Codes of Ethics Current Issues by Richard A. Steinwurtzel and Eve Filip 1

Transcription

1 M E M O R A N D U M Codes of Ethics Current Issues by Richard A. Steinwurtzel and Eve Filip 1 1. Background a. Foundation: The elements of Rule 204A-1 under the Investment Advisers Act of 1940, as amended ( IAA ) 2 were modeled largely on Rule 17j-1 of the Investment Company Act of 1940, as amended (the ICA ), which itself dates back to Specifically, the requirements for reporting of personal securities trading mimic those of the ICA. In addition, Rule 17j-1 was amended at the time Rule 204A-1 was adopted in order to conform the two regulatory regimes. The two rules differ in certain respects. i. Scope: Rule 204A-1 expanded upon the contents of the Code already required under Rule 17-j. The IAA rule mandates that code of ethics set forth standards of conduct applicable to the supervised persons of an adviser. This provision implicitly requires the inclusion of standards that promote broader compliance goals. ii. Personal Securities Trading: Access person reports of personal securities transactions and holdings must be submitted to the CCO or to another designated individual. This requirement parallels a similar requirement in the ICA. iii. Definition of Access Person. Rule 17j-1 defines individuals as access persons in the mutual fund context only if they make, participate in, or obtain information regarding, the purchase and sale of the fund s securities, or if their functions relate to the making of any 1 Richard A. Steinwurtzel is a partner, and Eve Filip is an associate, with Fried, Frank, Harris, Shriver & Jacobson, LLP 2 Rule 204A-1 only applies to investment advisers that are registered or required to be registered under the IAA. 3 Investment Adviser Codes of Ethics, SEC Rel. No. IA-2209, at 5, available at (last visited May 4, 2006) (the Proposing Release ). Fried, Frank, Harris, Shriver & Jacobson LLP A Delaware Limited Liability Partnership New York Washington London Paris Frankfurt

2 recommendations for such transactions. 4 In contrast, Rule 204A-1 is slightly more broad. An access person under this rule is someone who has access to nonpublic information regarding clients purchase or sale of securities, is involved in making securities recommendations to clients or who has access to such recommendations that are nonpublic. 5 b. Parallel Code of Ethics Requirements: The IAA code of ethics requirement was passed at about the time codes of ethics requirements were concurrently adopted in various regulatory regimes. i. SOX. In early 2003, the SEC adopted rules mandated by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act ) with respect to corporate codes of ethics. 6 These rules require a reporting issuer to disclose whether it has adopted a code of ethics applicable to principal executive officers or persons performing similar functions and, if not, explain why not. The rules, in addition, set out requirements for the minimum contents of a code. The passage of these sections, and the SEC s adoption of these rules, signaled a much broader legislative and administrative push for compliance with fiduciary standards and applicable federal laws. ii. NYSE. Listed companies are required to adopt and disclose a code of business conduct and ethics for directors, officers and employees, and are required to disclose any waivers of the code for directors or executive officers. 7 iii. NASDAQ. Under the NASD Marketplace Rule 4350(n) listed companies must adopt a code of conduct applicable to all directors, officers and employees, which must be publicly available. A code of conduct that satisfies this rule must comply with the definition of a code of ethics set out in Section 406(c) of the Sarbanes-Oxley Act, including any regulations 4 Investment Adviser Codes of Ethics, SEC Rel. No. IA-2256, available at htm (last visited June 13, 2006) (the Adopting Release ). 5 Id. 6 See Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002, SEC Rel. Nos A, A (Jan. 23, 2003). 7 Self-Regulatory Organizations; Order Granting Approval of Proposed Rule Change by the New York Stock Exchange, Inc. and Notice of Filing and Order Granting Accelerated Approval to Amendment Nos. 2 and 3 Thereto To Amend Section 303A of the NYSE Listed Company Manual Relating to Corporate Governance, SEC Rel. No (Nov. 3, 2004). 2

3 promulgated thereunder. The code must also provide for an enforcement mechanism. 8 c. Administrative Purpose: Rule 204A-1 was passed as a part of a regulatory initiative responding to increased violations of fiduciary obligations to clients. It serves to remind current and new employees of a registered adviser of their fiduciary responsibilities as well as requires increasing reporting by access persons. d. Fiduciary Responsibilities: The Adopting Release to Rule 204A-1 states: Advisers are fiduciaries that owe their clients a duty of undivided loyalty. The Commission has become concerned that the obligations attendant to this duty were lost on the growing number of advisers the Commission sees each month on its enforcement calendar. 9 The SEC highlighted select enforcement actions in the Adopting Release as support for its adoption of Rule 204A i. In Re Strong Capital Management, Inc., Investment Advisers Act Release No (May 20, 2004) (adviser disclosed material nonpublic information about fund portfolio holdings to hedge fund, and permitted own chairman and hedge fund to engage in undisclosed market timing of funds managed by adviser); ii. In Re Massachusetts Financial Services Co., Investment Advisers Act Release No (Feb. 5, 2004) (2 senior executives of adviser permitted undisclosed market timing in certain funds in the complex managed by the adviser); iii. In Re Alliance Capital Management, L.P., Investment Advisers Act Release No (Dec. 18, 2003) (disclosure of material nonpublic information about certain mutual fund portfolio holdings permitted favored client to profit from market timing); iv. In Re Robert T. Littell and Wilfred Meckel, Investment Advisers Act Release No (Dec. 15, 2003) (portfolio manager of hedge fund made misrepresentations to investors and potential investors concerning performance, management oversight, and risk management practices); v. In Re Zion Capital Management LLC and Ricky A. Lang, Investment Advisers Act Release No (Dec. 11, 2003) (adviser favored an advisory account in which he had an interest, allocating profitable trades 8 Qualitative Listing Requirements for Nasdaq National Market and Nasdaq Capital Market Issuers Except for Limited Partnership, NASD Marketplace Rule 4350(n) (March 30, 2006). 9 Proposing Release. 10 Adopting Release n.3, at 3, 28. 3

4 to this account while allocating numerous unprofitable trades to another client); vi. In Re George F. Fahey, Investment Advisers Act Release No (Nov. 24, 2003) (president of investment adviser made misrepresentations to clients as to risk of investment strategy and value of investments); vii. In Re Putnam Investment Management LLC, Investment Advisers Act Release No (Nov. 13, 2003) (adviser failed to reasonably supervise employees who market timed funds managed by the adviser and failed to disclose their timing activities); viii. In Re Wendell D. Belden, Investment Advisers Act Release No (Nov. 6, 2003) (associate of adviser defrauded clients by misleading them about their investment options and the security of their invested principal and by investing their money in a manner calculated to enrich himself at their expense); ix. In Re James Patrick Connelly, Jr., Investment Advisers Act Release No (Oct. 16, 2003) (adviser s vice chairman permitted more than a dozen clients to market time certain funds in the complex managed by the adviser in exchange for stable investments in other funds in the complex); x. In Re Marshall E. Melton and Asset Management & Research, Inc., Investment Advisers Act Release No (July 25, 2003) (investment adviser made material misrepresentations to its clients to induce them to invest their funds in limited liability companies controlled by adviser s principal). e. Effect of Codes of Ethics on Federal Sentencing: Approximately at the time of the adoption of Rule 204A-1, the United States Sentencing Commission approved significant changes to the federal Sentencing Guidelines for organizations. These guidelines give credit to organizations with proper compliance programs, including the implementation of an appropriate code of ethics. The existence of an effective compliance and ethics program is one of two factors that a federal judge may use to mitigate a sentence. To qualify as a proper ethics and compliance program, an organization must (i) exercise due diligence to prevent and detect criminal conduct and (ii) otherwise promote an organizational culture that encourages ethical conduct and a commitment to compliance with the law. 11 This two part standard includes satisfying the following seven minimum requirements: i. Establishment of standards and procedures to prevent and detect criminal conduct. 11 Guidelines Manual, ch. 8, 8B2.1, at 476 (Nov. 1, 2004). 4

5 ii. The governing authority of the organization shall be knowledgeable about the compliance program and provide oversight. High level personnel shall ensure the effectiveness of the compliance and ethics program. Daily operational responsibility shall be delegated to particular individuals in the organization. iii. The supervisory personnel of the organization should not include any person who the organization knew, or should have known, engaged in illegal activities or other activities inconsistent with an effective compliance and ethics program. iv. The organization should communicate periodically and practically its procedures related to compliance and ethics by proper training and information dissemination to its employees and supervisory personnel. v. The organization should (i) ensure the program is followed by monitoring and auditing conduct; (ii) evaluate periodically the effectiveness of the program and (iii) publicize and retain a system which does not penalize those who report questionable conduct. vi. The compliance program shall be promoted and enforced consistently through appropriate incentives to perform in accordance with the compliance program and appropriate disciplinary methods for engaging in criminal conduct or not detecting and preventing criminal conduct. vii. After the detection of criminal conduct, the organization must take reasonable steps to respond appropriately. f. Future Goal: Some argue that, from a policy perspective, the focus of compliance efforts today should turn to managing programs effectively in the long term. 12 Proper management includes applying new compliance and ethics tools to assess risk properly. This objective may require outside audits and periodic internal reviews as to the effectiveness of the compliance instruments in place, including the code of ethics. Ultimately, firms should look to develop measures of compliance that are tied to actual reductions in violations See, e.g., Jeffrey M. Kaplan, Risk-Based Compliance Program Management, ETHIKOS (March/April 2006). 13 Lori Richards, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Compliance: Some Core Principles 4 (April 20, 2005). 5

6 2. Regulatory Framework a. Elements: There are five principal requirements under Rule 204A-1. A registered investment adviser must create and maintain a code of ethics that includes the following requirements: 14 i. Create a standard of business conduct for supervised persons that reflects fiduciary obligations. 1. Practical Effects: Practically, this requirement generally leads to the adoption of (x) a general statement of policy and (y) the inclusion of standards to address potential problematic areas specific to the adviser. Usually, the code includes a statement regarding the fiduciary obligations of the adviser, including the duties of honesty, good faith and fair dealing, and the requirement to act in the clients best interests at all times Conflicts: Advisers need to disclose any and all possible material conflicts of interest between the adviser (and its supervised persons) and its clients, as well as conflicts between particular clients. 3. Restrictions to Prevent Insider Trading: Advisers need to prohibit supervised persons from trading while in possession of any material nonpublic information. Although Rule 204A-1 itself does not explicitly require such a prescription, advisers should include provisions directed at preventing insider trading (particularly in light of Section 204A of the IAA which requires procedures reasonably designed to prevent insider trading). 4. Personal Securities Transactions: A code of ethics typically includes provisions limiting personal trading by access persons to ensure fiduciary obligations are maintained. Examples of restrictions include: (i) IPO prohibitions, (ii) pre-clearance of limited/private offerings, (iii) blackout periods, (iv) restrictions on short-term trading, (v) prohibition on margin accounts, (vi) prohibition on short sales, (vii) restrictions on options and futures, (viii) restriction on the percentage of holdings in any one company, (ix) maintaining a list of restricted securities, and (x) restricting frequent trading. 14 See Karen Barr, Best Practices for Investment Adviser Codes of Ethics, The Investment Law. at 17 (Nov. 2004). 15 See also, e.g., Investment Counsel Association of America, Best Practices for Investment Adviser Codes of Ethics (July 20, 2004). 6

7 5. Confidentiality: A code also often includes a confidentiality provision reflecting the adviser s fiduciary duty to keep client matters confidential. 6. Gifts and Entertainment Policy: A code also should include a gift and entertainment policy which limits the amount that supervised persons may accept from or give to outside sources. This limitation serves a variety of purposes, including (i) the prevention of undue influence by outside parties, (ii) restricting inappropriate relationships, and (iii) preventing conflicts of interest. 7. Suitability: An investment adviser should also examine whether the code of ethics sufficiently expounds upon its fiduciary duties, as the adviser s specific responsibilities as a fiduciary are not spelled out specifically in Rule 204A-1. This ambiguity leaves an adviser exposed to some risk in several respects, including (x) whether the standards of business conduct are fully reflective of the adviser s fiduciary obligations and (y) without more, whether the adviser is vulnerable to regulatory or client criticism. ii. Include provisions requiring supervised persons to comply with applicable securities laws. 1. This provision implicates various federal securities law provisions. At a minimum, an adviser should note that supervised persons may not mislead clients or engage in market manipulation. It is recommended that advisers consider provisions addressing other areas of their business, including the IAA advertising rule, antimoney laundering, considerations, and privacy regulations. iii. Require periodic reports from access persons as to their personal securities transactions and holdings. 1. Depending on the strategies of the adviser and its clients, the adviser may want to consider imposing differentiating restrictions in order to prevent inappropriate investment activity by its personnel. For example, if relevant to client investments, some commentators suggest limiting the investment personnel entirely from participating in IPOs and private offerings in order to prevents conflicts with clients. An adviser may also exempt certain transactions depending on the nature of the transactions and the potential for conflict with its clients. 2. An adviser is required to analyze these reports for problematic behavior, as well as inconsistencies and inaccuracies. An adviser should take care to assess whether the internal procedures implemented (such as blackout periods/preclearance requirements) were adequately followed by each access person. The adviser 7

8 should compare the access person s account to those of its clients to determine if the same securities are being traded, the timing of the transactions and the percentage of trades that are profitable for each account (among other things). As noted, the critical objectives include assessing whether there are problematic compliance patterns. iv. Include provisions that require supervised persons to report violations of the code of ethics to the CCO or another designated individual. 1. This provision requires self reporting of violations by supervised persons. An adviser should consider stating that confidentiality will be granted towards these reports when legally permissible. The adviser may also allow anonymous reporting. v. Include provisions that require providing each supervised person with a copy of the code and any amendments and require each supervised person to provide a written acknowledgement of receipt of the code. 1. An adviser may want to supplement this acknowledgement by obtaining a further acknowledgement that the supervised person has read and understands the code and has agreed to comply with the code s provisions. The advisers may want to obtain these certifications on an annual or other periodic basis. b. Functional Role: A code of ethics is an interactive part of at least three compliance mechanisms for advisers: i. Code of Ethics 1. It is not a business manual; it serves as a preventive and educational tool for advisers. 2. As the SEC explained, [A] code of ethics should set out ideals for ethical conduct premised on fundamental principals of openness, integrity, honesty and trust. A good code of ethics should effectively convey to employees the value the advisory firm places on ethical conduct, and should challenge employees to live up not only to the letter of the law, but also to the ideals of the organization. 16 ii. Compliance/Supervisory Manual The SEC staff considers the code of ethics to be an important extension of Rule 206(4)-7 and its general compliance 16 Adopting Release at 4. 8

9 iii. Employee Manual c. Benefit of a Code of Ethics: proscriptions. The requirements in Rule 204A-1, in contrast, are more specific. If a firm blends the requirements of these two rules in respect to its compliance and supervisory materials, this approach helps to ensure satisfaction of the broad compliance goal under Rule 206(4)-7 and the specific goals under Rule 204A-1. This manual provides a guide as to general employee and business procedures. The content of this document should overlap and be consistent with an adviser s compliance and supervisory tools. i. Specific Requirements under Rule 204A-1 1. A code of ethics requires disclosure of a standard of business conduct. Through this disclosure, the adviser restates its obligation to perform as a fiduciary with its attendant duties of care, loyalty and good faith. Both federal law and state law impose fiduciary obligations upon money managers. Examples include: a. Federal Law: Sections 206(1) and 206(2) of the IAA impose a federal fiduciary duty on an investment adviser with respect to its clients and a duty of full and fair disclosure of all material facts. 17 Federal courts have developed case law which recognizes the delicate nature of an investment advisory relationship and requires advisers to make full and frank disclosure under circumstances that create potential conflicts of interest. 18 b. NY Law: A financial adviser who accepts money from others for management and either makes investment decisions for or provides investment advice regarding such funds is a fiduciary with respect to the investing individual Gardner Russo & Gardner, SEC No-Action Letter (June 7, 2006). 18 SEC. v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191, 194, 197 (1963). 19 See, e.g., Brooks v. Key Trust Co. Nat l Ass n, 809 N.Y.S.2d 270, 272 (N.Y. App. Div. 2006). See also Rasmussen v. A.C.T. Envtl. Servs. Inc., 739 N.Y.S.2d 220, 222 (N.Y. App. Div. 2002); Scalp & Blade, Inc. v. Advest, Inc., 722 N.Y.S.2d 639 (N.Y. App. Div. 2001). 9

10 c. CT Law: Under Connecticut law, an investment adviser is a fiduciary, 20 and, in this regard, the Supreme Court of Connecticut has specifically refused to define a fiduciary relationship in precise detail and in such a manner as to exclude new situations. 21 A fiduciary in Connecticut has a duty to make full disclosures and maintain an undivided loyalty. 22 Under Connecticut law, a claim for breach of fiduciary duty requires the plaintiff to prove that a fiduciary relationship exists. 23 Once a fiduciary relationship is established, the burden of proving fair dealing shifts to the fiduciary. 24 Proof of fair dealing must be shown by clear and convincing evidence. 25 d. IL Law: Illinois case law focuses on the general characteristics of fiduciary relationships. A fiduciary relationship can be established in one of two ways: either through the relationship of the parties, or from facts of particular situation, for example, where there is trust reposed on one side and resulting superiority and influence on the other. 26 Factors considered in determining the existence of such a relationship include the degree of kinship, disparity in age, health, mental condition, education and business experience between the parties and the extent to which the allegedly servient party entrusted the handling of his business and financial affairs to the dominant party and reposed faith and confidence in him. 27 Two things must appear: that one party was, in fact, servient and the other party dominant. 28 Once the Conn. Sec. No-Act. LEXIS 21 (Jan. 29, 1993). See also, Advisers Cautioned on Use of Hedge Clauses, Release of the Connecticut Securities and Business Investments Division, Blue Sky L. Rep. (CCH) 14,551 ( 1991 Investments Division Release ). 21 Alaimo v. Royer, 188 Conn. 36, 41 (Conn. 1982). 22 Fenn v. Yale Univ., 283 F. Supp. 2d 615, 632 (D. Conn. 2003). 23 Oakhill Assoc. v. D Amato, 228 Conn. 723, 726 (Conn. 1994). 24 Id. 25 Konover Dev. Corp. v. Zeller, 228 Conn. 206, (Conn. 1994). 26 In re Estate of Louise Rothenberg v. Lois H. Seibrandt et. al., 530 N.E.2d 1148, 1150 (Ill. 1988). 27 Id. at Id. 10

11 fiduciary relationship has been established, the law presumes that any transaction by which the fiduciary has profited is fraudulent. If the fiduciary cannot meet the burden to prove by clear and convincing evidence that the transaction did not occur as a result of undue influence, the transaction will be set aside The provisions preventing unnecessary access to material nonpublic information are designed to prevent fraud. These procedures typically include: a. When personnel may trade; b. What types of trades they may effect; c. Exempt transactions; d. What clearances are required; and e. Position and trading limitations. ii. General Implications: The code of ethics ensures compliance with the such regulations as follows: Principal Benefits a. IAA Section 204A, which focuses on the prevention of the misuse of material non-public information by advisory firm personnel. 31 b. ICA Section 17(j) and Rule 17j-1 thereunder. c. IAA Section 206 and its fraudulent and deceptive proscriptions. 2. Secondary Benefits a. IAA Rule 206(4)-7 obligations to adopt compliance policies and procedures reasonably designed to prevent IAA violations Id. at Proposing Release n.18, at 4, Id. at Id. 11

12 b. A code of ethics must also address and prevent misuse of clients securities holdings and an adviser s recommendation. A misuse of this sort, in addition, violates the adviser s fiduciary duty as well as prohibitions against fraud and other provisions of the federal securities laws that prohibit insider trading. 33 c. Section 352 of the USA Patriot Act requires the establishment of anti-money laundering programs through rulemaking by the Department of the Treasury. 34 A code of ethics can implement appropriate compliance procedures, although a compliance manual may be the more sensible location. Employee training, auditing, and designated compliance individuals are examples of items reinforced by a code of ethics. Investment advisers are not yet subject to an anti-money laundering requirement pursuant to this statute. 3. Current Issues a. Examination Concerns. i. Reporting Timeliness: Access persons are required to report their trades. The SEC staff has noted that, although it typically does not see fraud in this area, it observes timeliness problems. Certain employees frequently report trading activity late, follow up can be minimal and patterns of tardiness with the same employees appear. Advisers must follow up to ensure these reports are timely submitted by employees. ii. Holdings Reports: Some firms do not utilize their holdings reports with a compliance orientation, the SEC staff has noted. These reports are often gathered and stored by an administrative or clerical employee, which would not serve to fulfill this objective. The SEC staff would like these reports to be used to identify problematic patterns or inappropriate trades. Potential violations have typically involved the pre-clearance requirements, blackout periods, and other trading restrictions. iii. Breaches Log : The combination of the three rules may indicate a potential requirement for firms to maintain a breaches log. 33 Id. at n.18, at 4, Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT ACT) of 2001, Pub. L. No , 352, 115 Stat. 272,

13 1. Under Rule 204A-1(a)(2) supervised persons must comply with applicable federal securities laws. 2. Under Rule 204A-1(a)(5) supervised persons are required to report any violations of the code of ethics to the CCO or another designated person. 3. Under Rule 204-2(a)(12)(ii) registered investment advisers (or those required to be registered) must keep records of any violations of the code of ethics and of any action taken as a result of the violation. 4. These three requirements, when viewed in conjunction with one another, seem to indicate that registered investment advisers must maintain a breaches logs regarding all federal securities laws in order to satisfy these rules. It is still unclear whether the SEC intended this outcome, but structurally, this possible requirement should be evaluated. iv. Gift & Entertainment Policy: This policy should be based on the adviser s status as a fiduciary. An adviser must examine when and to what extent its personnel may give and accept gifts without compromising client interests. Recommendations include: 1. Receipt: Limit amounts received by employees from (i) any single source and (ii) all sources so as to prevent undue influence. 2. Gifts: Require employees to report all gifts; reporting will deter receipt of extravagant gifts. 3. Review the disclosures to clients as compared to actual behavior by the adviser and the adviser s employees. v. Reporting Violations on Examination 1. A certification by the Chief Compliance Officer is no longer required at the beginning of the examination. Nonetheless, the SEC staff will continue to request, in an examination, information about the material compliance problems at the start of an examination. b. Frequent Violations by Investment Advisers Related to a Code of Ethics i. Disclosure of Conflicts: A principal violation on the part of advisers, the SEC staff has noted, is the failure to disclose fully all conflicts of interest on the Form ADV. ii. Weakness in Control Procedures: This is the second most common area where registered advisers have had difficulties. 13

14 iii. Recordkeeping Related Requirements: Registered investment advisers often have trouble satisfying the books and records rule. 1. For example, advisers may not comply with the technical requirements under Rule 204-2(a)(12)(iii). Under this rule, an adviser must keep a record of all written acknowledgements as required by Rule 204A-1(a)(6) for each person who is currently, or within the past five years was, a supervised person of the investment adviser. Thus, if a employee, who is a supervised person, remains at a firm for 20 years, the firm must keep his/her acknowledgements for 25 years. c. General Preventative Measures i. Training upon Entry; Training Periodically: A firm should seek to incorporate required ethics training each year for (x) continuing employees and (y) new employees. This training session serves to remind the employees of the specific obligations that the firm and the employees themselves are required to maintain. ii. Testing Mechanisms & Regular Monitoring: A firm should incorporate testing procedures in order to make sure that a code of ethics is reflective of what the firm actually is doing and what is actually needed to maintain applicable legal and other standards. d. Electronic Transition Holdings and Transactions Reports i. In order to improve compliance, investment advisers should begin or continue the process of moving from manual reporting systems to electronic reporting systems. Investment advisers should also consider adding mechanisms with their various brokerage firms in order to receive electronic feeds. 14 ffdc02\filipev\