such as limiting employeesí investments to non-affiliated mutual funds. "We have not made it that restrictive," he said. Nor has his firm flatly prohibited employees from investing in IPOs and private placements. "There are definitely firms that do that," he said. However, his firm has not imposed an "across-the-board" restriction on such investments.

He noted that his firmís executive committee carefully weighed the pros and cons of each policy change before accepting them. For example, they knew that limiting the number of places where their employees could hold brokerage accounts would impact certain employees, but concluded that the resulting efficiencies were worth it. "At the end of the day, we felt that the amount of the burden that we were relieving on our compliance team and the benefits we would gain from that" outweighed any potential negative impacts on certain employees, he said.

The executive noted that all code of ethics infractions are formally reported to his firmís executive committee. That, he said, seems to serve as an additional deterrent to late filing and other violations. "Thatís not a report you want your name showing up on," he said. When thereís late reporting, "not only does compliance see it and crack down on it" but "to the extent it would be a problem, it would be there for everyone to see."

He also said that his firm does not currently require portfolio managers to "eat their cooking" by investing in the funds that they manage. However, he noted that many fund companies "are talking about whether directors and employees need to own shares of [their] funds."

While his firm is not currently requiring portfolio managers to take an ownership stake in their funds, he indicated that it may move in that direction in the future. "We are trying to think through all the issues about where you draw the lines," he said. "Are you going to set thresholds for people? Is it just any investment? Is it an investment of a certain amount?"

What about the old argument that requiring portfolio managers to invest in their funds might force them to invest in funds that are not suitable for their personal investment objectives? That, according to the executive, may not carry much weight. "Arguably, if you are asset allocated, you would think that you have some percentage of the fund, whatever the fund is," he said.

The executive also pointed to a recent academic study that found a positive correlation between fund performance and portfolio manager ownership. According to the study, as of the end of 2004, 43 percent of portfolio managers owned a stake in their funds, with an average holding of $97,000. In August 2004, the SEC adopted rule changes requiring funds to disclose their portfolio managers' ownership of fund sharings, using a set of specified ranges such as "$1-$10,000" up to "over $1,000,000."