Fund directors are being asked to shoulder heavier responsibilities when it comes to codes of ethics. These codes govern personal trading by persons who have access to information regarding a fund's investment activities ("access persons"). The Securities and Exchange Commission ("Commission") recently announced amendments to Rule 17j-1 (the "Rule") under the Investment Company Act of 1940 (the "Investment Company Act").
Although personal trading by access persons is already a highly regulated area, the amendments to the Rule add additional regulation and put more oversight responsibility on fund directors, holding them more directly accountable for substantive review of the codes of ethics of not only the fund, but also the organizations that provide services to the fund (i.e., the investment adviser and the principal underwriter to the fund - "fund organizations").
The most significant amendments to the Rule are summarized below. For further information, please feel free to contact any of the lawyers listed at the end of this Client Alert.
1. Code of Ethics.
- The old Rule required the fund board to adopt a code of ethics for the fund and to review the codes of ethics for any investment adviser to the fund and the principal underwriter of the fund.
- The amended Rule continues to require the fund board to adopt a code of ethics for the fund but also requires the fund board to approve the codes of ethics for any investment adviser to the fund and the principal underwriter of the fund upon their initial engagement and within six months of any material change to their codes of ethics.
These amendments expand the role of the fund board. The fund board must now review and approve the codes of ethics for fund organizations - basing its approval upon a determination that a code of ethics contains provisions reasonably necessary to prevent access persons from violating the Rule. The amended Rule does not specify what provisions must be in a code of ethics. Rather, specific provisions are left to the fund board's evaluation on a case by case basis. Significantly, the Commission states that fund boards should address the threshold question of whether the codes of ethics should even permit personal trading by access persons.
2. Annual Issues and Certification Report.
- The amended Rule requires each fund organization to (i) provide a written report to the fund's board, on an annual basis, any material issues that arose during the previous year and (ii) certify that it has adopted procedures in compliance with the Rule.
The amendments require the fund board to review material violations of a fund organization's code of ethics and to review immaterial violations if, in the aggregate, these immaterial violations suggest that the fund organization is having problems implementing or complying with its code of ethics. The board must therefore "consider" the report provided by the fund organization - carefully evaluating the effectiveness of the code of ethics and the procedures used by the fund organization. If the fund board's careful consideration reveals problems, the fund board should request, or even require, the fund organization to amend its code of ethics or procedures accordingly.
The fund organization's annual report should also include information that is not a violation of its code of ethics but may present conflicts of interest issues in the future (i.e., a portfolio manager is the director of a company whose securities are held by the fund).
3. Reports by Access Persons.
- The old Rule required an access person to report personal securities transactions to a fund organization at least quarterly.
- The amended Rule requires an access person to report all of the securities held in his or her account - including those that the access person acquired before becoming an access person to a fund organization.
- The amended Rule requires an access person to report personal securities transactions to a fund organization at least quarterly.
- The amended Rule requires an access person to report all of the securities held in his or her account to a fund organization on an annual basis.
- The amended Rule requires that all personal securities transaction and holdings reports be reviewed by appropriate management or compliance personnel of the fund organization.
These amendments are designed to improve the information a fund organization receives regarding the personal trading of its access persons. Although most fund organizations probably already review the quarterly personal securities transactions reports of their access persons, the Rule now requires the reports to be reviewed by "appropriate" management or compliance personnel in order to detect conflicts of interest and abusive practices. Further, access persons are required to submit to their fund organizations an initial holdings report within 10 days of becoming an access person and within 10 days after each calendar quarter. The fund organization must review the initial, annual and quarterly reports and maintain a record of the names of the persons responsible for the review.
If an access person violates the Rule, the fund organization should take appropriate action and report any material violation to the fund board in its annual report, or sooner if the violation is significant.
4. Pre-Approval of Investments in IPOs and Private Placements.
- The new Rule requires control persons, portfolio managers and other persons involved in making investment recommendations ("investment personnel") of a fund organization to obtain approval before investing in initial public offerings ("IPOs") and private placements.
The amendment requires fund organizations to review carefully each request for approval. The amendment does not prohibit investment personnel from investing in IPOs or private placements, but does require the fund organization to monitor closely which investments may present future conflicts with the fund and (i) disallow the investment if a serious conflict is anticipated (i.e., a fund expects to purchase a private placement security when sold to the public) or (ii) closely monitor the investment if a minor or possible conflict is anticipated. The amendment also requires the fund organization to retain a record of each approval, including the rationale behind the approval, of investment personnel investing directly or indirectly in an IPO or private placement. The Rule specifically defines the term "investment personnel" to mean not all "access persons" (which is a broad term), but only persons who are involved in investment decisions for the fund and who may have significant opportunities to influence fund investment decisions to their personal benefit.
5. Disclosure of Policies.
- The amended Rule requires a fund to disclose information regarding its code of ethics in its prospectus or statement of additional information.
The amendments to the Rule require a fund to disclose to investors in its prospectus or SAI that (i) the fund and its investment adviser and principal underwriter have adopted codes of ethics; (ii) that the codes of ethics permit (or do not permit) access persons to invest in securities; and (iii) that the codes of ethics are on file with the Commission. The Commission requires that the codes of ethics be filed as an exhibit to the fund's registration statement.
6. Excepted Securities and Funds.
- The old Rule excepted from its coverage transactions in money market fund instruments, U.S. Government securities, and mutual fund securities.
- The amended Rule expands the exclusion to except all funds that are money market funds, or that limit their investments to certain money market instruments, certain U.S. Government securities and securities of other mutual funds.
These funds do not need to adopt codes of ethics, and access persons of these funds do not need to make transaction or holding reports. In addition, access persons do not need to report transactions in, or initial or annual holdings of, any of these instruments.
7. Compliance Dates.
- October 29, 1999:
- Rule amendments become effective.
- March 1, 2000:
- fund organizations must have identified access persons and notified them of reporting obligations;
- fund organizations must have adopted procedures for review of access person reports;
- fund organizations must have established a record of access persons and the persons who review the reports;
- investment personnel may not directly or indirectly acquire any interest in securities in an IPO or private placement without prior approval;
- fund organizations must retain records of approval, and reason for approval of an investment person's investment in an IPO or private placement;
- any access person hired after this date must, within 10 days, provide an initial holdings report; and
- the next post-effective registration statement amendment of the fund must include as exhibits, the codes of ethics of the relevant fund organizations.
- September 1, 2000.
- fund boards must have approved codes of ethics for the fund and fund organizations;
- fund organizations must have provided to fund boards annual issues and certification reports; and
- access persons must have provided annual holdings reports to their fund organizations.
For more information please contact any of the following attorneys in the Investment Management Law Practice Group in our London, Los Angeles, San Francisco and Washington, D.C. offices:
Julie Allecta (415) 835-1606
Wendell M. Faria (202) 508-9574
Robert E. Carlson (213) 683-6299
Michael M. Metzger (202) 508-9548
Michael Glazer (213) 683-6207
Darek A. DeFreece (415) 835-1654
David A. Hearth (415) 835-1607
Kelvin K. Leung 011-44-171-562-4023
Mitchell E. Nichter (415) 835-1609
Thao H. Ngo (415) 835-1649
William A. Crowfoot (213) 683-6312
Jacob M. Simon (213) 683-6125
Client Alert is published solely for the interest of friends and clients of Paul, Hastings, Janofsky & Walker LLP and should in no way be relied upon or construed as legal advice. For specific information on recent developments or particular factual situations, the opinion of legal counsel should be sought. PHJ&W is a partnership, including professional corporations.