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News July 12, 2004 Issue

An IM Insight Special Report: The New Code of Ethics Rule (Part 1 of 3)

On July 2, the SEC released the final text of new Advisers Act Rule 204A-1, which for the first time requires all SEC-registered advisers to "establish, maintain and enforce" a written personal trading code of ethics.

This article is the first in a three-part series on the new rule. While the first two parts will discuss the SECís expectations, the third part will focus on the industryís practical experience in implementing the rule, including tips on integrating the code into the overall compliance program.

Overview. An adviserís personal trading code of ethics must contain the following five elements:

  • A general standard of business conduct and a provision requiring compliance with applicable federal securities laws;
  • A requirement that the firmís "access persons" report their personal securities holdings upon becoming access persons and annually thereafter, and report their personal securities transactions quarterly;
  • A requirement that access person preclear their investments in IPOs and privately-placed securities;
  • A whistleblower provision requiring supervised persons to promptly report any violations of the code to the firmís CCO or another person designated in the code; and
  • A requirement that the firm provide a copy of the code and any amendments to all supervised persons, and obtain their written acknowledgment of having received those documents.

By January 7, 2005, the ruleís compliance date, an adviser must have:

  • adopted a code of ethics (or amended an existing one to comply with the new rule) and be prepared to maintain and enforce it;
  • identified its access persons and supervised persons;
  • provided a copy of the code to each supervised person and received his acknowledgement;
  • obtained an initial holdings report from each access person; and
  • arranged for the submission of quarterly transaction reports. The first set of transaction reports required under the new rule will be for the calendar quarter ended March 31, 2005 and will be due no later than April 30, 2005.

Here are 10 steps to think about in preparing your code (or in revising your existing code):

Step 1: Figure out who your firmís supervised persons and access persons are.

To "enforce" the code (one of the action verbs used in the new rule), you need to know who is supposed to be doing what. And, of course, to understand which of the codeís requirements apply to them, your firmís employees need to know their status under the code.

Itís not a bad idea to include a brief definition of "supervised person" and "access person" somewhere toward the front of your code. But as Barry Schwartz, a consultant with Adviser Compliance Associates, points out, itís probably not realistic to expect a busy trader or portfolio manager to parse through those definitions. So, to make sure people are crystal clear about their status, you may want to individually notify each of your firmís access persons and supervised persons of their status under the code.

Speaking of which:

Supervised persons are: all of your firmís employees; all of its partners, officers, directors, and similar persons; and all non-employees who 1) provide investment advice on behalf of your firm and 2) are subject to your firmís supervision and control.

Access persons are a subset of supervised persons. Basically, a supervised person is also an access person if he:

  • is involved in making securities recommendations to clients;
  • has access to client securities recommendations before they are public;
  • has access to nonpublic information regarding a clientís purchase or sale of securities (including the writing of an option to purchase or sell a security); or
  • has access to nonpublic information about the portfolio holdings of a registered investment company advised by the adviser, or for whom one of the adviserís control affiliates (corporate owner, subsidiary, sister company, etc.) serves as adviser or principal underwriter.

Merely having access to information about a clientís portfolio holdings is not enough to cause a supervised person to become an access person, unless that client happens to be an investment company advised by the adviser, or whose adviser or principal underwriter is in a direct or indirect control relationship with the adviser.

Keep in mind that three of the four prongs under the access person definition relate to "access" to information. Even if the individual never actually obtains the information, and even if his job functions have nothing to do with the advisory process, if he has access, heís an access person.

Practically speaking, the following groups of folks are likely to be access persons:

  • Portfolio managers and their assistants;
  • Traders and their assistants;
  • Legal and compliance personnel;
  • Client service representatives who communicate recommendations or other investment advice to clients; and
  • Directors, officers, and partners (the rule contains a presumption that these are access persons if the firmís primary business is providing investment advice. But the old Rule 204-2(a)(13) revenue test for determining an adviserís primary business is gone, so youíre on your own in deciding whether your firmís primary business is advice).

And donít forget the secretaries and computer whizzes. Administrative, technical, and clerical personnel can be access persons if their functions or duties give them access to nonpublic information, said the SEC.

Time for a quiz: You hire a third-party compliance consultant to come on site and do a mock audit. He spends days poring over your firmís records and has ready access to your firmís nonpublic client recommendations and transactions.

Question: Under the rule, must the consultant be subject to your code?

Answer: No.

While the consultant might walk, talk, and quack like an access person, he probably doesnít meet the definition of "supervised person," and therefore, technically speaking, isnít an access person. A short-term third-party compliance contractor typically doesnít provide advice on behalf of the adviser, and arguably isnít under the firmís supervision and control. (Of course, thatís just the legal answer. Practically speaking, the best consultants should agree to keep the information they obtain during their audit confidential, and to refrain from using it for their own purposes.)

In any event, be sure to consider whether your firm uses third-party contractors, temporary workers, and other "quasi-employees" that might provide advice on your firmís behalf. Also consider treating long-term contractors (say, four weeks and over) as if they were employees, and subject them to the code.

Also: keep in mind that the number of access persons you have will depend on how your firm is run. "Organizations in which employees have broad responsibilities, and where information barriers are few, may see a larger percentage of their staff subject to the reporting requirements," noted the SEC. "In contrast, organizations that keep strict controls on sensitive information may have fewer access persons."

Hereís Schwartzís golden rule about access persons: "When in doubt, put them in." Or, stated another way: "If thereís a question about whether one of your supervised persons is an access person, the conservative route would be to include them."

If this all leaves you spinning, hereís another approach to consider: simply treat all of your companyís personnel as access persons. The SEC noted that this approach, while not required, "offers certainty as to whether reports are required from a given individual." And some firms do, in fact, treat everyone who shows up for work in the morning as an access person.

Step 2: Draft your firmís general standard of business conduct.

The code must set forth a standard (or standards) of business conduct required of all supervised persons. The standard must reflect the adviserís and supervised personsí fiduciary obligations. The SEC explained that the code "should set out ideals for ethical conduct premised on fundamental principals of openness, integrity, honesty and trust. 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."

The SEC said that advisers can adopt standards based on those established by professional or trade groups, provided they meet the requirements of the rule. Among the groups that have developed codes of ethics: the Financial Planning Association, the CFP Institute (formerly AIMR) the CFP Board of Standards, the ICAA, and the AICPA.

Hereís a quick checklist of points you might want to include in your general standard:

  • we expect high standards of personal and professional conduct;
  • we owe a fiduciary duty to our clients, which includes a duty of care and a duty of loyalty;
  • to that end, we must put clientsí interests above our own personal interests;
  • we must try to avoid situations and arrangements that give rise to actual or even potential conflicts of interest, or that give rise to an appearance of impropriety;
  • we must not take advantage of our positions or the access to information that comes with our positions;
  • we must comply with applicable federal securities laws (consider referring to state and foreign laws, as well); and
  • itís not enough to comply with the letter of the code, we must comply with spirit of code, particularly in situations not specifically addressed in the code.

The code also must require compliance with the "applicable federal securities laws." It makes sense to put that requirement in or near the general standard. Incidentally, the term "federal securities laws" is defined in the rule to mean the 1933, 1934, 1940 and Advisers Acts, as well as Title V of the Gramm-Leach-Bliley Act, the Sarbanes-Oxley Act, and the anti-money laundering provisions of the Bank Secrecy Act as they apply to registered investment companies and advisers. Not to mention the dozens of related rules adopted by the SEC (and, for the AML piece, Treasury).

Thatís a lot of laws and rules to keep in oneís head.

However, the rule didnít explicitly require that the list of statutes be spelled out in the code, and there may be good reasons, particularly for smaller shops whose personnel may wonder why on earth they need to worry about Gramm-Leach-Bliley or Sarbanes-Oxley, to simply make reference to compliance with "applicable federal securities laws."

Step 3: Get Your Arms Around the New Reporting Requirements.

The reporting requirements are the heart of the code. There are three things to keep in mind:

First, the parameters of the familiar quarterly personal transaction reports have changed. Second, advisers now need to collect initial and annual holdings reports from access persons, as well as transaction reports. Third, advisers are now explicitly required to review the reports.

The code must require the adviserís access persons to make initial and annual holdings reports, and quarterly transaction reports, to the adviserís CCO or other person(s) designated in the code. To get you started, here are two basic model forms that contain the information required in the rule.

MODEL FORM 1

Personal Securities Holdings

Initial Report

Name:

Date report is submitted:

We have recently determined that you are an "access person," as defined in our code of ethics. As such, you are required to complete this form and submit it to [name of CCO or other person(s) designated in code of ethics] by ___ [a date no later than 10 days after the person became an access person].

Instructions: This form asks for information about your personal securities holdings.

1. The information you provide below must be current as of [a date no more than 45 days before the person became an access person], or any more recent date.

2. You must include securities held by your immediate family members with whom you live, unless you are not a beneficial owner of those securities.

3. You do not need to report holdings in the following types of securities:

  • Shares of money market funds;
  • Shares of open-end mutual funds [advisers with affiliated funds, add the following: "except you must report your holdings of shares of the funds we advise, or for whom [name of firmís control affiliate(s)] serves as adviser or principal underwriter." or, even better, name the specific funds]. Shares of all closed-end funds and non-U.S.-registered funds (such as UCITS) are reportable;
  • Direct obligations of the U.S. government;
  • Money market instruments, such as bankersí acceptances, bank certificates of deposit, commercial paper, repurchase agreements and other high quality short-term debt instruments; or
  • Units of a unit investment trust (UIT) invested exclusively in unaffiliated mutual funds (technically, this is narrower than the SECís requirement, but the alternative may be too complicated for most firms to spell out on their form).

4. You do not need to report securities held in accounts over which you had no direct or indirect influence or control, such as a blind trust.

A. For each security in which you have any direct or indirect beneficial ownership, provide the following information:

  • the title of the security;
  • the type of the security;
  • the exchange ticker symbol or CUSIP number (as applicable);
  • the number of shares (as applicable); and
  • the principal amount of the security (as applicable)

B. List the name of any broker, dealer or bank with which you maintain an account in which any securities (regardless of whether they are otherwise "reportable securities," as described in Instruction 3, above) are held for your direct or indirect benefit.

The annual holdings report is identical, except that it should be titled "Annual Report." The preface should begin "As you know, you are an "access person," as defined in our code of ethics." and it must require the report to be submitted at least once annually on an anniversary date selected by the adviser. The information provided must be current as of a date no more than 45 days before the report is submitted.

MODEL FORM 2

Personal Securities Transactions

Quarterly Report

Name:

Date report is submitted:

As you know, you are an "access person," as defined in our code of ethics. As such, you are required to complete this form and submit it to [name of CCO or other person(s) designated in code of ethics] no later than [date no later than 30 days after the end of the calendar quarter].

Instructions: This report covers all of your personal securities transactions occurring during the past calendar quarter.

1. If you had no personal securities transactions during the quarter, you may disregard this form (you are not required to report that that you had no transactions).

2. You must include securities transactions of your immediate family members with whom you live, unless the member was not a beneficial owner of the securities at the time of the transaction.

3. You do not need to report transactions in the following types of securities:

  • Shares of money market funds;
  • Shares of open-end mutual funds [advisers with affiliated funds, add the following: "except you must report your holdings of shares of the funds we advise, or for whom [name of firmís control affiliate(s)] serves as adviser or principal underwriter." or, even better, name the specific funds]. Shares of all closed-end funds and non-U.S.-registered funds (such as UCITS) are reportable;
  • Direct obligations of the U.S. government;
  • Money market instruments, such as bankersí acceptances, bank certificates of deposit, commercial paper, repurchase agreements and other high quality short-term debt instruments; or
  • Units of a unit investment trust (UIT) invested exclusively in unaffiliated mutual funds (technically, this is narrower than the SECís requirement, but the alternative may be too complicated for most firms to spell out on their form).

4. You do not need to report transactions:

  • occurring in an account over which you had no direct or indirect influence or control, such as a blind trust; or
  • made pursuant to an automatic investment plan, such as a dividend reinvestment plan. However, any transaction that overrides the pre-set schedule or allocations of the automatic investment plan must be included in this report.

5. Documents Provided In Lieu of This Form. If you have provided, or plan to provide, trade confirmations or account statements to the firm, do not complete this report. For all transactions occurring during this quarter, you must provide copies of the confirmations or statements to [CCO or other designated recipient within the firm] no later than 30 days after the close of the quarter. However, if the confirmation or statement does not contain all of the information required on this form, you must provide the remaining information on this form.

For each transaction in a security in which you had, or as a result of the transaction acquired, any direct or indirect beneficial ownership, provide the following information:

  • date of the transaction;
  • the title of the security;
  • the exchange ticker symbol or CUSIP number (as applicable);
  • interest rate and maturity date (as applicable);
  • the number of shares involved in the transaction (as applicable);
  • the principal amount of each reportable security involved (as applicable);
  • the nature of the transaction (i.e., purchase, sale or any other type of acquisition or disposition);
  • the price of the security at which the transaction was effected; and
  • the name of the broker, dealer or bank with or through which the transaction was effected.

A bit more about reporting:

  • You can keep a cumulative, composite record of an access personís holdings based on past holdings statements or brokerage confirmations, and provide that to the access person, who can simply confirm the accuracy of the record (instead of affirmatively providing an initial or annual holdings reports). However, the record must contain all of the information required by the rule.
  • But that doesnít mean that an access person can argue his way out of filing an initial or annual holdings report on the grounds that he has previously provided all required information over a period of time in various transaction reports. "One reason for requiring a holdings report is so that the adviser's compliance personnel and our examiners have ready access to a Ďsnapshotí of the access personís holdings and are not required to piece the information together from transaction reports," explained the SEC.
  • Interestingly, the standard of what constitutes an account over which an access person doesnít have direct or indirect influence or control has changed. Now, even if the access personís employer (i.e., the adviser) or one of the access personís colleagues has direct or indirect control over an account, as long as the individual access person himself doesnít have influence or control over it, he doesnít have to consider it when reporting holdings or transactions. Thatís a change from the old Rule 204-2 standard.
  • The SEC stated that an adviser is free to require its access persons to report their holdings and transactions in all securities, notwithstanding the exceptions provided in the rule. So, for example, an adviser could require its access persons to report shares in money market funds, etc.
  • The SEC provided some relief for advisory firms with only one access person, such as a sole proprietor with a clerical assistant or bookkeeper who is not himself an access person. The sole proprietor need not submit reports to himself. However, he must maintain records of all holdings and transactions that would otherwise be required to be reported.

What has to be done with the reports?

Unlike the old days, where advisers were required to collect quarterly personal securities transaction reports but were not explicitly required to do anything with them, the new rule requires that the code actually require the adviser to review the reports. The goal of the review, said the SEC, is to identify improper trades or patterns of trading by access persons. The holdings reports "will facilitate an adviserís assessment of whether an individualís personal securities holdings present a conflict of interest."

The SEC stated that it expected that the adviserís CCO, or persons under his authority, will have primary responsibility for enforcing the code, which must include reviewing access personsí personal securities reports. However, the SEC made clear that the CCO need not personally review all reports.

The SEC said that it expects most advisers to designate another individual to review the CCOís reports.

According to the SEC, the review of the holding and transaction reports should include the following:

  • an assessment of whether the access person followed any required internal procedures, such as preclearance;
  • a comparison of each access personís personal trading to any restricted lists;
  • an assessment of 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;
  • a periodic analysis of the access person's trading for patterns that may indicate abuse, including market timing;
  • an investigation of any substantial disparities between the quality of performance the access person achieves for his own account and that he achieves for clients; and
  • an investigation of 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.

Step 4: Draft a preclearance policy and procedures.

The code must require access persons to obtain preapproval before they directly or indirectly acquire beneficial ownership in an IPO or limited offering, such as a private placement under Reg D. Keep in mind that virtually all hedge fund investments will be subject to preclearance (there may be exceptions, such as publicly-offered funds of hedge funds). The SEC said that an access personís IPO or private placement purchase "raises 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."

Of course, an adviser can simply prohibit its access persons from investing in IPOs and private placements altogether. These advisers do not have to require preclearance of IPO and limited offering transactions, since they should not be occurring.

Advisory firms that have only one access person, such as a sole proprietor with a clerical assistant or bookkeeper who is not himself an access person, do not need to include this preclearance provision.

Step 5: Draft your whistleblowing policy and procedures.

The code must require access persons to promptly report any violations of the code to the adviserís CCO or another person designated in the code. If someone other than the CCO is designated, however, the adviser must have additional procedures designed to ensure that the CCO officer receives periodic reports of all violations.

The SEC cautioned advisers "that it is incumbent on them to create an environment that encourages and protects supervised persons who report violations." The SEC said that advisers should consider how they can best prevent retaliation against someone who reports a violation. It noted that many advisers may choose to permit anonymous reporting, by recording the facts and circumstances surrounding a violation of the code, but not the employee who reported the problem. Other advisers, said the SEC, have decided that retaliation itself is a violation of the code.

Next Week: More on Whistleblowing, plus Acknowledgements, Form ADV, Records, and more.