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News March 12, 2012 Issue

Spotlight on the Code of Ethics

"Itís one of those tiny acorns in investment adviser law that has turned into an oak tree."

With that observation, Schiff Hardin partner Michael Wolensky launched into a panel discussion on the code of ethics at the Investment Adviser Associationís 2012 Compliance Conference last week.

Since it became effective in 2005, Rule 204A-1 requires advisers to maintain a code of ethics, and mandates the inclusion of certain items.

An adviserís code of ethics must include:

  • The standard of business conduct you require of your supervised persons, which must reflect the adviserís fiduciary duty;
  • A requirement for all supervised persons to abide by the federal securities laws;
  • A policy addressing personal securities trading by firm "access persons" (officers, directors, employees, and some third party service providers) that establishes reporting and periodic review requirements for such trades;
  • A requirement that all access persons get pre-clearance for certain types of personal trading, such as IPOs, limited offerings and private placements, and that access persons must strictly comply with the adviserís policies and procedures regarding personal trading;
  • A policy of providing the code of ethics and any amendments to firm supervised persons, and for those persons to acknowledge receipt of the code and any amendments in writing; and
  • A requirement that supervised persons report any violations of your code of ethics to the CCO, or to another designated person provided the CCO receives reports of all violations.

Under the code "must haves," access personsí holdings and personal transactions reporting is a critical part of the rule, said Wolensky. The SEC exam staff is looking at this issue very hard, and writing people up for deficiencies. "This is real easy, and you need to get it right," he said. The reports need to be collected, and they need to be complete. The adviser is required to review the reports periodically, but gets to determine how often to conduct reviews provided the time period is reasonable related to the adviserís business.

Practical suggestions.

These tips go beyond the basics of the code of ethics, and offer some ideas learned "in the trenches," said Harding Loevner CCO and general counsel Lori Renzulli.

Put a time limit on pre-clearances to trade.

A trading pre-clearance should stipulate the time period for which the clearance is valid. Typically, her firm will deny pre-clearance on days the firm is active in the same security, but the firm does provide exceptions for things like de minimis trading, she said.

Think about including related policies and procedures in the firmís code of ethics as a "best practice."

Renzulliís firm includes other related material in the firmís code of ethics. Two schools of thought can govern the code of ethics process, she said. Some firms have all their policies and procedures "baked" into the code, producing a single document for access persons to focus on and refer to. Some firms prefer to leave any number of the best practices items out of the code, because it provides the CCO with more flexibility of action.

If something is in the code, then it is subject to the requirement to report violations of the code, she observed. The inclusion of additional items may create work that otherwise would not be there.

Renzulliís firm includes a section on insider trading, which goes hand-in-hand with personal trading. Her firmís code also includes sections on:

  • rumors;
  • gifts and entertainment;
  • outside affiliations, such as other employment and board positions; and
  • mentions of the Foreign Corrupt Practices Act and the pay to play rule.

Include the consequences of failure to comply.

Her firmís code of ethics also includes an enforcement section that describes the broad discretion that the firmís Compliance Committee has in meting out punishments for code violations. The firmís code includes a list of seven different sanctions available in escalating order:

  • warning;
  • reprimand;
  • disgorgement of profits;
  • limits on trading;
  • monetary fines;
  • termination; and
  • referral to civil and/or criminal authorities.

Beware the rogue spouse.

One of the issues that often arises is not a problem with access persons, but rather with their spouses. It is the access personís responsibility to ensure compliance with the code of ethics and annually certify that they are complying with the code, said Renzulli. Spouse accounts are considered to be beneficially owned by the access person, and therefore must also comply with code requirements.

Yes, said Sutherland partner and former OCIE general counsel John Walsh. OCIE used to perform a training skit for staff that showed a couple marrying at the altar, he said. The officiant warns the soon-to-be spouse that before he or she says "I do," they should understand and must agree to the restrictions of their spouseís employment.

Personal trading with multiple broker-dealers.

One issue Renzulli sees related to personal trading oversight is the use of multiple broker-dealers by access persons. Her firm does not generally limit an access personís use of multiple broker-dealers, but at least every two years, compliance staff reviews the reasons why an access person requires multiple broker-dealers.

Wolensky said it might be tempting to direct employee trading to certain broker dealers, but that might be more trouble than itís worth. He noted that California has a law on its books that prohibits an employer from requiring an employee to use the services of the employer. Several years ago, a Charles Schwab employee sued the company for requiring all employees to maintain their brokerage account, if any, with Schwab. The court found that Schwabís policy was based on its responsibilities under a regulatory scheme, and that the requirement therefore did not violate the state law. Itís good to know, especially if your firm is in California, he said.

Code of ethics enforcement actions on the rise.

The SECís enforcement program with respect to a firmís code of ethics has changed, said Walsh. Until recently, the "classic" code of ethics enforcement action was a 2007 case brought against Joe Meals. Meals, the founding partner and CCO of registered adviser Consulting Services Group, failed to obtain and retain annual acknowledgments of receipt of the firmís code of ethics from the firmís access persons. This omission was discovered during an SEC examination, and Meals promptly responded by getting the required acknowledgments and backdating them.

"Thatís what it took to get an enforcement action for a code of ethics violation," said Walsh, the presence of out-and-out fraud.

In 2011, all that changed. Multiple actions were brought in 2011 based on code of ethics violations. It began with the Aletheia Research and Management case. Similar to the Meals action, Aletheia also failed to obtain code of ethics acknowledgments. In 2005, Aletheia received a deficiency letter that noted the failure. The SEC returned for a subsequent examination in 2008 to find the same problem uncorrected. In 2011, the SEC brought an enforcement action against the adviser and its CCO. "I think itís pretty clear, if you ignore them twice, you can expect an enforcement action," said Walsh.

Recently however, SEC actions highlight simple non-compliance with the regulation, versus affirmative violation of the rule, he said.

In the Wunderlich case, the adviser experienced a business change, and hired a consultant to help it develop a compliance program. The consultant noted the firm failed to have a code of ethics, yet six months later, no action had been taken to establish one. The CCO was added to the resulting enforcement action because the CCO failed to implement policies and procedures the firm was supposed to have.

In the Belsen Getty case, the code of ethics contained an isolation procedure for access persons who served on a board. The firm failed to follow the isolation procedure and the SEC brought an enforcement action. "Donít forget the bread and butter stuff," said Walsh, "this is a classic issue, persons serving on boards."

A trio of enforcement actions were released in November, and each of them included a code of ethics component, he observed.

The code of ethics is increasingly coming up in enforcement cases, and with reason. The Division of Enforcement wants to bring more cases every year, and the code of ethics is a good source for them, said Walsh.

Look at the AXA Rosenberg case as an example, he said. There the larger issue was an individual exerting undue control, but the action also cited code of ethics failures because employees didnít escalate the problem internally.

These enforcement actions involving the code of ethics really represent basic "blocking and tackling," said Wolensky. The Division of Enforcement is not questioning whether a code has sufficient breadth, for example. These actions do not involve subjective calls, he said. The actions are based on the nuts and bolts of the process, whether a firm is implementing the rule.

If you donít have the basics right, "youíre really looking at an enforcement action these days," said Walsh.

Panel moderator and IAA special counsel Paul Glenn observed that the Division of Enforcementís new Asset Management Unit has certainly had an impact on the recent rise in adviser enforcement actions. When you have a unit in Enforcement devoted to adviser issues, the way you measure its effectiveness is by the number of cases it produces, he said. Now Enforcement is bringing cases on the deficiency, rather than putting it in a deficiency letter.

Walsh agreed generally that this appears to be an emerging trend. However, he noted that in almost all of the recent cases brought by Enforcement, the registrants had been given a "first bite at the apple" to correct a deficiency before an enforcement action was ultimately brought.

Final take-aways on the code of ethics.

"This is a time when you should be reviewing your firmís code of ethics description in the firmís Form ADV," said Wolensky. He also observed that some firms capture personal trading and holding reports in a specific area that may not be the compliance area. Make sure those reports get to the CCO and are reviewed, he said.

Waivers of code of ethics requirements can be an area of concern, said Walsh. He said that current Division of Investment Management deputy director Robert Plaze once observed that the issuance of code of ethics waivers will catch the staffís attention, and will garner review to ensure that the waivers were really thought through.

Renzulli agreed. She said that any waivers of code of ethics requirements at her firm must be fully documented by a specific request and a written justification for any grant of a waiver.

Think of including a de minimis policy for granting waivers from certain trading prohibitions, such as during a blackout period for example, said Glenn. It can demonstrate youíre actively assessing the risk of certain employee activities, and it allows more emphasis on truly concerning conduct, he said.

Code of ethics oversight can involve manual or electronic methods, said Renzulli. Her firm uses a hybrid of both.

Renzulliís firm has 70 employees and they are all access persons, she said. Even using electronic methods, code oversight still generates "plenty of paper," she said. However, the paperwork puts accountability for compliance with the code of ethics where it belongs Ė with the access person.