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News July 19, 2004 Issue

An IM Insight Special Report: The New Code of Ethics Rule (Part 2 of 3)

Whistleblowing, continued . . .

If someone other than the CCO is designated as the recipient of the whistleblowing reports, he or she "should have sufficient status within the organization to engender respect for the code of ethics," according to the SEC. The SEC also said that the CCO, or designated person, should not be a person involved in the matter giving rise to the violation. The SEC did not, however, provide guidance as to whom a supervised person should report to if the CCO and designated person are involved (presumably, in such an instance, the report should be made to another senior officer at the firm).

In the proposing release, the SEC noted that supervised persons might self-report "inadvertent and some technical violations." Consider whether your code should reflect the SECís observation.

Also consider asking your supervised persons to phone in their whistleblowing reports, rather than submitting them in writing. Although whistleblowing reports do not need to be kept as part of an adviserís books and records, there is a chance that written reports, which might not present facts in the best light, may fall into the hands of SEC examiners. Thatís especially a risk if the reports are sent via e-mail.

Lastly, hereís something to mull over: since the code must require compliance with applicable federal securities laws, a violation of a federal securities law could technically be viewed as a code violation that must be reported, notes Pickard & Djinis LLP partner Mari-Anne Pisarri.

Step 6: Draft your distribution and acknowledgement procedures.

The code must require the adviser to provide each supervised person with a copy of the code and any amendments. The code also must require each supervised person to acknowledge, in writing, his receipt of the code and any amendment. Advisers must keep copies of those written acknowledgements. Written acknowledgements may be made and kept electronically.

Some practical pointers: Even if you already have a code and have circulated it to employees in the past, in all likelihood youíll need to re-circulate it after itís been amended to comply with Rule 204A-1.

Hereís some model language for the acknowledgment, which goes beyond that required by the SEC:

"I certify that I have received a copy of our firmís code of ethics. I have read and understand the code. I will comply with the code, and will report all of the information that I am required to report under the code. If I have any questions about the applicability of the code, or my obligations, I will ask [name of firmís chief compliance officer (or other person)]."

Step 7: Consider the "should considers."

The SEC said that advisers "should consider" a number of topics when crafting their procedures for employeesí personal securities trading.

Before running down the list, keep in mind that these are "should considers," not "musts." While most larger advisers have adopted many of these practices, some may be simply too challenging, at a practical level, for smaller advisers to realistically implement. When deciding which of the practices to adopt, firms should consider how much work they want to impose on themselves, advises Vicki Hulick, a director at PricewaterhouseCoopers. "Itís time consuming and tedious to do the kind of checking that would be required around blackout periods and preclearance if you donít have an automated system that permits you to check personal trading against client trading and restricted lists," she notes.

With that in mind, hereís the SECís list:

Preclearance. Advisers should consider requiring access persons to obtain prior written approval before placing a personal securities transaction (presumably, that means before placing an order). Some decision points:

  • Who must preclear? All personnel? All supervised persons? Or only access persons?
  • What must be precleared? All transactions? Only those otherwise reportable on the quarterly transaction report?
  • How will preclearance be handled? Manually, by the compliance department? Using software that checks the trade against the firmís restricted list and against other filters?
  • How will employees be notified that they have been given approval?
  • How long will approval be valid?
  • What if an approval needs to be revoked? How will that be accomplished?
  • How will quarterly transaction reports (or other information) be checked against the log of pre-clearance approvals?

"Recommended" and "Restricted" Lists. An adviser should consider maintaining a list of issuers of securities that the firm is analyzing or recommending for client transactions, and prohibiting personnel from personally trading securities of those issuers. The SEC also said that advisers should consider maintaining a "restricted list" of issuers about which the firm has inside information. Client trading, as well as personal trading, should be prohibited in those issuersí securities.

Blackout Periods. An adviser should consider imposing blackout periods during which access persons may not place personal trades in securities that clients are trading in or receiving recommendations about. A side benefit noted by the SEC: this eliminates the possibility of improper allocations, since employee and client trades will not be bunched together.

"Client Goes First" Standard. An adviser should consider adding a reminder to its code that investment opportunities must be offered to clients before the adviser or its employees may act on them, and procedures to implement this principle.

Short-Swing Trading. An adviser should consider prohibiting or restricting "short-swing" trading and market timing. The SEC noted that many advisers that prohibit short-swing trading require the disgorgement of any profits resulting from short-swing trading. If your firm goes that route, consider to whom the disgorgement must be made (some firms pick a charity).

Limiting Brokers. An adviser should consider requiring personnel to trade only through certain brokers, or limitations on the number of brokerage accounts that may be opened. Although not discussed by the SEC, the assumption here seems to be that the adviser will receive confirms or account statements from each of the brokers, facilitating the monitoring of personal trading activities. Speaking of which:

Duplicate Confirms and Account Statements. An adviser should consider requiring personnel to provide the adviser with duplicate trade confirmations and account statements.

Who Researches What. An adviser that does in-house research should consider adopting procedures for assigning new securities analyses to employees whose personal holdings do not present apparent conflicts of interest.

Gift Policies. An adviser should consider adopting a gift policy. Some advisers prohibit their employees from accepting gifts of more than a de minimis amount, such as $100. Customary business entertainment, such as meals and sporting events typically are permitted. Employees should be warned against accepting or providing gifts that would cause embarrassment to the firm if made public.

Board Service. An adviser should consider limiting the circumstances under which an access person may serve as a director of a publicly traded company. The concern here is that board service would cause the adviser to obtain material non-public information about the company, thereby freezing its ability to trade in companyís shares for its clients.

Who is an Access Person? An adviser should consider adding a detailed description of who is considered an access person within the organization

Review Procedures. An adviser should consider adding procedures for the firm and its compliance personnel to periodically review the code and the various reports (initial holdings report, annual holdings report, quarterly transaction reports, any whistleblower reports, etc.) required by the code.

Also consider:

Employee Education. The SEC said that it would expect most advisers to "ensure that their employees have received adequate training on the principles and procedures of their codes." The SEC noted that many firms hold periodic orientation or training sessions with new and existing employees to remind them of their obligations under the code.

Discussion of Penalties. The SEC noted that many codes discuss penalties "so that employees have a meaningful understanding of the importance of the code and of the consequences of violating it." Examples of penalties: requiring employees to cancel trades, disgorge profits, or sell positions at a loss, and/or issuing internal reprimands, fines, or firing.

What about protection of material nonpublic information? The SEC had proposed to require that codes prevent access to material nonpublic information about recommendations and client holdings and transactions by individuals who do not need the information to perform their duties. That didnít make it into the final rule. However, in the adopting release, the SEC reminded advisers that Section 204A requires them to maintain and enforce policies and procedures to prevent the misuse of material nonpublic information. The SEC said that it believed that would pick up the "misuse of material nonpublic information about the adviserís securities recommendations, and client securities holdings and transactions." The advisersí duty of care requires advisers to safeguard this information, said the regulator: "Advisers should carefully consider how to control dissemination of sensitive information both within their organizations and outside them."

The SEC noted that Section 204A procedures usually contain a summary of insider trading law and procedures for determining whether information has become public. That summary may be distinct from the adviserís Section 204A procedures to guard against misuse of material nonpublic information about client recommendations, trading, and holdings, it said.

The SEC noted that the obligation to safeguard sensitive client information would not preclude the adviser from providing necessary information to the adviserís or accountís service providers, such as brokers, accountants, custodians, and fund transfer agents, in other circumstances when the client consents, or as necessitated by SRO rules, such as NASD Rule 3040.

Step 8: Revise your recordkeeping procedures.

The SEC amended the Advisers Act books and records rule, Rule 204-2, to reflect the new personal trading regime. Although the relevant paragraphs are still (a)(12) and (13), they have been completely overhauled. Hereís what you need to keep:

  • A copy of each version of your firmís code of ethics that has been in effect at any time within the past five years;
  • A record of any violation of the code, and of any action taken as a result of the violation;
  • A record of all written acknowledgments for each person who is currently, or within the past five years was, a supervised person;
  • A record of each holding and transaction report made by an access person, including any information in lieu of such reports;
  • A record of the names of persons who are currently, or within the past five years were, access persons; and
  • A record of any decision, and the reasons supporting the decision, to approve the access personsí acquisition of IPOs or private placements for at least five years after the end of the fiscal year in which the approval is granted.

The documents must be kept in an easily accessible place for five years from the end of the fiscal year in which the last entry was made on the record, the first two years in an appropriate office of the adviser. There are three exceptions to this general rule:

  • Codes must be kept for five years after the last date they were in effect.
  • Supervised person acknowledgements must be kept for five years after the individual ceases to be a supervised person.
  • The list of access persons must include every person who was an access person at any time within the past five years, even if some of them are no longer access persons of the adviser.

Reports made by whistleblowers do not need to be kept.

The old recordkeeping requirements in Rule 204-2(a)(12) and (13) remain in effect until an adviser complies with the new requirements.

Good news: the SEC did not ultimately require advisers to keep holdings and transaction information electronically in a database, as had been proposed. However, it stated that "we have strong expectations that most advisers will need to maintain these records electronically in order to meet their responsibilities to review these records and monitor compliance with their codes." The SEC warned that it would "question seriously whether a larger investment advisory firm will be able adequately to review such reports manually or on paper."

Next week: Form ADV disclosure, and practionersí perspectives.