SEC Staff Recommends That Advisers' Code of Ethics Cover All Open-End ETFs
A no-action letter recently issued to consulting firm National Compliance Services is causing some waves. In it, the staff of the SECís Division of Investment Management confirmed that ETFs organized as UITs are reportable securities, subject to reporting in access personsí holdings and transaction reports. No news there.
However, the staff went on to recommend that advisers consider treating all open-end ETFs as reportable securities under their codes of ethics, even though not technically not required by Rule 204A-1, the code of ethics rule.
Thatís the part that people are jazzed up about.
Under the rule, an adviserís code must treat shares in the following types of ETFs as reportable securities:
ETFs organized as UITs (unless, under a narrow exclusion designed for variable insurance products, the UIT is invested only in unaffiliated open-end funds);
ETFs organized as open-end funds, but only if the adviser formally serves as the fundís adviser, or if the fundís adviser or principal underwriter is in a control relationship with the adviser; and
ETFs organized as closed-end funds.
On the flip side, advisersí codes are not required to cover shares in ETFs that are organized as open-end funds not affiliated with the adviser.
Those positions are pretty well settled, particularly since the SEC staff seems to have made a concerted effort to spread the word at conferences about which types of ETFs are in and which types are out.
Still, NCS made a run at the UIT issue, asking whether an adviser could exclude ETFs organized as UITs from the definition of reportable securities in its code.
Not surprisingly, the staff turned them down. "[W]e believe that the purchase and sale by access persons of UIT ETF shares in the secondary market ó as with any market traded security ó presents the opportunity" for the types of conflicts the rule was intended to reveal, said the staff.
However, the staff went on to recommend that advisers "consider treating open-end ETF shares as Reportable Securities." (The staff made a similar recommendation under Investment Company Act Rule 17j-1.) While acknowledging that shares of open-end funds typically "present little opportunity" for the type of improper trading that the code of ethics rule was intended to cover, the staff asserted that open-end ETFs present the same sort of concerns as UIT ETFs, "because both types of shares are purchased and sold in the secondary market at a negotiated price, unlike traditional open-end funds."
The staff noted that advisers might want to treat open-end ETFs as reportable securities because "it may be difficult for their access persons to determine whether an ETF is an open-end ETF or a UIT ETF." And, the staff pointed out, the SECís code of ethics adopting release stated that Rule 204A-1 established "only a minimum requirement" for an adviserís code.
Does that mean you have to go back and revise your code to pick up open-end ETFs as reportable securities?
First of all, keep in mind that the staffís recommendation is just that ó a staff-level recommendation. If youíve been paying close attention, youíll know that itís really nothing different than what SEC staffers have been saying at speeches over the past year. For example, at one conference last winter, Jennifer McHugh, a senior advisor in the SECís Division of Investment Management, noted that since most advisory firm employees canít tell simply by looking at the name of an ETF whether itís organized as a UIT or an open-end fund, 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" (IM Insight, March 11, 2005).
On the other hand, the recommendation, now that itís in writing, could create a presumed best practice ó at least in the minds of SEC examiners. "I think weíre going to recommend to our clients that they do it," said Adviser Compliance Associates partner Barry Schwartz (IM Insight is owned by ACA). "We think the examiners are going to wind up in tune to it." Schwartz predicted that examiners are going to ask firms that do not require reporting of all open-end ETFs why they donít. "Not that itís wrong not to," he added. "But why raise an issue where there doesnít have to be one?"
The good news: broadening a code of ethics to cover reporting of all ETFs may not involve significant on-the-ground changes. "If, practically speaking, people are using brokerage statements to report their quarterly transactions ó and that still remains the overwhelming trend in the industry ó it isnít really so bad to add it into the code of ethics," Schwartz said.
Moreover, from a practical perspective, covering all ETFs alleviates the problem of access persons trying to determine which ETFs are covered by their firmís code and which arenít. Even assuming that an access person knows whether a particular ETF is organized as an open-end fund or a UIT, thereís the secondary question of whether the open-end ETF is affiliated with the firm or its control affiliates. While access persons at stand-alone RIC advisers may have a clear idea of which open-end ETFs technically are reportable securities, said Schwartz, some RIC advisers are part of larger organizations with many control affiliates. It may not be clear to some access persons, particularly administrative employees, "how far the scope of their organizations" can go, he said.