Do Advisers Have to Collect Personal Trading Reports From Outside Directors?
Is there any way that an outside director of an advisory firm can be carved out of the firmís general personal trading reporting requirements? The question came up a number of times during the recent spring conferences.
The short answer is yes, but only if the director truly has no day-to-day involvement in the adviserís investment decision-making process (which would seem to be an easy test to meet) and does not have "access" to non-public information about clientsí transactions or holdings, or the firmís investment recommendations (perhaps a tougher test to meet).
As you undoubtedly know, under the new Advisers Act personal trading rule, all directors, officers, and partners of an advisory firm that is primarily engaged in the advisory business are legally presumed to be "access persons," subject to the ruleís personal securities transactions and holdings reporting requirement. As access persons, they also must obtain preclearance before investing in IPOs or private placements.
As they say, when you presume something, you make an . . . wait, never mind. The point is, a legal presumption is rebuttable: Itís not a hard and fast rule, but instead can be proven incorrect by the facts.
So: letís assume your firm is primarily engaged in the advisory business. If one of your outside directors asks, "Why on earth should I have to submit these reports? It makes no sense!" ó and your firm agrees ó there may be something you can do about it.
To rebut the legal presumption that an outside director is an access person, youíll have to be prepared to prove the following:
The director has no access to non-public information regarding clientsí purchases or sales of securities.
The director has no access to non-public information about the portfolio holdings of a reportable fund.
The director is not involved in making securities recommendations to clients.
The director does not have access to recommendations before they become public.
When deciding whether you can prove those elements, consider the following:
Does the outside director in question have unfettered access to the firmís records, such as file cabinets or computer systems?
If the director picked up the phone and asked someone at the firm for non-public information about client transactions or holdings, or the firmís investment recommendations, what would the response be? Are there any controls in place that would prevent that non-public information from being conveyed to the outside director?
Is the director provided with any report (such as a best ex report or compliance review report) containing non-public information about client transactions or holdings, or the firmís investment recommendations?
Are client transactions or holdings, or the firmís investment recommendations, discussed orally at board meetings? This could occur as when the board considers topics such as best ex or the firmís compliance program, or when the board discusses the firmís general investment strategy.
Of course, before putting up any information barriers to prevent an outside director from having access to information, consider how that lack of information might impact his or her effectiveness as a director.
In its FAQ on the personal trading rule, the Investment Adviser Association (formerly the ICAA) suggested that the CCO of a firm seeking to carve out a director from the definition of access person "document any such determination" and "be kept apprised of any changes in the directorís involvement or access to information."
What if the director also happens to be a firm client? According to past SEC staff guidance, his personal account statement wouldnít seem to cause him to fall out of the carve-out. However, if the directorís account is non-discretionary and he is contacted prior to transactions, he would in fact have access to non-public information about the firmís investment recommendations.
If your firm is not primarily engaged in the business of investment advice (such as an accounting firm that provides financial plans on the side, or an insurance company with an investment advisory unit), the legal presumption does not apply, and the test becomes whether the directors, officers, and partners have access to nonpublic information about clientsí securities transactions or holdings, or the investment recommendations made by the firm.
Could inside directors ever rebut the presumption that they are access persons? IAA general counsel Karen Barr advised against it. Employees of a company, she pointed out, typically have access to a host of information by virtue of their physical proximity to records (unless, of course, information barriers are established). Any attempt to rebut the legal presumption, she said, "would be more appropriate for an outside director." Barr also noted that passive investors in a partnership may be able to rebut the presumption (on that score, see the IM no-action letter to W.R. Huff, pub. avail. Aug. 10, 1994)
How many advisory firms actually have boards of directors? According to Chip Roame of Tiburon Strategic Advisors, the largest 1000 SEC-registered advisory firms (approximately 350 of which are part of investment company complexes) are likely to have boards of directors. The remaining 7,000 or so SEC-registered advisers, he said, are more likely to be one or two man shops without formal boards.