After Henry Hill took his first pinch in Goodfellas, Jimmy Conway praised young Henry in the courtroom for learning and personifying the Mafia code: “Never rat on your friends and always keep your mouth shut.” While certainly one of the great bro-quotes in movie history, I don’t think I’m venturing too far out on a limb to suggest that the SEC would take issue with that code. In fact, the SEC imposes its own code on its registrants, and that code can be found in SEC Rule 204A-1.
The code I’m speaking of is the code of ethics, and each federally-registered advisor is required to have one. Contrary to the mafia’s code, the SEC’s version requires supervised persons to always rat on their friends (and themselves), and never keep their mouth shut. In regulatory-speak, all supervised persons are required to promptly report any violations of the firm’s code of ethics to the CCO. But what must a code of ethics include?
In principle, a code of ethics must hold all supervised persons to a fiduciary standard of business conduct and require compliance with applicable federal securities laws. “Access persons” (distinct from “supervised persons”) must report their personal securities transactions and holdings, and somebody must be tasked with reviewing those transactions and holdings. Lastly, the code must actually be provided to all supervised persons who in turn must acknowledge in writing they’ve received it.
Before going any further, it’s important to address the distinction between “supervised persons” and “access persons.” The former is a broader category of folks that includes:
“any partner, officer, director (or other person occupying a similar status or performing similar functions), or employee of an investment advisor, or other person who provides investment advice on behalf of the investment advisor and is subject to the supervision and control of the investment advisor.”
The latter includes anybody in the former category that also:
“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 who is involved in making securities recommendations to clients, or who has access to such recommendations that are nonpublic.”
All directors, officers and partners are presumed to be access persons if the firm’s primary business is providing investment advice.
All access persons are supervised persons, but not all supervised persons are necessarily access persons. The distinction is worth a tailored analysis, because certain provisions of Rule 204A-1 are applicable only to access persons.
Most notably, only access persons are required to submit personal securities transactions and holdings reports. The reality is that many supervised persons will likely be access persons as well, but it is not a distinction without a difference.
The SEC is essentially calling for heightened scrutiny of supervised persons that also have access to nonpublic information or who make securities recommendations to clients… and therefore may be in a position to use that information for their own benefit instead of for the benefit of clients. All of the other required provisions of the code other than reporting, however, are applicable to all supervised persons.
The required contents of holdings and transaction reports are spelled out in the Rule, but remember that holdings reports must be provided by each access person within ten days of them becoming an access person and annually thereafter. Transaction reports must be provided by each access person no later than thirty days after each calendar quarter.
Reporting is not required for securities over which the access person has no direct or indirect influence or control, or for transactions effected pursuant to an automatic investment plan (e.g. dividend reinvestment or auto-rebalance, etc.). Participation in IPOs and limited offerings must be pre-cleared.
Two other definitions are worth noting: “reportable securities” and “beneficial ownership”. The nuance of both determines what needs to be included in personal securities transactions and holdings reports submitted by access persons.
Reportable securities are essentially all securities with the exceptions enumerated in the Rule, the most impactful exception being open-end mutual funds not advised by the advisor or in a control relationship with the advisor. In other words, an access person investing solely in certain mutual funds (or other excluded securities) may not necessarily need to submit holdings or transaction reports. The beneficial ownership definition essentially results in reporting by immediate family members sharing the same household with the access person.
The good news is that there are several third-party vendors that will establish electronic feeds with your access persons’ personal brokerage firms to receive automated transaction and holding data, and flag any code violations. This is certainly more efficient than manually reviewing paper copies of brokerage statements and trade confirms received in the mail.
A final point: Rule 204A-1 represents the minimum of what an advisor must adopt in its code of ethics. Many firms go beyond this minimum to address such controls as transaction preclearance, short-term trading prohibitions, and black-out periods. Each advisor’s code will therefore be unique and should be tailored to the nature of the advisor’s business.