SEC Proposes Written Code of Ethics

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Winter 2004 issue of The Investment Adviser s Counsel. Reprinted by permission. Kenneth L.

1 By Kenneth L. Greenberg Click the image to view our investment management capabilities This article was first published in the Winter 2004 issue of The Investment Adviser s Counsel. Reprinted by permission. Kenneth L. Greenberg Drinker Biddle & Reath LLP Philadelphia, PA (fax) Kenneth.Greenberg@dbr.com Philadelphia New York Washington Los Angeles San Francisco Princeton Florham Park Berwyn Wilmington

2 O n January 20, 2004, the SEC proposed a new rule under the Investment Advisers Act of 1940 ( IAA ) that will require all SEC-registered IAs to adopt written codes of ethics. (Release Nos. IA-2209, IC-26337). The proposed codes of ethics would be required to contain both general standards to reinforce fiduciary principles and specific provisions to address personal trading issues. The proposed personal trading requirements are similar to the existing requirements for IAs to registered investment companies under Rule 17j-1 of the Investment Company Act of 1940 (the 1940 Act ). --- CODES OF ETHICS --- Under proposed Rule 204A-1, IAs would be required to adopt codes of ethics that would take into consideration the nature of their advisory businesses. In addition to this broad requirement, the proposed rule will require that the codes contain provisions for a standard of conduct, compliance with federal securities laws and protection of material nonpublic information. Standards of Conduct and Compliance with Laws Each code of ethics must set forth a standard of business conduct that the IA requires of all its supervised persons (i.e., partners, directors, officers, employees and anyone providing investment advice on behalf of the IA that is subject to the supervision and control of the IA). This standard must reflect the IA s fiduciary obligations and those of its supervised persons, and must require compliance with the federal securities laws. For purposes of this rule, federal securities laws means the Securities Act of 1933, the Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002, the 1940 Act, IAA, Title V of the Gramm-Leach-Bliley Act (privacy), the Bank Secrecy Act as it applies to funds and investment advisers (anti-money laundering) and any rules adopted under these statutes. Protection of Material Nonpublic Information The proposed codes of ethics must have procedures reasonably designed to prevent access to material nonpublic information about the IA s securities recommendations, client securities holdings and transactions. The proposed rule would require IAs to restrict access to client information on a need to know basis. IAs would be allowed to provide necessary information to service providers such as brokers, accountants, custodians, and transfer agents. --- PERSONAL SECURITIES TRADING --- To prevent harm to client assets as a result of the personal securities trading of an IAs supervised persons, each IA s code of ethics would require access persons to report holdings and trades for securities in which they have beneficial ownership. Persons who have access to nonpublic information regarding clients purchases or sales of securities, or those involved in making securities recommendations to clients or who have access to such recommendations that are nonpublic are access persons. 2

3 Access persons would include portfolio managers. In some organizations, they might also include client service, administrative, technical, and clerical personnel where their duties make them privy to nonpublic client information. According to the SEC s release, employees of other organizations, including affiliated organizations such as broker-dealers, custodians, and banks that may acquire information about client securities transactions in the course of their duties, would not be subject to reporting requirements. If the IA s primary business is providing investment advice, then all of its directors, officers, and partners are presumed to be access persons. If the firm has another primary business, then a director, officer, or partner would only be an access person if the individual has access to nonpublic client information. Exempt Securities The following securities would be exempt from the reporting requirements: shares of money market funds; shares of open-end mutual funds, except for affiliated funds (see Reportable Mutual Funds below); bankers acceptances; bank certificates of deposit; commercial paper; and repurchase agreements and other high quality short-term debt instruments and direct obligations of the Government of the United States Reportable Mutual Funds Under the proposed rule, access persons must report holdings and transactions in affiliated or reportable funds. A fund is a reportable fund if the IA acts as investment adviser to the fund; or if persons who control the IA, who are controlled by the IA, or who are under common control with the IA serve as either investment adviser or principal underwriter to the fund. Currently, Rule 17j-1 excludes all open-end mutual fund shares, even affiliated funds from the reporting requirements because the SEC previously believed that trading in mutual funds present[ed] very little opportunity for the type of improper trading that the rule is intended to cover. This proposal to include reportable mutual funds in the reporting requirements is an SEC response to recent enforcement actions against portfolio managers who market-timed their own funds. Initial and Annual Holdings Reports The proposed rule will require access persons to report their securities holdings ten days after the person becomes an access person and at least once a year thereafter. 3

4 Quarterly Transaction Reports Access persons will be required to report their personal securities trades to the chief compliance officer within ten days after the end of each calendar quarter. If an access person made no reportable trades during a quarter, the access person would file a report indicating that there were no trades. Access persons would not need to report trades effected pursuant to an automatic investment plan unless that access person overrides the pre-set schedule or allocations of the plan. The proposed rule would not require access persons to submit transaction reports if the IA receives duplicate trade confirmations or account statements that contain the required information. Although quarterly transaction reports are an existing requirement under the IAA rules, the proposed rule would also require the IA to keep the reports in an electronic database. (See Recordkeeping below.) IPOs and Private Placements The code of ethics must require that access persons obtain prior written approval ( preclearance ) before trading in initial public offerings ( IPOs ) or private placements. This requirement is intended to prevent the misappropriation of investment opportunities that should first be offered to eligible clients and to prevent portfolio managers from receiving personal benefits for directing client business or brokerage. Recommended Best Practices In its release, the SEC listed the following best practice procedures it believes all IAs should consider including in their personal trading procedures, but stopped short of proposing that these procedures be required: Pre-clearance before access persons can make a personal trade. Maintenance of restricted lists of securities that the IA firm is analyzing or recommending for clients, and prohibitions on personal trading in those securities. Blackout periods when client trades are being placed or recommendations are being made and access persons are not permitted to make personal trades. Procedures to ensure that investment opportunities are offered to clients before the IA or its supervised persons. Prohibitions or restrictions on short-swing trading and market timing. Requirements to trade only through certain brokers, or limitations on the number of brokerage accounts. Requirements to provide the IA with duplicate trade confirmations and account statements. Procedures for assigning new securities analyses to supervised persons whose personal holdings do not present apparent conflicts of interest. 4

5 --- CODE OF ETHICS ENFORCEMENT --- The code of ethics will require IAs to provide each supervised person with a copy of the code of ethics and any amendments, and require each supervised person to acknowledge its receipt in writing. The code of ethics must also require the IA s supervised persons to promptly report violations of the code to the IA s chief compliance officer or to another employee designated in the code of ethics. In addition, the proposed rule would require IA s to maintain and enforce the provisions of their codes of ethics. Enforcement of the code would include reviewing the access persons securities holdings and transaction reports. According to the release, the SEC expects that responsibility for enforcing the code of ethics will lie substantially with the IA s chief compliance officer. --- OTHER PROPOSED CHANGES --- Recordkeeping: The SEC also proposed amendments to Rule Under the amendments, an IA must maintain copies of: the code of ethics; supervised persons written acknowledgments of receipt of the code; records of violations of the code, records of action taken as a result of violations; a record of the names of their access persons; holdings and transaction reports made by access persons; and records of decisions approving access persons acquisitions of securities in IPOs and private placements. IAs must keep these records in an easily accessible place for five years, the first two years in an office of the IA. The SEC has also proposed a requirement that IAs keep records of access persons personal securities reports, or duplicate brokerage confirmations or account statements in lieu of those reports, electronically in an accessible computer database. IAs must arrange and index the records in a way that permits easy location, access and retrieval of any particular record. The SEC suggested that small IAs might be able to keep the data in a spreadsheet and that larger IAs may use their portfolio analysis programs to track supervised person trades. Form ADV: A proposed amendment to Form ADV, Part II, Item 9 will require IAs to describe their codes of ethics and provide a statement that they will give clients a copy of the code upon request. Investment Company Advisers Rule 17j-1: These proposed reporting requirements under the IAA are not identical to the existing rules under Rule 17j-1. For uniformity, the SEC has proposed to revise Rule 17j-1 to read that no report would be required under rule 17j-1 to the extent that the report would duplicate information required under the IAA recordkeeping rules. 5

6 IAs to investment companies may require each access person to provide one report that covers all information required under both rules. For example, an access person s quarterly report could be required to include information on new securities accounts (Rule 17j-1 requirement) along with trades in reportable funds (a proposed requirement under the IAA). --- COMMENTS RECEIVED --- The SEC received thirty-four comments on this proposal (which were due on March 15, 2004). Many commenters, including the Investment Company Institute ( ICI ), The National Society of Compliance Professionals, The Investment Counsel Association of America, and the Securities Industry Association were concerned that requiring advisers to maintain records of access persons securities reports in an electronic database would be too burdensome and costly for most IAs. Commenters noted that most broker-dealers do not provide account statements and trade confirmations in a format that can be readily integrated into an electronic database and that the broker-dealer rules do not require them to be sent in an electronic format. Several commenters also expressed concern that the need to know procedure regarding material nonpublic information would be too restrictive. The ICI recommended that the SEC simply require that the code of ethics be reasonably designed to prevent misuse of material nonpublic information. * * * Kenneth L. Greenberg is a partner in the Investment Management Group of Drinker Biddle & Reath LLP, a full service law firm of more than 450 lawyers that was founded in Loretta E. Wise, an associate in the Group, assisted with preparation of this article. One Logan Square 18 th & Cherry Streets Philadelphia, PA (fax) Kenneth.Greenberg@dbr.com Philadelphia New York Washington Los Angeles San Francisco Princeton Florham Park Berwyn Wilmington 2004 Drinker Biddle & Reath LLP, a Pennsylvania limited liability partnership. All rights reserved. This discussion is not intended to constitute legal advice regarding any client s legal problems or specific questions and should not be relied upon as such. 6

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