The Advisor's Professional Library

Code of Ethics Rule

January 1, 2012

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In a Dilbert cartoon published on August 13, 2011 in the Sun-Sentinel, the nerdy engineer was offered one million dollars a year to work at a hedge fund. All Dilbert had to do was pretend he created an algorithm that makes winning trades. The hedge fund manager assured Dilbert that he would do the insider trading. Unfortunately, in real life, there have been investment advisors with business models that aren’t much different.

Investment advisors should not need a code of ethics to help them distinguish between right and wrong. Nevertheless, the Code of Ethics Rule, found in Rule 204A-1, helps to ensure that IARs do the right thing. It provides oversight that can ferret out wrongdoing. All SEC-registered investment advisors must adopt and enforce a code of ethics. Some states have also implemented a code of ethics requirement.

The consequences for violating the Code of Ethics Rule are severe. On March 9, 2009, the SEC filed a fraud action against Locke Capital Management. Among other allegations in the SEC’s complaint, the RIA was accused of not having a code of ethics. The Commission further alleged that the firm’s principal made numerous misrepresentations. The advisor lied about the firm’s performance for years, and about the number of clients the firm had. Even if this RIA had implemented a code of ethics, it does not appear that the advisor would have been deterred from this type of misconduct. You can read more about this case at:
 http://www.sec.gov/litigation/litreleases/2009/lr20936.htm.

Nevertheless, a code of ethics can serve important purposes at advisory firms. The fact that an RIA owes a fiduciary duty is an abstract concept. A code of ethics brings specificity to concepts that might otherwise be abstract.

Rule 204A-1 of the Investment Advisers Act

Access persons should pay particular attention to the Code of Ethics Rule. An access person is a supervised individual who has access to nonpublic information pertaining to clients’ purchases or sales of securities and makes securities recommendations to clients. The definition also includes supervised persons who have access to non-public information about the portfolio holdings of affiliated mutual funds. Just about every IAR of an advisory firm will meet the definition of access person.

Pursuant to Rule 204A-1, each SEC-registered RIA must adopt a code of ethics that does the following:

  • Sets forth a standard of business conduct required of all employees that, at a minimum, reinforces the RIA’s fiduciary obligations and requires compliance with the federal securities laws
  • Requires an RIA’s access persons to report their personal securities transactions and holdings on an initial and ongoing basis
  • Requires an RIA’s access persons to obtain the advisor’s approval before investing in an Initial Public Offering (IPO) or private placement
  • Requires an advisor to maintain and enforce the code of ethics, including reviewing the personal trading reports to identify improper trades or patterns of trading and promptly reporting any violations
  • Requires an RIA to provide a copy of the code of ethics to all employees and to obtain each employee’s written acknowledgment of receipt

A code of ethics must require all supervised persons to promptly report violations to the CCO or other appropriate personnel, as long as the CCO gets a copy. RIAs may permit reports to be submitted anonymously. It is recommended that whistleblowers be afforded protection from retaliation. They might also be protected from retaliation by the SEC’s new rule relating to whistleblowers, which we will examine in Whistleblowers.

Doing the Bare Minimum is not Enough

An RIA’s code of ethics should go well beyond the minimum requirements stipulated by Rule 204A. An RIA may elect to implement a code of ethics that requires:

  • prior written approval before access persons can implement any personal securities transaction, commonly referred to as a pre-clearance of these trades;
  • maintenance of lists of issuers of securities that the RIA is analyzing or recommending for client transactions, and prohibitions on any trading (personal or for clients) in securities of those issuers;
  • maintenance of restricted lists of issuers about which the RIA has inside information, and prohibitions on any trading (personal or for clients) in securities of those issuers;
  • blackout periods for personal trades;
  • training and communication to remind employees that investment opportunities must be offered first to clients before acting upon them, and implementing procedures to enforce this principle;
  • prohibitions or restrictions on short-swing trading and market timing;
  • requirements to provide the CCO with duplicate trade confirmations and account statements;
  • requirements to trade only through certain brokers, or limitations on the number of brokerage accounts permitted; and
  • procedures for assigning new securities analysis responsibilities to employees whose personal holdings do not present apparent conflicts of interest.

Although RIAs are not required to implement these requirements, there must be strict compliance with them after they are adopted.

Purpose of the Code of Ethics Rule

One goal of the Code of Ethics Rule and personal securities transactions reporting requirements is to ensure that RIAs comply with their fiduciary duty to keep clients’ security holdings and financial circumstances confidential. Each RIA’s code of ethics must maintain and enforce procedures to prevent the misuse of material nonpublic information about the adviser’s securities recommendations, client securities holdings, and transactions.

Reporting personal securities transactions prevents misuse of confidential information. An RIA’s code of ethics must also require the review of such reports in order to identify improper trades or patterns of trading by access persons.

The purpose of the Code of Ethics Rule and restrictions on personal trading is to prevent misconduct such as:

  • potential misuse of nonpublic information;
  • inappropriate allocation of investment opportunities like IPOs;
  • failure to report new accounts; and
  • front-running.

Front running occurs when an RIA takes advantage of advance knowledge of pending transactions involving the firm’s clients.

Who is an Access Person?

Rule 204A-1 under the Investment Advisers Act is better known as the Code of Ethics Rule. The rule focuses on access persons who, not surprisingly, have access to confidential information that might be exploited for personal gain. Rule 204A-1(e)(1) defines access persons to include any supervised person who:

  • has access to nonpublic information regarding a client’s securities transactions or holdings;
  • is involved in making securities recommendations to clients; or
  • has access to nonpublic securities recommendations.

An access person might also be someone who has access to nonpublic information regarding the securities holdings of affiliated mutual funds.

If providing investment advice is an RIA’s primary business, an access person includes any director, officer, or partner of the RIA. The definition of access person also includes any employee with access to that kind of information. All of these individuals are subject to the Code of Ethics Rule, because they are in a position to take advantage of nonpublic information about clients’ securities holdings and transactions.

An RIA’s access persons may go far beyond high-level employees. According to the SEC’s adopting release, administrative, technical, and clerical personnel may be viewed as access persons if their duties give them access to nonpublic information. In some circumstances, a summer intern may fall within the definition of access person and could be subject to the reporting requirements imposed by the Code of Ethics Rule. In some firms, all employees are treated as access persons.

Holdings Reports

A firm’s CCO can uncover potential misconduct by reviewing each access person’s holdings reports. Holdings reports provide a trail for investigating an access person’s misuse of non-public information, and contains a complete listing of the access person’s securities holdings (see Figure 9-1).

Initial/Annual Holdings Reports

The annual holdings report must be submitted at least once during each twelve-month period and thereafter on a date selected by the RIA. The information must be current as of a date no more than 45 days prior to the date the report was submitted.

For new access persons, initial holdings reports must be submitted no later than ten days after the individual becomes an access person. The report must be current no more than 45 days prior to the individual becoming an access person. These holdings reports must be submitted to a designated person, usually the CCO.

At a minimum, each holdings report must contain the following:

  •       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
  •       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
  •       The date the access person submits the report.

Figure 9-1.  Initial/Annual Personal Securities Holdings Report

To: Chief Compliance Officer, (Insert the name of Investment Adviser)

From:  ________________________________________
                      (Access Person – Please Print)

Note: in lieu of the reporting form, duplicate copies of brokerage statements may be submitted provided the statements include the information required below

Re: Initial/Annual Personal Securities Holdings Report pursuant to Rule 204-2(a)(13) of the Investment Advisers Act, as amended:

As of, _____ 20__, I hold the following Covered Securities:

Security Title*

Type of
Security

Ticker/CUSIP

# Shares

Principal Amount

Name of Broker Dealer

           
           
           
           
           
           
           
           

 *Include interest rate and maturity date if applicable

The following broker/dealer bank or other custodian hold accounts which are invested in Non-Reportable Securities in which I have Beneficial Ownership.

Name of Broker, Dealer, or Bank

Account Title

Account Number

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Use additional sheet(s) if necessary

As of_____, 20__, I do not have any direct or indirect Beneficial Ownership in any account containing any securities. However, I agree to promptly notify the designated Chief Compliance Officer, if any such account is opened, so long as I am associated with (Insert the name of Investment Adviser).

Signed: _____________________________       Date:  __________________

Report reviewed by:  ___________________   Date: __________________

*Used with permission from National Compliance Services, Inc.

Quarterly Transaction Reports

The code of ethics must require quarterly reports of certain personal securities transactions by access persons, which are due no later than thirty days after the close of the calendar quarter. An RIA may excuse access persons from submitting transaction reports that would duplicate information contained in trade confirmations or account statements, so long as the advisor has received them no later than thirty days after the close of the calendar quarter in which the transaction takes place (see Figure 9-2).

Even though an RIA is filing quarterly transaction reports, it must still file an annual holdings report. The annual holdings report provides examiners with a snapshot of access persons’ holdings. Examiners cannot be expected to compile them from the quarterly transaction reports.

At a minimum, each transaction report (both quarterly and annual) must contain the following information about each transaction involving a reportable security in which the access person had, or because of the transaction acquired, any direct or indirect beneficial ownership:

  •       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
  •       The nature of the transaction and whether it is a purchase, sale, or any other type of acquisition or disposition
  •       The price of the security at which the transaction was effected
  •       The name of the broker, dealer, or bank with or through which the transaction was effected
  •       The date the access person submitted the report

 

Figure 9-2.  Quarterly Report of Personal Securities Transactions

To:             Chief Compliance Officer, (Insert the name of Investment Adviser)

From:  _________________________________________
                       (Access Person – Please Print)

Note: in lieu of the reporting form, duplicate copies of brokerage statements may be submitted provided the statements include the information required below

Re: Quarterly Report of Personal Securities Transactions pursuant to Rule 204-2(a)(13) of the Investment Advisers Act, as amended:

During the quarter ending______, I have purchased, sold, or have otherwise obtained Beneficial Ownership in the following securities:

Date

Nature of the Transaction

Security Title*

Ticker/CUSIP


# Shares

 

Price

Principal Amount

Name of Broker Dealer

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  • During the above period, I have not purchased or sold any Covered Securities in my personal brokerage account or in any account in which I have a direct or indirect Beneficial Ownership.
  • During the above period, no Covered Accounts in which I have a Beneficial Ownership have been opened, which I have not disclosed to (Insert the name of Investment Adviser)
  • I do not currently have a personal securities brokerage account and/or I do not have Beneficial Ownership in any Covered Account. However, I agree to promptly notify  (Insert the name of Investment Adviser)  if any such account is opened, so long as I am associated with (Insert the name of Investment Adviser)

 

Signed: _____________________________       Date: __________________

Report reviewed by:  _________________    Date: __________________

*Include interest rate and maturity date if applicable (Use additional sheet(s) if necessary)

*Used with permission from National Compliance Services, Inc.

 

Exceptions to Reporting Requirements

Certain types of personal securities transactions need not be reported. A firm’s code of ethics need not require an access person to submit:

  • any report with respect to securities held in accounts over which the access person had no direct or indirect influence or control;
  • a transaction report with respect to transactions effected pursuant to an automatic investment plan;
  • a transaction report if the report would duplicate information contained in broker trade confirmations or account statements that are held in the RIA’s records, so long as it receives the confirmations or statements no later than thirty days after the end of the applicable calendar quarter.

Reportable Securities

In general, access persons must submit holdings and transaction reports for “reportable securities” in which the access person has, or acquires, any direct or indirect beneficial ownership. The term “reportable securities” consists of all securities, except those falling within the following five exceptions from the reporting requirements under Rule 204A-1:

  • Direct obligations of the Government of the United States
  • Money market instruments, bank certificates of deposit, commercial paper, and high quality short-term debt instruments, including repurchase agreements
  • Shares of money market funds
  • Shares of open-end mutual funds, unless the advisor or a control affiliate acts as the RIA or principal underwriter for the fund
  • Shares of a unit investment trust if it is invested exclusively in unaffiliated mutual funds

In a July 28, 2010 no-action letter to the law firm of WilmerHale, SEC staff stated that Section 529 plans are not reportable securities. The investments in Section 529 plans present little opportunity for improper trading that transaction and access reports were designed to uncover. Therefore, the SEC would not recommend enforcement action against an RIA for failing to keep records regarding access persons’ transactions and holdings in Section 529 plans. The no-action letter can be found at
http://www.sec.gov/divisions/investment/noaction/2010/wilmerhale072810.htm.

Recordkeeping Requirements

When it adopted the Code of Ethics Rule, the SEC also amended Rule 204-2, more commonly known as the Books and Records Rule. An RIA must retain a copy of the following books and records:

  • Code of ethics
  • Records of code violations
  • Records of actions taken as a result of code violations
  • Supervised persons’ written acknowledgment of receipt of the code
  • Record of the names of its access persons
  • Holdings and transactions reports made by its access persons
  • Records of decisions approving access persons’ acquisition of securities in IPOs and limited offerings

As noted previously, an RIA in Santa Monica, California, received severe sanctions for failing to comply with the Code of Ethics Rule. Among other violations, the SEC charged the RIA and its principals with failing to make and/or retain copies of employees’ acknowledgments that they received the firm’s code of ethics. The RIA received deficiency letters in 2005 and 2008 notifying the firm of that requirement. In today’s compliance environment, it is very doubtful that an RIA will get more than one opportunity to correct a deficiency.

The penalties for compliance violations are also likely to become much tougher. On November 28, 2011, the SEC issued an order against Asset Advisors, an SEC-registered firm in Troy, Michigan. The RIA did not adopt a code of ethics until SEC examiners ordered the firm to do so after an examination. After the code of ethics was adopted, the firm failed to abide by it. Asset Advisors agreed to pay a $20,000 penalty, but that wasn’t the extent of the SEC’s sanctions. The RIA was required to de-register with the Commission and shift the firm’s accounts to another advisor that maintained a viable compliance program.

Optional Provisions in Codes of Ethics Such as Gift Giving

A code of ethics only establishes a minimum standard of conduct. RIAs are free to set higher standards. A code of ethics should challenge employees to do more than just live up to the letter of the law. It might also be a reflection of the ideals to which the firm aspires.

In footnote 17 of the Adopting Release for Rule 204A-1, the SEC stated that RIAs should consider putting limitations on acceptance of gifts in their codes of ethics. Nevertheless, even though an RIA must have a code of ethics, it need not implement restrictions on accepting or giving gifts. A dually-registered advisory firm, however, is also bound by FINRA’s rules governing gift giving.

Accepting gifts may lead to allegations that an RIA has breached its fiduciary duty to clients. A fiduciary must always act in the client’s best interest and disclose any conflicts. Therefore, an RIA’s policy on giving and accepting gifts should be disclosed in the firm’s Form ADV brochure, which will be discussed in The New and Improved Form ADV. When clients read in the Form ADV that the RIA accepts gifts, they may question whether the firm has a conflict of interest. The giving or receiving of gifts may give the impression that the RIA is not giving objective advice.

Another problem is that an unscrupulous employee may have a questionable relationship with a client. The managing partner of one RIA discovered that his secretary was receiving monetary gifts from an elderly client. This conduct should be forbidden in a code of ethics, because the secretary might be exerting undue influence over the elderly client.

Best Practices for Gift Giving and Receiving

A code of ethics is only the beginning. An RIA should strongly consider raising the bar by establishing a stronger code of ethics. Best Practices go above and beyond the obligations established by the Investment Advisers Act and its rules.

As related to gift giving, here are best practices that should be considered:

  • No supervised person may receive any gift, service, or other item of more than de minimis value from any person or entity that does business with or on behalf of the RIA, including clients.
  • No supervised person may give or offer to give any gift of more than de minimis value to existing clients, prospective clients, or any entity that does business with or on behalf of the RIA without pre-approval by the firm’s CCO.
  • No supervised person may give or accept extravagant forms of entertainment, such as tickets to a concert or sporting event, to a person or entity who does or seeks to do business with or on behalf of the RIA.
  • Business entertainment above a reasonable value must be pre-approved. An offer of travel expenses or hotel accommodations must also be pre-approved, such as the cost of attending a seminar sponsored by a vendor in a popular tourist destination.

It is a best practice for RIAs to create and retain logs of gifts given and received. The firm’s CCO can then investigate accounts where gifts were given or received to see if any special treatment was given.

The firm’s policies and procedures should define “gifts” to include discounts on products and services that are not available to the general public. Certain types of gifts and entertainment must always be approved, such as gifting involving public officials and government entities. As we will see in Pay-to-Play Rule, violations of the pay-to-play rule can effectively bar an RIA from doing business with government entities.

It is wise for an RIA to define what is meant by “nominal” or de minimus. Usually, the definition includes a dollar limitation, such as $100. Although $100 does not go as far as it used to, many RIAs’ compliance policies stipulate that a gift greater than that amount is not nominal.

The Big Picture

In an ideal world, instituting a code of ethics would ensure that all advisory personnel would act ethically in all of their dealings with investors. Unfortunately, even if Bernard Madoff’s advisory firm had implemented a code of ethics, it is still quite likely that he would have cheated investors with his Ponzi scheme. Judging from Madoff’s apparent lack of a personal moral compass, it is doubtful that he would have complied with his firm’s code of ethics.

Although it cannot necessarily prevent RIAs and IARs from acting improperly, the Code of Ethics Rule was enacted with good intentions. The rule requires federally-registered investment advisors to report important information about their securities holdings. Even where there is no code of ethics requirement, state-registered advisors may wish to adopt one in order to reinforce the fiduciary duty owed to clients. An RIA’s code of ethics may be a separate document or it can be incorporated by reference into the firm’s policies and procedures.

Certainly, an RIA’s code of ethics must satisfy all of the minimum requirements set forth in Rule 204A-1. Examiners are likely to look more favorably on advisory firms that exceed the minimum requirements of the Code of Ethics Rule. Furthermore, there must be documentation to demonstrate that the RIA is enforcing the Code of Ethics Rule. Having a strong code of ethics is meaningless without enforcement.

The Code of Ethics Rule will also help an RIA to guard against insider trading by controlled persons. Under Section 21A of the Securities Exchange Act of 1934, controlling persons of an advisory firm will not be subject to civil penalties unless they “knowingly or recklessly failed to establish, maintain, or enforce any policy or procedure required under section 15(f) or section 204A of the Investment Advisers Act of 1940 and such failure substantially contributed to or permitted the occurrence of the act or acts constituting the violation.”

A code of ethics can also reinforce other policies and procedures in the RIA’s compliance manual. For example, a firm doing business with government entities may be required to comply with the SEC’s pay-to-play rule or similar state regulations. One section of the RIA’s compliance manual will establish policies and procedures for employees to follow. The RIA’s code of ethics may also address the importance of following the pay-to-play rule when dealing with government entities and officials.

Implementing a code of ethics may even give RIAs a marketing advantage. Since RIAs post a copy of their code of ethics on their websites. In addition, RIAs are required to describe their code of ethics in their Form ADV disclosure brochures, which we will discuss in The New and Improved Form ADV.

Les Abromovitz

Les Abromovitz

Les Abromovitz is the author of The Investment Advisor’s Compliance Guide, published for 2012 by The National Underwriter Company/Summit Business Media. Les Abromovitz is an attorney and member of the Pennsylvania bar. Les has handled hundreds of consulting and publishing project for a leading compliance and regulatory services firm. He has conducted a number of seminars and training sessions dealing with compliance subjects. Les is also the author of several White Papers that analyze compliance issues impacting Registered Investment Advisors (RIAs).