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News January 2, 2006 Issue

Survey: Most Firms Do Not Use Personal Trading Data for Forensic Tests

Unlike the old days, where there was no explicit requirement that advisers actually do anything with their employeesí personal trading reports, the recently-revised Advisers Act code of ethics rule now affirmatively requires advisers to review the annual holdings and quarterly transaction reports required to be submitted under the rule.

According to the SEC, an adviser "should":

  • review access personsí personal trading for compliance with internal firm procedures (compliance with applicable pre-clearance requirements, etc.);
  • compare access personsí personal trading to any restricted lists maintained by the firm;
  • assess whether any 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;
  • periodically analyze access personsí trading for patterns that may indicate abuse;
  • investigate any substantial disparities between the quality of performance that an access person achieves for his own account and the performance that he achieves for clients; and
  • investigate 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.

Are firms following the SECís guidance?

Yes and no: Most firms seem to hit the first two bullets. But relatively few firms make it all the way down the list.

Thatís one of the findings of the industry compliance testing survey recently conducted by compliance professional Amy Yuter, consulting firm Adviser Compliance Associates, and IM Insight. According to the survey, the typical firm tests to ensure compliance with the four squares of the code of ethics rule and the firmís specific code of ethics requirements (reporting, pre-clearance, etc.). However, the typical firm does not mine the personal trading data collected in its access personsí holdings and transaction reports to conduct "forensic" tests to reveal patterns of abusive trading.

Testing for compliance with the rule and code. Of the 54 compliance officers and in-house lawyers who participated in the survey, most (73 percent) said that they compare information on employeesí confirm and account statements to information submitted on the employeesí holdings and transaction reports. This, of course, would validate that access persons are correctly reporting holdings and transactions, as required by the code of ethics rule.

Most firms (67 percent) compare access personsí pre-approval forms with their executed personal trades, which would confirm that employees are complying with applicable pre-clearance requirements.

A majority of firms (62 percent) review their list of access persons and confirm that all new employees are aware of their reporting obligations. A similar number of firms (58 percent) determine which access persons did not timely file their holdings and transaction reports. About a third sample employeesí trades and review each trade in the sample for compliance with applicable code of ethics restrictions (e.g., blackout periods, pre-clearance, etc.).

Looking for trends. Based on the survey, it appears that many firms are not conducting "forensic" tests using personal trading data to reveal trends over time that indicate nefarious activity. Only half of the respondents reported that they manually compared personal trades to client trades. Only two firms said they used an automated system to compare personal trades to client trades.

More significantly, despite the SECís recommendations, less than half (40 percent) of the survey respondents reported that they check employeesí trading patterns over time. And only five firms (11 percent) said that they used back-end tests to determine whether employeesí trades should have been offered to clients.

Perhaps most surprising: Only two firms (4 percent) compared performance of personal accounts to performance of client accounts.

Automation key to forensic testing. Why arenít more advisers slicing and dicing their access personsí personal trading data?

Lack of automation.

As you may recall, when the SEC adopted the Advisers Act code of ethics rule, it decided not to require advisers to maintain personal trading records in an electronic database, as it had initially proposed. However, in the adopting release, the SEC cautioned that it would "question seriously whether a larger investment advisory firm will be able adequately to review such reports manually or on paper."

According to the survey results, the SECís warning seems to have been spot on. Survey respondents resoundingly said that most significant way of improving their firmís code of ethics testing would be to automate the process of comparing personal trades against trades executed for clients. "Automation would significantly help the process," said one respondent. "We need more automated processes rather than manual," said another. "Some sort of electronic review would be helpful," said a third. Another respondent said that his firm would benefit from more automated tests, but noted that the firmís small size and lack of IT professionals limited the firmís ability to create exception reports and other tests. Other respondents expressed similar views.

Other items of note:

  • Nearly all of the firms reported that they test personal trading on a quarterly basis (71 percent). Seven firms (16 percent) said that they test on a monthly basis.
  • Most advisers reported that their employees are permitted to engage in personal trading through any broker (73 percent). However, nine firms (20 percent) reported that their employees are permitted to trade only at certain specified brokers that supplied the advisory firm with copies of statements and confirms. One respondent in the former category said that his firmís code of ethics could be improved by limiting employees to opening brokerage accounts only with certain brokers. "Allowing usage of any broker seems too liberal to me," said the respondent.
  • Eight firms reported that they hired a third-party firm to test personal trading (18 percent).
  • Only four firms (9 percent) reported that they tested to identify whether their employees had any unreported brokerage accounts. The vast majority (91 percent) reported that they did not test this area. 
  • Interestingly, two firms (4 percent) said that they did not test personal trading. One of those firms explained that it was a small shop with fewer than twelve employees, all of whom engage in daily communication. "Any areas of concern that arise are handled as necessary and addressed by the CCO and/or principals as appropriate," said the respondent.
  • Three firms (7 percent) said that they did not allow their employees to engage in any personal trading.