SEC Staff Considering Additional Code of Ethics Guidance
If youíve been wrestling with the practical application of Rule 204A-1, help may be on the way.
"We are always open to assisting registrants with technical questions related to our rules," Jennifer McHugh, a senior advisor in the SECís Division of Investment Management, told IM Insight. "In the case of the code of ethics rule, we are examining the possibility of issuing additional staff guidance, perhaps in the form of an FAQ, on issues of broad applicability to the investment adviser community."
Many advisers have found the ruleís reporting requirements less than intuitive. "I think itís fair to say that these requirements . . . are causing enormous distress among the ranks of employees," said Christine Carsman, vice-president of legal and compliance for AMG. "Not because they donít want to comply, but because they really donít understand why all this information is suddenly meaningful."
Hereís a look at what might be covered in an SEC staff FAQ:
401(k) plans. Carsman, who was speaking at the recent ICAA/IA Week conference, said that talking with employees about reporting 401(k) transactions "is an extremely challenging conversation" because those transactions "have just been off the screen in terms of things to report."
The general rule: access persons must report transactions and holdings in their 401(k) plans, since they beneficially own the interests in the securities held in those plans. ICAA general counsel Karen Barr, Carsmanís co-panelist, noted that if an advisory firm already has the required information about the access personís 401(k) investments (because, for example, the 401(k) plan is a defined benefit plan managed by the firm), the access person wouldnít necessarily have to submit duplicate reports "of what the employer already knows." Compliance still would need to monitor the securities held in the plan "to make sure that there is nothing funny going on," Barr added.
In contrast, employees generally have control over investments held in a defined contribution plan and would have to report them "as with any other funds over which they have control," said Barr.
Some advisers may turn to the 401(k) sponsor for information about access personsí holdings and transactions. However, one lawyer at a large fund adviser pointed out that sometimes the sponsor is not able to provide all of the information required to be reported under the rule. His firmís policy is to ask employees to provide any missing information.
Rule 204A-1 contains an exception from the quarterly transaction reporting requirement (but not the initial and annual holding reporting requirements) for investments made pursuant to an automatic investment plan. An access person who has set up automatic investments in his 401(k) plan (i.e., a set payroll deduction) would not need to report those transactions. As a practical matter, however, each adjustment made by an employee to his automatic investment would result in a reportable transaction. Keeping track of if and when an employee reallocated his 401(k) investment may present practical challenges, Barr noted.
ETFs. Whether an ETF is a reportable security under the code of ethics rule depends on how it is structured. McHugh noted that many of the largest and earliest ETFs are structured as UITs, which are generally picked up as reportable securities. The status of ETFs organized as open-end funds depends on whether the fund is affiliated with the adviser. Since most advisory firm employees donít know by looking at the name of an ETF whether itís organized as a UIT or an open-end fund, said McHugh, the "best advice" is to require the reporting of all ETFs, "so you donít get tripped up in terms of whether the ETF is organized as a UIT or an open-end fund."
Carsman noted that an alternative approach is for the firm to provide access persons with a list of affiliated ETFs organized as open-end funds.
529 plans. Technically, 529 plans are municipal securities, which are not excluded from the definition of reportable security and are therefore reportable. Barr noted that some 529 plans organized as "life-cycle" funds invest in underlying funds. In some instances, she said, access persons have not been able to determine whether the underlying investments are in an affiliated open-end fund. "Thereís no great way of getting any underlying information about" the life-cycle 529 plans, she said. The ICAAís FAQ on personal trading advises that "in these situations, the access person should supply whatever information he or she has available."
Affiliated open-end funds. Carsman noted that the ruleís treatment of affiliated open-end funds as reportable securities has caused practical difficulties for some firms. "There are a number of firms across the country that are finding that their distant affiliatesí mutual fund operations are now a very real part of their own compliance programs," said Carsman. Familiarizing employees with a "far-flung universe of affiliated funds," she said, can be challenging. The fund lawyer agreed that the SEC had swept with a "very broad brush" by including all affiliated open-end funds as reportable securities.
Spouses and other family members. When asked whether their code of ethics defined "access person" to include all of their employees, virtually all of the attendees at the ICAA/IA Week conference raised their hands. "As a practical matter, identifying all of your employees as access persons brings a little bit of simplicity to the administration of the code, because then you donít have to worry about people who are in or out," noted Carsman. "It also helps you in conveying the fiduciary message across the organization. There arenít different rules for different people in the company."
However, educating all those access persons about how the rule applies to their particular personal situations can present challenges. "It can be a little tricky when you donít have a definite familial relationship," said Carsman. You really start to get into the middle of your employeesí personal Ďstuffí." Carsman said she uses training as an opportunity to remind employees that as their family situations change, so do their personal securities reporting requirements. "You need to have some kind of regular opportunity for talking to your employees about the code of ethics," she advised. In addition to reminding employees about the importance of their fiduciary obligation, thereís the "reality of keeping pace of whatís going on in their lives."
Carsman suggested that firms memorialize any case-by-case determinations about the reporting status of an access personís familial member or housemate. "Have a record that you had that thoughtful process about that particular situation," she said.
Rob Stirling, CCO of Eubel Brady & Suttman Asset Management, reported that some of his access personsí spouses have balked at the reporting requirements, with one spouse complaining that it was an invasion of privacy. Stirling found that he was able to address the spousesí concerns by explaining the SECís rule and the rationale underlying the reporting requirements. In one instance, said Stirling, he took a spouse out to lunch to explain the requirements.
Now, the notion that employees and their spouses will be required to make personal securities holding and transaction reports is discussed with potential hires before they become employees. "Itís posed enough of a practical problem that weíve decided to address it in the interview process," said Stirling. "Particularly for new employees coming in from outside the securities business," he said, itís best to "get that out up front."
At least one adviser, however, is not reporting significant issues with the new rule. "Weíve had a
17j-1 code of ethics in place for a long time," said the lawyer at a large fund adviser, who said that Rule 204A-1 imposed "very modest changes." With respect to requiring spouses and other familial members to report, "we did that kind of education years ago." And, he added, "weíve always treated ETFs as securities that have to be reported."