Tag: Rule 204A-1

SEC Loosens the Standards in Trade Monitoring

One of the more difficult aspects of a private equity fund when it registers as an investment adviser is dealing with the Rule 204A-1 requirement of monitoring employee trading. The SEC recently issued guidance on the applicability to managed accounts when there is no direct or indirect influence or control.

im guidance update

The Guidance focuses on the code of ethics rule: Advisers Act rule 204A-1. The rule requires supervised persons to report their personal securities holdings and transactions. Subsection (b)(3)(i) offers an exception to the personal trading review requirement provided the supervised person has “no direct or indirect influence or control.”

Typically, CCOs have taken a hard line on this and the SEC has as well. For example, the hard line standard had typically been a blind trust, where the access person has no influence or control, and may not even know the holdings in the accounts. Some CCOs have take a more liberal approach. Clearly, the SEC has seem some CCOs incorrectly determine that some access persons’ trusts and third-party discretionary accounts qualify for the exception when they don’t.

Under the Guidance, the SEC is demanding more diligence.

Having “a third-party manager with discretionary authorities isn’t enough to qualify for the exception.” That does not eliminate actual or possible influence on what securities the third-party manager sells or purchases. The Guidance recommends CCOs probe deeper with managed accounts.

The Guidance states that obtaining a general certification alone is insufficient to determine if the access person exercised direct or indirect influence or control. The Guidance recommends that the CCO issues some probing questions:

“Did you suggest that the trustee or third-party discretionary manager make any particular purchases or sales of securities for account X during time period Y?”

“Did you direct the trustee or third-party discretionary manager to make any particular purchases or sales of securities for account X during time period Y?”

“Did you consult with the trustee or third-party discretionary manager as to the particular allocation of investments to be made in account X during time period Y?”

The Guidance may offer some relief for CCOs that took the hard line on the definition of managed accounts. On the other hand, it may he a tougher standard for those CCOs who took a more liberal view. In either case, there is clear guidance.

Sources:

Are ETFs Reportable Securities?

As a compliance officer for a registered investment adviser, you need to verify transactions where the account has a “reportable security” to make sure your employees are not violating your insider trading policy. That means checking you employees’ securities accounts at least quarterly. You’re compelled by Rule 204A-1 (b)(2) to do this for access persons.

The big exclusions from the definition of reportable security are US Treasuries and open-end mutual funds (assuming they are not funds where you act as the investment adviser).

The question I had was how Exchange Traded Funds fit into that definition. Index funds fit into the open end fund exclusion. Exchange Traded Funds act sort of like index funds so should they be reportable securities?

The answer turns out to be yes and no.

National Compliance Services asked this same question in 2005, shortly after Rule 204A-1 came out.

ETFs are structured as either an open-end fund or a unit investment trust. The SEC’s response in a no action letter was that the open-end fund variety is not a reportable security and the UIT variety is a reportable security.

Is the UIT variety of ETF rare enough that you don’t need to worry about them? No. Actually, it’s the opposite. Some of the largest ETFs are Unit Investment Trusts: SPY, QQQ, DIA and MDY. That means you should probably just through all ETFs under the “reportable securities” label.

Sources:

Another CCO in Trouble

With failure, comes learning. As a compliance officer, disciplinary actions against other compliance officers can be a road map showing me what not to do. Recently, the SEC charged affiliated firms and their former chief compliance officer with failing to have adequate policies and procedures to prevent misuse of nonpublic information.

Section 204A and Rule 204A-1 make it very clear that every investment adviser must have written policies and procedures reasonably designed to prevent the misuse of material, nonpublic information. Buckingham Capital Management Inc. and its broker-dealer parent company, The Buckingham Research Group Inc. apparently did not.

BRG and BCM’s policies and procedures were deficient in a number of ways. BRG had a written procedure to address the misuse of material, nonpublic information, but did not follow its written procedure in practice. Important compliance policies and procedures were not contained in BCM’s written policies and procedures. Further, in some instances, BCM’s written policies and procedures were so unclear that employees did not understand their responsibilities. In other instances, the practices BCM employed varied materially from its written policies and procedures. These failures led to inadequate implementation and enforcement of the firms’ written compliance policies and procedures.

That’s bad, but more likely to result in a deficiency letter than an enforcement action, assuming they were not misusing the information. The problem was that these deficiencies were discovered during a 2003 SEC examination. BCM said they would fix the problem.

Trouble

In preparation for a 2006 SEC exam,  BCM discovered it was missing more that 100 pre-approval forms for trades and that its compliance review logs for 2005 and 2006 were incomplete.

Rather than deliver incomplete records, BCM staff altered the records. This apparently angered the SEC and they moved the case from examination into enforcement.

The former CCO, Karp was censured and agreed to pay a $35,000 penalty.

Lessons

If the SEC tells you there is deficiency, fix it and make it a priority. The first thing they will look at on their next visit is the area of the deficiency. I’m still surprised that the SEC reported only 90% of deficiencies get cured.

Don’t falsify records. That will get the problem moved from the inspection side to the enforcement side of the SEC. That would be a CCO Failure. (The complaint indicates that Mr. Karp did not participate in the falsification.)

Sources:

Private Investment Funds and Reporting Requirements Under the Ethics Code Rule

As I wrote about yesterday on the code of ethics for an investment adviser, one of the requirements of registering with SEC as an investment adviser is implementing a code of ethics. The most involved part of the code is the extensive reporting requirement on securities activities to the chief compliance officer.

Rule 204A-1 under the Investment Advisers Act of 1940 takes the approach that extensive reporting of trading activities by employees of an investment adviser will been a strong deterrent from getting involved in insider trading.The rule breaks the reporting into two baskets: holdings report and transaction report.

Holding Report Under Rule 204A-1

Annually, each access person needs to submit a report of their securities holdings. The report needs to include the following:

  • title of the security;
  • type of security
  • as applicable, the exchange ticker symbol or CUSIP number
  • number of shares
  • principal amount of each reportable security
  • The name of any broker, dealer or bank
  • The date of the report

The rule does not require this to be a calendar year.

Transactions Report Under Rule 204A-1

Quarterly, each access person needs to submit a report of their securities trading activity. The report needs to include the following:

  • date of the transaction
  • title of the security
  • as applicable the exchange ticker symbol or CUSIP number
  • interest rate and maturity date for bonds and debt instruments
  • number of shares
  • principal amount
  • nature of the transaction (i.e., purchase, sale or any other type of acquisition or disposition)
  • price of the security
  • name of the broker, dealer or bank who effected the trade
  • submission date of the report

The report is due within 30 days after the end of the calendar quarter.

Access Person Under Rule 204A-1

The reporting obligations are limited to “access persons” at the investment adviser. These are every employee that

  1. has access to nonpublic information regarding any clients’ purchase or sale of securities
  2. has access to nonpublic information regarding the portfolio holdings of any reportable fund
  3. is involved in making securities recommendations to clients
  4. has access to securities recommendations that are nonpublic

Those are some very broad categories. For most private funds, I would guess that most of their employees could be considered “access persons.” It’s probably easier and less likely to get you in trouble if you consider all employees to be access persons and require all employees to submit reports. Not easier on the compliance officers, but easier on employee understanding.

Exceptions From Reporting Requirements

Rule 204A-1 has some exceptions to personal securities reporting. No reports are required:

  • With respect to transactions effected pursuant to an automatic investment plan.
  • With respect to securities held in accounts over which the access person had no direct or indirect influence or control.

Plus there is also a group securities that are not reportable:

  • Direct obligations of the Government of the United States;
  • Bankers’ acceptances, bank certificates of deposit, commercial paper and high quality short-term debt instruments, including repurchase agreements;
  • Shares issued by money market funds;
  • Shares issued by open-end funds other than reportable funds; and
  • Shares issued by unit investment trusts that are invested exclusively in one or more open-end funds, none of which are reportable funds

Preclearance for IPOs and Limited Offerings

Rule 204a-1 requires an access person to obtain approval before they any security in an initial public offering or in a limited offering. A “limited offering” is a private placement and would include the purchase of an interest in a private investment fund.

What About Alternative Investment Fund Advisers?

These rules make sense for an adviser focusing on tradable securities, but make much less sense for advisers to funds that focus on alternative investments. Venture capital is an obvious example, but it seems they have escaped from the registration requirement imposed on other private equity firms under the financial reform bills.

Sources:

Image of 100 dollar bill is by mokra from RGBstock.com

Code of Ethics for an Investment Adviser

With the upcoming requirement that advisers to many private investment funds must register with the SEC, I figured it was time to look at some of the requirements that registration will impose.

Section 204A of the Investment Advisers Act requires registered investment advisers to

“establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment adviser’s business, to prevent the misuse … of material, nonpublic information by such investment adviser or any person associated with such investment adviser.”

It also requires the SEC to adopt “adopt rules or regulations to require specific policies or procedures reasonably designed to prevent misuse.” That leads to the issuance of  Rule 204A-1 under the Investment Advisers Act of 1940

Rule 204A-1 has three key elements: Adoption, Reporting, IPOs.

The adoption element lays out what needs to be in the advisers code of ethics:

  1. A standard of business conduct that you require which reflect the fiduciary obligations;
  2. Provisions requiring your supervised persons to comply with applicable federal securities laws;
  3. Provisions that require all of your access persons to report, and you to review, their personal securities transactions and holdings periodically;
  4. Provisions requiring supervised persons to report any violations of your code of ethics promptly; and
  5. Provisions requiring you to provide each of your supervised persons with a copy of your code of ethics and any amendments, and requiring your supervised persons to provide you with a written acknowledgment of their receipt of the code and any amendments.

Number five requires the standard delivery of the code and signature that they received the code. The prompt reporting is also standard for a code of conduct, as is the compliance with laws.

The fiduciary obligations may be a surprise for the advisers to private investment funds. Fund managers typically structure the funds as limited partnerships. The enabling statute impose a fiduciary duty on the general partner of a limited partnership, which for a private fund will be the investment adviser affiliate. Delaware limited partnership law allows a general partner to reduce its fiduciary obligations, but still must retain the implied contractual covenant of good faith and fair dealing. (see 17 Del Code §17-1101)

On the other hand, Section 206 of the Investment Advisers Act imposes fiduciary duties on investment advisers, regardless of whether or not they are registered with the SEC. This is a different body of law defining the obligations of an investment adviser as opposed to the general partner of a limited partnership.

The fiduciary obligation in 206 make its a violation to

  • employ any device, scheme, or artifice to defraud any client or prospective client;
  • engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;
  • engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative;

Those are your conventional anti-fraud provisions. There is one more violation and it gets the most attention:

“Acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.”

The key here is that is a violation to if you don’t disclose the conflict prior to completion of the transaction.

Fora private fund, you will need to take a look at Rule 206(4)-8 because it lays out some additional fraud prohibitions for investment advisers to private investment funds.

If you run a private fund and don’t have written code of  ethics, it’s time to start thinking about putting one in place. Here are some examples of investment adviser code of ethics:

If you don’t have a code of conduct and are looking for a starting point. Those three are worth taking a look at. There are plenty of others out there and findable with an internet search.

Also keep in mind that you will have to revisit your code next year. Rule 206(4)-7 requires an annual review of your code of ethics.

Sources:

  • Section 204A of the Investment Adviser Act
  • Rule 204A-1 – Investment Adviser Code of Ethics
  • Investment Adviser Code of Ethics Rule by Shearman and Sterling
  • Section 206 of the Investment Advisers Act
  • Rule 206(4)-7
  • Rule 206(4)-8