Code of Ethics and Personal Trading

Transcription

1 P R E P A R E D F O R F R A H e d g e F u n d R e g u l a t i o n a n d C o m p l i a n c e F o r u m By Terrance J. O Malley November 30, 2006 Code of Ethics and Personal Trading Rule 204A-1 under the Advisers Act requires a registered investment adviser to establish, maintain and enforce a written code of ethics. This outline reviews the required contents for a registered adviser s written code of ethics and also highlights a number of open issues that typically need to be considered and resolved. A. Minimum Requirements 1. Standard of Conduct. A registered investment adviser s code of ethics must include a standard (or standards) of business conduct that the adviser requires of its supervised persons, and the standard must reflect the adviser s fiduciary obligations and those of its supervised persons. Open Issue: The adopting release for Rule 204A-1 mentions that advisers are free to set higher standards for their employees, such as those established by professional or trade groups. The release mentions that certain professional trade groups have established professional codes which may set forth higher standards. What standard is higher than that of a fiduciary and why might an adviser impose a higher standard on itself? 2. Compliance with Applicable Federal Securities Laws A registered investment adviser s code of ethics must include provisions requiring the adviser s supervised persons to comply with applicable federal securities laws. Rule 204A-1(e)(4) defines federal securities laws to mean the Securities Act of 1933, the Securities Exchange Act of 1934, the Sarbanes- Oxley Act of 2002, the Investment Company Act of 1940, the Investment Advisers Act of 1940, Title V of the Gramm-Leach-Bliley Act, any rules adopted by the Commission under any of these statutes, the Bank Terrance J. O Malley is a partner in the Asset Management Group at Fried, Frank, Harris, Shriver & Jacobson LLP, where he specializes in providing regulatory advice to hedge fund managers. Copyright 2006 Fried, Frank, Harris, Shriver & Jacobson LLP A Delaware Limited Liability Partnership

2 Secrecy Act as it applies to funds and investment advisers, and any rules adopted thereunder by the Commission or the Department of the Treasury. Open Issue: Neither the rule nor the adopting release suggest how and to what extent the federal securities laws are applicable to a registered adviser. Accordingly, should an adviser s code attempt to enumerate all applicable federal securities laws and the way in which each one might apply to the adviser and its personnel? 3. Personal Trading Reports A registered investment adviser s code of ethics must require all of its access persons to report, and for the adviser to review, their personal securities transactions and holdings periodically. This requirement is discussed in greater detail below. 4. Reporting Violations A registered investment adviser s code of ethics must require supervised persons to report any violations of the code promptly to the adviser s chief compliance officer or, provided the chief compliance officer also receives reports of all violations, to other persons the adviser designates in the code. Open Issue: Should personnel be required to report all violations or can there be some discretion for reporting only material violations? Should it depend on the type of violation? Open Issue: The adopting release suggests that an investment adviser can choose to have its personnel report violations to either the chief compliance officer or to other persons designated in the code of ethics. The adopting release adds, however, that if an adviser designates someone other than the chief compliance officer to receive reports violations, there must be procedures requiring that the chief compliance officer also receive reports periodically of all violations. Under what circumstances might an adviser have the violations reported to someone other than the chief compliance officer? Open Issue: The adopting release cautions that advisers should create an environment that encourages and protects personnel who report violations. The adopting release suggests that advisers should consider allowing anonymous reporting, provide that retaliation constitutes a further violation of the code, or find other methods to ensure that personnel feel safe to speak freely. How should an adviser encourage the reporting of violations? 5. Distribution and Certification A registered investment adviser s code of ethics must require that the adviser provide each of its supervised persons with a copy of its code of ethics and any amendments, and require its supervised 2

3 persons to provide the adviser with a written acknowledgment of their receipt of the code and any amendments. Open Issue: Should an adviser distribute a copy of, and get acknowledgements for, every change or just material changes? Open Issue: Can adviser use s to get written acknowledgements? Is this a practical approach? Open Issue: Assuming that the adviser makes no changes to its code, should it nevertheless distribute its code of ethics once a year and get written acknowledgments? B. Persons Covered by the Code of Ethics As a practical matter, an adviser s code of ethics must cover all of its supervised persons. Although the Code of Ethics rule does not define the term supervised person, Section 202(a)(25) of the Advisers Act defines the term to mean: any partner, officer, director (or other person occupying a similar status or performing similar functions), or employee of an investment adviser, or other person who provides investment advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser. Open Issue: How should the adviser treat certain person who may not be employees, but otherwise provide services on behalf of the adviser or occupy space in the adviser s offices such, as (a) consultants (both short-term and long-term) or (b) other investment advisers. How should the adviser treat interns? C. Personal Trading As noted above, a registered adviser s code of ethics must require an adviser's "access persons" to periodically report their personal securities transactions and holdings to the adviser's chief compliance officer or other designated persons. The code must also require the adviser to review those reports. 1. Prohibition on Personal Trading As a threshold matter, the adopting release notes that Rule 204A-1 rule does not prohibit or restrict personal securities transactions by access persons, but requires only that they report their personal securities trading and holdings. Open Issue: Should an adviser include a blanket prohibition on personal trading? Alternatively, should an adviser prohibit trading in certain sectors or in certain types of securities, such as securities in which the adviser s funds are likely to invest? 3

4 2. The Definition of an Access Person Rule 204A-1(e)(1) defines an access person to mean any of the adviser s supervised persons: [w]ho has access to nonpublic information regarding any clients' purchase or sale of securities, or nonpublic information regarding the portfolio holdings of any reportable fund, or [w]ho is involved in making securities recommendations to clients, or who has access to such recommendations that are nonpublic. The definition also notes that [i]f providing investment advice is [the adviser s] primary business, all of [the adviser s] directors, officers and partners are presumed to be access persons. Open Issue: Should an adviser attempt to make distinctions between access persons and nonaccess persons, or just apply the reporting requirements to all supervised persons? If an adviser chooses to make the distinction, what standard should it use and how should it track or periodically review the designations? Open Issue: How can a director, officer or partner rebut the presumption that he or she is an access person? Are there factors that might be helpful in rebutting the presumption? (See Mackenzie Investment Management, Inc., SEC No-Action Letter (Aug. 8, 2000) providing limited relief under Rule 17j-1 under the Investment Company Act only to an adviser s independent directors. ) 3. Initial and Annual Holdings Reports A registered adviser s code of ethics must require each of its access persons to submit to the chief compliance officer or other designated persons a report of the access person's current securities holdings. The report must contain generally: (i) the title and type of security, and as applicable the exchange ticker symbol or CUSIP number, number of shares, and principal amount of each reportable security in which the access person has any direct or indirect beneficial ownership; (ii) the name of any broker, dealer or bank with which the access person maintains an account in which any securities are held for the access person's direct or indirect benefit; and (iii) the date the access person submits the report. Open Issue: How does an adviser interpret beneficial ownership? Rule 204A-1(e)(3) references Rule 16a-1(a)(2) of the Exchange Act, which covers spouses and certain other family relationships. How does an adviser convince an access person to submit reports covering the holdings of spouses and other family members? How should an adviser treat accounts managed by a spouse employed by another investment adviser? Open Issue: Does an adviser have an affirmative obligation to verify the information provided by its access persons? 4

5 4. Quarterly Transaction Reports A registered adviser s code of ethics must require each of its access persons to submit to the chief compliance officer or other designated persons quarterly securities transactions reports. The reports must generally contain the following information about each transaction involving a reportable security in which the access person had, or as a result of the transaction acquired, any direct or indirect beneficial ownership: (i) the date of the transaction, the title, and as applicable the exchange ticker symbol or CUSIP number, interest rate and maturity date, number of shares, and principal amount of each reportable security involved; (ii) the nature of the transaction (i.e., purchase, sale or any other type of acquisition or disposition); (iii) the price of the security at which the transaction was effected; (iv) the name of the broker, dealer or bank with or through which the transaction was effected; and (v) the date the access person submits the report. Open Issue: The SEC considered, but decided not to adopt a requirement for access persons that had no personal securities transactions during the quarter to submit a report confirming the absence of transactions. Should an adviser nevertheless require negative reports in the event that an access person did not have any personal trades during the reporting period? 5. Timing of Reports An initial holdings report must be submitted no later than 10 days after a person becomes an access person, and the information must be current as of a date no more than 45 days prior to the date the person becomes an access person. The annual holdings report must be submitted at least once each 12-month period thereafter on a date selected by the adviser, and the information must be current as of a date no more than 45 days prior to the date the report was submitted. Quarterly transaction reports must be submitted no later than 30 days after the end of each calendar quarter, and must cover, at a minimum, all transactions during the quarter. Open Issue: What procedures should an adviser adopt to confirm the timeliness of required reports? 6. Substitute Brokerage Statements Rule 204A-1(b)(3)(iii) provides an exemption for a transaction report if the report would duplicate information contained in broker trade confirmations or account statements that the adviser obtains, provided the adviser receives the confirmations or statements no later than 30 days after the end of the applicable calendar quarter. Open Issue: Can brokerage statements also be used to satisfy the initial and annual holdings report requirements? Note that the adopting release states that access person cannot avoid filing an initial or annual holdings report merely because all information has been provided over a period of time in 5

6 various transaction reports. The SEC believes that the holdings report is intended to provide a "snapshot" of an access person's holdings, which would not be achieved through piecing together information from transaction reports. Nevertheless, it seems as though a year-end brokerage statement could provide such a snapshot assuming that an access person does not have too many personal accounts. 7. Exempt Accounts Rule 204A-1(b)(ii) provides a reporting exemption with respect to securities held in accounts over which an access person had no direct or indirect influence or control. Open Issue: Does direct or indirect influence or control limit exempt accounts only to blind trusts or can some other types of accounts also be excluded, such as accounts where discretion has been turned over to a third party money manager? 8. Exempt Securities Rule 204A-1 requires an access person to provide information only about reportable securities. This term is defined to exclude, among other types of securities shares issued by open-end funds other than reportable funds, but also excludes only shares issued by unit investment trusts that are invested exclusively in one or more open-end funds, none of which are reportable funds. Open Issue: Should an adviser require its access persons to report all ETFs? Some ETFs are organized as open-end funds (which are not reportable), while others are organized as UITs (which are reportable). The SEC staff has suggested that all ETFs should be reported, regardless of their form of organization. See National Compliance Services, Inc., SEC No-Action Letter (Nov. 30, 2005). D. Pre-Approval 1. Initial Public Offerings and Private Placements A registered adviser s code of ethics must require each of its access persons to obtain the adviser s approval before directly or indirectly acquiring beneficial ownership in any security in an initial public offering or in a limited offering (i.e., a private placement). In addition, an adviser must maintain a record of any decision, and the reasons supporting the decision, to approve the acquisition of an IPO or private placement. Open Issue: What factors should an adviser consider in deciding whether to grant approval for the acquisition of an IPO or private placement? The adopting release notes that most individuals rarely have the opportunity to invest in IPOs and private placements and that these opportunities raise questions as to whether the employee is misappropriating an investment opportunity that should first be offered to eligible clients, or whether a portfolio manager is receiving a personal benefit for directing client business or brokerage. 6

7 Open Issue: Should the pre-approval remain valid on the day when granted or could the approval remain valid for some longer period of time? Open Issue: Is an access person required to obtain pre-approval for IPOs issued outside the United States? 2. Other Types of Securities An adviser s code of ethics does not need to require each of its access persons to obtain preapproval for trades in other types of securities. However, the adopting release notes that some advisers choose to require pre-approval for all trades or certain types of transactions. Open Issue: Should an adviser require pre-approval for additional types of securities? Open Issue: If an adviser requires pre-approval for all securities transactions, should it also include certain exceptions. For instance, the following types of securities transactions likely should be exempt: (i) transactions in which an access person has no direct or indirect influence or control; (ii) transactions pursuant to an automatic investment plan; (iii) purchases effected upon the exercise of rights issued by an issuer pro rata to all holders of a class of its securities; and (iv) acquisitions of securities through stock dividends, stock splits, reverse stock splits, mergers, consolidations, spin-offs, and other similar corporate reorganizations. E. Other Personal Trading Policies and Procedures 1. SEC Suggested Items The adopting release suggests that many advisers include the following additional elements, or address the following issues, in their codes of ethics: Maintenance of lists of issuers of securities that the advisory firm is analyzing or recommending for client transactions, and prohibitions on personal trading in securities of those issuers. Maintenance of "restricted lists" of issuers about which the advisory firm has inside information, and prohibitions on any trading (personal or for clients) in securities of those issuers. "Blackout periods" when client securities trades are being placed or recommendations are being made and access persons are not permitted to place personal securities transactions. 7

8 Reminders that investment opportunities must be offered first to clients before the adviser or its employees may act on them, and procedures to implement this principle. 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 permitted. Procedures for assigning new securities analyses to employees whose personal holdings do not present apparent conflicts of interest. Open Issue: Should an adviser consider combining its insider trading policies and procedures with its code of ethics, which might incorporate watch and restricted lists? Open Issue: If an adviser imposes blackout periods, how should they be implemented. For instance, how can an adviser monitor personal trades that occur one or more days prior to a client trade? Should an adviser require an employee to break a trade, and if so, how should any profits be applied? Open Issue: Should an adviser require minimum hold periods? If so, how long should the minimum hold period last? Open Issue: Should an adviser require its personnel to maintain accounts at only one or a few brokerage firms? 2. Prohibitions on Certain Types of Transactions Some advisers include in their codes of ethics restrictions on additional types of transactions, including trading on margin, engaging in short sales, engaging in options and futures, and placing limit orders. Open Issue: How should any additional restrictions and prohibitions be implement? 3. Conflicts of Interest The SEC has frequently stressed the need for advisers to identify and monitor conflicts of interest, which might include where a supervised person has a personal stake in issuers whose securities the adviser might buy or sell for client accounts, or where a trader or portfolio manager has a relative who works at a brokerage firm that executes the firm s transactions. Open Issue: How should an adviser monitor potential conflicts? Should it require its personnel to complete questionnaires and keep the information current? 8

9 F. The Role of the Compliance Officer 1. Review of Securities Reports The adopting release notes that registered advisers must maintain and enforce their codes of ethics and that the SEC expects the chief compliance officer, or persons under his authority, to review access persons' personal securities reports. The adopting release further states that review should include: not only an assessment of whether the access person followed any required internal procedures, such as pre-clearance, but should also compare the personal trading to any restricted lists; assess whether the 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 takes for himself; periodically analyze the access person's trading for patterns that may indicate abuse, including market timing; investigate any substantial disparities between the quality of performance the access person achieves for his own account and 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. Open Issue: Does a compliance officer need to review all reports or is it sufficient to review only a sample of reports? Open Issue: The adopting release notes that SEC opted not to require that securities reports be maintained in an accessible electronic database, but also questions whether a larger investment advisory firm can adequately review such reports manually or on paper. At what point is an adviser so large that it needs to keep securities records electronically? How can an adviser receive reports electronically from executing brokers? Open Issue: How should a compliance officer address breaches of the code, including a lack of reporting by the firm s employees? 2. Reporting Violations As noted above, an adviser s code of ethics must require supervised persons to report violations of the code. Open Issue: How should a compliance officer respond to violations? What is the range of sanctions? Who should receive reports of violations? Who should be involved in determining an appropriate sanction? 9

10 3. Recordkeeping A registered adviser must maintain certain books and records relating to its code of ethics, including a copy of the code, securities reports, and access person lists. The adopting release also notes that the SEC opted not to require that advisers keep records of the reports of violations out of concern that these records could have a chilling effect on employees' willingness to report violations, particularly in smaller organizations. Open Issue: Should an adviser keep reports of violations? If so, under what circumstances? Would such reports create a paper trail leading SEC examiners to find issues uncovered by the adviser? 4. Training The adopting release notes that the SEC does not believe it is necessary to require employee training as part of the code. However, the adopting release further states that the SEC expects most advisory firms will ensure that their employees have received adequate training on the principles and procedures of their codes. Open Issue: Should the compliance officer require periodic training on the code? If so, how often should training occur? What evidence of attendance should the compliance officer maintain? 5. Review of the Code The adopting release notes that many codes of ethics include a requirement for the compliance officer to periodically review the code of ethics. Open Issue: How often should a compliance officer review the code? What might prompt such a review? G. Additional Elements of the Code of Ethics 1. Gifts and Entertainment and Outside Directorships The adopting release notes that many advisers address additional elements in their code of ethics, including limitations on acceptance of gifts (i.e., a gifts and entertainment policy) and limitations on the circumstances under which an adviser s personnel may serve as a director of a publicly traded company. Open Issue: What limits should be placed on accepting or giving gifts? Should the code include a specific dollar limitation? Should the adviser maintain a gifts and entertainment log? 10

11 Open Issue: Under what circumstances should an adviser s personnel be permitted to serve on the board of publicly traded company? Should limitations also be placed on serving on the board of a not-for-profit organization (e.g., serving as a financial officer)? 2. Exceptions Neither Rule 204A-1 nor the adopting release mention an exceptions provision for the code of ethics. Nevertheless unforeseen circumstances may arise that suggest an exception should be considered and granted. Open Issue: Under what circumstances should exceptions be granted? What procedures should be followed in granting an exception? Should the adviser keep a record of all exceptions, including the reason for the exception? * * * If you have any questions regarding the outline or your code of ethics, please feel free to contact the following attorney or your relationship partner at Fried Frank. New York Terrance O'Malley terrance.o'malley@friedfrank.com Fried, Frank, Harris, Shriver & Jacobson LLP New York One New York Plaza New York, NY Tel: Fax: Washington, DC 1001 Pennsylvania Avenue, NW Washington, DC Tel: Fax: Frankfurt Taunusanlage Frankfurt am Main Tel: Fax: Fried, Frank, Harris, Shriver & Jacobson (London) LLP 99 City Road London EC1Y 1AX Tel: Fax: Fried, Frank, Harris, Shriver & Jacobson (Europe) 65-67, avenue des Champs Elysées Paris Tel: Fax: