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News August 2, 2004 Issue

More Highlights from the New Code of Ethics Rule and the ICAA’s Best Practices

A few more odds and ends:

Are ETFs Reportable Securities? [Ed. note: This section was revised 1/18/2005:] Technically, ETFs are organized either as open-end funds or unit investment trusts (UITs). To end investors, however, they look and smell like closed-end funds.

Which leads to the question of how ETFs should be treated for purposes of access persons’ personal trading reports. Under new Rule 204A-1, holdings and transactions in closed-end fund shares are reportable, as are those in affiliated open-end funds. Holdings and transactions in unaffiliated open-end funds aren’t reportable.

What about UITs? The general rule under Rule 204A-1 is that all UITs are reportable whether they are affiliated or unaffiliated. There's a special exception for UITs that are invested exclusively in open-end funds that are not "reportable funds." ETFs that are UITs, however, generally do not meet this requirement, we're told. 

The upshot: the SEC did not address the status of ETFs in the Rule 204A-1 proposing or adopting releases. Nor has the question been addressed in the fund context, under Rule 17j-1. There may be some guidance coming down the pike from the SEC staff, but until then, the conservative course is to treat ETFs as reported securities (which some advisers are doing). 

In the Family Way. Put yourself, for a moment, in the shoes of your hypothetical rogue employee. You’ve decided you want to buy XYZ Co. stock for yourself, because you know that in a day or two, your firm is going to begin a program of buying XYZ for clients. But you also know your firm’s compliance department is watching your personal securities accounts like a hawk.

"Ha!" you say to yourself deviously. "I’ll just tell my spouse to buy XYZ in his/her brokerage account! They’ll never find it there!"

New Rule 204A-1 addresses such deviousness by requiring access persons to report holdings and transactions in shares that are owned by immediate family members sharing the same household as the access person. If that’s news to you, it shouldn’t be: the new rule, like old Rule 204-2(a)(12) and (13), cross-references the Exchange Act beneficial ownership rule that says that a person is a beneficial owner of shares "held by members of a person’s immediate family sharing the same household" (that presumption can be rebutted).

But what if the hypothetical rogue employee is more devious than we thought? What if he decides to have his non-immediate relatives buy XYZ stock in their brokerage accounts? Or to have his immediate relatives, who live clear across town, buy XYZ?

The ICAA’s Best Practices would pick this up. The group recommends that an adviser’s code define terms such as "employee," "account," "supervised person," and "access person" in a way that they include:

  • the person’s immediate family (regardless of where they live);
  • any relative by blood or marriage living in the employee’s household; and
  • any account in which the person has a direct or indirect beneficial interest, such as a trust.

The group also noted that some advisers include any individuals living in the employee’s household, regardless of whether they are related (i.e., the nanny).

The ICAA also noted that advisers may wish to consider whether the scope of their code provisions, other than those related to personal securities transactions, should extend beyond employees to their family members.

"People are looking at the Wall Street Journal factor," explained ICAA general counsel Karen Barr. Even if technically you’re not required to report a transaction under the rule, "how would it look if your aunt who lives with you, but who is not your immediate family member, buys a security before you submit a big block?" she asked. "People are looking at the spirit of the rules."

Incidentally, the broad definition of beneficial ownership means that under Rule 204A-1, access persons must obtain preclearance before their immediate family members living in the same household invest in IPOs or private placements.

Treating Clients Fairly. It’s Fiduciary Duty 101: Treat clients fairly.

That’s definitely a goal to strive for. The reality, however, is that advisers constantly are called upon to make decisions about which client to treat better. Every time an adviser picks up the phone to check on one of his clients, he is, in effect, favoring a client.

So: instead of putting a flat admonition to "treat all clients fairly" in your firm’s code of ethics, consider this elegant approach suggested by the ICAA’s Best Practices: the code should "specifically prohibit inappropriate favoritism of one client over another client that would constitute a breach of fiduciary duty."

The ICAA recommended that advisers include in the code or elsewhere procedures designed to address such conflicts. Some examples: IPO allocation procedures and procedures designed to guard against conflicts when managing hedge funds and mutual funds side by side. The ICAA highlighted other situations where an adviser or its supervised persons might have reason to favor the interests of one client over another:

  • large over small accounts;
  • performance fee over non-performance fee accounts;
  • personal accounts (including accounts where firm employees have made material personal investments) over purely client accounts; and
  • friends and family accounts over other accounts.

Influence or Control Over Discretionary Accounts. The new rule states that an access person does not have to report holdings or transactions in accounts over which the access person has no "direct or indirect influence or control."

Does that include a discretionary advisory or brokerage account?

It could. According to Barr, some advisers’ codes allow discretionary accounts to be excluded from the reporting requirements, but only if the access person has agreed, in writing, that he will not provide any instruction or attempt to exert any direct or indirect influence or control over the way in which the account is managed. This "exclusion letter" should go to the access person’s employer as well as adviser, she noted. "Not only do you tell your employer you’re not going to do it, you have to tell the adviser who manages your account that you’re not going to do it," explained Barr. General investment guidelines and restrictions would not seem to fall into this category, particularly those issued at account inception.

What if the access person opens the discretionary account at his own employer? As long as he is not part of the team that manages his account, and has no direct or indirect influence or control over his account, it would seem that he would not have to report holdings or transactions in it. That’s a change from old Rule 204-2, which allowed advisory representatives to carve out only those accounts over which neither the adviser nor any advisory representative of the adviser had any direct or indirect influence or control.

"As Applicable." Rule 204A-1 lists the categories of information required to be provided on an access person’s holding and transaction reports. Stuck in midway through those lists: the phrase "as applicable."

Hmmm . . . what does that "as applicable" modify, exactly?

On the holdings report, the following information must be provided "as applicable":

  • exchange ticker symbol or CUSIP number;
  • number of shares; and
  • principal amount.

On the transaction report, the following information must be provided "as applicable":

  • exchange ticker symbol or CUSIP number;
  • interest rate and maturity date;
  • number of shares; and
  • principal amount.

This, of course, makes sense: If the share does not have a CUSIP number, there’s no need to report it. If the security is not a fixed income or OTC security, there’s no need to report a principal amount, etc. (Note: The electronic versions of the IM Insight model forms have been revised to reflect this clarification (IM Insight, July 12, 2004)).