On July 2, 2004, the Securities and Exchange Commission (the "SEC" or "Commission") adopted Rule 204A-1 under the Investment Advisers Act of 1940 (the "Act") and related amendments that require registered investment advisers to adopt a code of ethics. See Final Rule: Investment Adviser Codes of Ethics, Investment Advisers Act Release No. IA-2256, (Jul. 2, 2004) [hereinafter Final Rule]. Certain provisions of Rule 17j-1 under the Investment Company Act of 1940 were amended to make them consistent with the provisions of Rule 204A-1. Id. The code of ethics must set forth a standard of conduct expected of advisory personnel, require "access persons" to submit periodic securities holdings and transactions reports, require "access persons" to obtain the adviser's approval prior to investing in an initial public offering ("IPO") or private placement, and require prompt reporting of violations of the code. The new rule is designed to address certain fraudulent trading practices that have been the subject of several recent enforcement actions against investment advisers and to reinforce the fiduciary principles that define the relationship between advisers and their clients. See, e.g., In the Matter of Strong Capital Management, Inc., Investment Advisers Act Release No. 2239 (May 20, 2004); In the Matter of Massachusetts Financial Services Co., Investment Advisers Act Release No. 2213 (Feb. 5, 2004); In the Matter of Alliance Capital, L.P., Investment Advisers Act Release No. 2205 (Dec. 18, 2003); In the Matter of Robert T. Littell and Wlifred Mickel, Investment Advisers Act Release No. 2203 (Dec. 15, 2003); In the Matter of Zion Capital Management LLC and Ricky A. Lang, Investment Advisers Act Release No. 2200 (Dec. 11, 2003).
New Rule 204A-1 and the related amendments become effective on August 31, 2004. Investment Advisers must comply with the new rule and related amendments by January 7, 2005. This advisory summarizes new Rule 204A-1 and the related amendments and, where appropriate, indicates how these new regulations may affect advisory firm operations and communications with employees.
Standard of Business Conduct
What Standard of Business Conduct Must Advisers Impose on Their Supervised Persons?
Rule 204A-1 requires that each adviser adopt a code of ethics that sets forth a standard of business conduct required of all of its supervised persons. The term "supervised persons" includes an adviser's partners, officers, directors, employees and any other persons who provide advice on behalf of the adviser and are subject to the adviser's supervision and control. Advisers Act § 202(a)(25). The rule does not require advisers to adopt specific standards, but does require the standard adopted to reflect, at a minimum, the fiduciary obligations of the adviser and its supervised persons and to require compliance with the federal securities laws.
Personal Securities Trades Reporting Requirements and Procedures
Who is Subject to the Personal Trading Reporting Requirements that Advisers Must Include in their Codes of Ethics?
Under Rule 204A-1, an adviser's code of ethics must require certain supervised persons called "access persons" to report periodically their personal securities transactions and holdings to the adviser's chief compliance officer or the person designated in the adviser's code. The rule defines access persons as an adviser's supervised persons who:
- Have access to nonpublic information regarding clients' purchases or sales of securities, or nonpublic information regarding the portfolio holdings of any affiliated mutual funds; or
- Are involved in making securities recommendations to clients, or who have access to the adviser's nonpublic recommendations.
The SEC does not consider a supervised person to be an access person solely because he or she has access to nonpublic information about non-mutual fund clients' portfolio holdings. See Final Rule.
Rule 204A-1 presumes that all of a firm's directors, officers and partners are access persons if the firm's primary business is providing investment advice. Access persons will also typically include portfolio management personnel and, in some cases, client service representatives who discuss investments with and dispense advice to clients. Furthermore, administrative and technical staff may qualify as access persons if their job functions give them access to material nonpublic information.
What Reporting Obligations Must an Adviser's Code of Ethics Impose on its Access Persons?
Initial and Annual Holdings Reports
Under Rule 204A-1, an adviser's code of ethics must require a report of each access person's securities holdings at the time the person becomes an access person and at least annually thereafter. The reports must be current as of 45 days prior to the date the person became an access person for the initial report, and current as of 45 days prior to the submission of each annual report.
Quarterly Transaction Reports
An adviser's code of ethics must also require access persons to submit quarterly reports of all their personal securities transactions. These reports must be due no later than 30 days after the completion of each calendar quarter. To ease the burden of compliance, however, Rule 204A-1 permits the code of ethics to excuse access persons from submitting transaction reports that would duplicate information contained in trade confirmations and/or account statements held in the adviser's records as long as the adviser received them within 30 days after the end of the calendar quarter in which the transactions took place. An access person who engages in no reportable transactions during the quarter is not required to submit a transaction report.
Are Access Persons Required to Report all of Their Securities Holdings and Transactions?
No. An adviser's code of ethics must require access persons to submit holdings and transactions reports only with respect to "reportable securities" in which the access person has any direct or indirect "beneficial ownership." The term "beneficial ownership" is interpreted in the same manner as for purposes of Rule 16a-1(a)(2) under the Securities Exchange Act of 1934. Rule 204A-1 defines "reportable securities" as all securities with the following five exceptions:
- Transactions and holdings in direct obligations of the U.S. government;
- Money market instruments, including bankers' acceptances, bank certificates of deposit, commercial paper, repurchase agreements, and other high quality short-term debt instruments;
- Shares of money market funds;
- Transactions in shares of mutual funds, unless the adviser or a control affiliate of the adviser acts as the investment adviser or principal underwriter of the fund; and
- Transactions in units of a unit investment trust as long as the trust is invested exclusively in unaffiliated mutual funds.
The SEC interprets "high quality short-term debt instruments" to include any instrument that has a maturity at issuance of less than 366 days and is rated in one of the two highest rating categories by a Nationally Recognized Statistical Rating Organization or, if unrated, is of comparable quality. See Final Rule.
The SEC also included the unaffiliated mutual fund exception to capture variable insurance contracts funded by insurance company separate accounts organized as unit investment trusts. See id.
An important aspect of the new reporting requirements is that access persons will now be required to report their holdings in mutual funds for which the adviser or a control affiliate acts as adviser or principal underwriter. Access persons of such mutual funds were not previously required to disclose this information under the Investment Company Act of 1940 (the "1940 Act") or the rules adopted thereunder. This requirement is designed to address abusive and fraudulent trading by portfolio managers and supervised persons with access to material nonpublic information about a mutual fund's portfolio holdings that have come to light in recent enforcement actions brought by the Commission. See, e.g., In the Matter of Putnam Investment Management LLC, Investment Advisers Act Release No. 2192 (Nov. 13, 2003).
Rule 204A-1 also permits advisers to exclude from the reporting requirements of its code of ethics:
- Transactions effected pursuant to an automatic investment plan, unless the transaction overrides the set schedule or allocations of the plan;
- Securities held in accounts over which the access person has no direct or indirect influence or control; and
- Transactions by firms that have only one access person, as long as the adviser otherwise maintains records of holdings and transactions that would otherwise be required to be reported pursuant to Rule 204A-1.
What Other Personal Trading Procedures Must Advisers Include in Their Codes of Ethics?
In addition to the reporting requirements outlined above, an adviser's code of ethics must require access persons to obtain the approval of the adviser prior to investing in any IPO or private placement. With the exception of this requirement and the securities holdings and transaction reports, Rule 204A-1 does not require advisers to include any other specific prophylactic measures in their codes. The Commission decided in favor of providing advisers with the flexibility to adopt procedures that best fit the particular adviser. The SEC did, however, encourage advisers to consider including the following policies and procedures that are commonly found in the codes of ethics adopted by advisers pursuant to Rule 17j-1 under the 1940 Act:
- Pre-clearance of all access persons' personal securities transaction;
- Maintenance of a list of issuers that the adviser is analyzing or recommending, and prohibitions on personal trading in the securities of those issuers;
- Maintenance of "restricted lists" of issuers for which the firm has inside information, and prohibitions on trading, either personal or on behalf of clients, in those securities;
- "Blackout periods" that restrict access persons' personal securities transactions when clients' trades are being recommended or placed;
- Reminders that fiduciary principles require the adviser to offer investment opportunities to clients before the adviser or its employees may act on them;
- Restrictions or prohibitions on "short-swing" trading and market timing;
- Requirements that access persons trade only through certain brokers or limitations on the number of brokerage accounts they are permitted to maintain;
- Requirements to provide the adviser with duplicate trade confirmations and account statements; and
- Procedures to ensure that new securities analyses are not assigned to employees whose personal holdings would present a conflict of interest.
Reporting of Violations, Education, Review and Enforcement, and Recordkeeping
Does Rule 204A-1 Require Advisers to Include Provisions in Their Codes of Ethics Related to Reporting Violation of the Code?
Yes. An adviser's code of ethics must require prompt internal reporting of any violations of the code to the adviser's chief compliance officer or other designated person identified in the code. If an adviser decides to designate someone other than the chief compliance officer to receive reports of violations, then its code of ethics must include procedures that require the chief compliance officer to receive periodic reports of all violations. Although Rule 204A-1 does not mandate the adoption of specific reporting procedures, advisers are required to adopt procedures that create an environment that encourages supervised persons to report violations and discourages retaliation against individuals who do report violations.
Are Advisers Required to Adopt Training and Education Programs for Their Supervised Persons?
No. Under Rule 204A-1, an adviser must provide a copy of its code of ethics to each supervised person and each supervised person must acknowledge receipt of the code in writing. The rule permits these acknowledgements to be made electronically. Advisers are not, however, required to adopt training and education programs with respect to their codes. Although no additional training and education is required by Rule 204A-1, the SEC stated in its release that it expects advisers to ensure that their supervised persons receive adequate training on the principles and procedures of their codes.
What Review, Enforcement and Recordkeeping Obligations do Advisers Have Under Rule 204A-1?
Review and Enforcement
Rule 204A-1 requires advisers to maintain and enforce their codes of ethics by, among other things, reviewing their access persons' securities holdings and transactions reports. An adviser's review of these reports should include:
- An assessment of whether access persons followed internal procedures set forth in the code of ethics;
- A comparison of access persons' personal trades with any restricted securities lists maintained by the adviser;
- An assessment of whether access persons are trading in the same securities for both personal and client accounts and, if so, whether client accounts are receiving less favorable terms;
- A periodic review of transactions to identify market timing;
- An investigation of any substantial disparities between the quality of performance access persons achieve for their personal accounts compared to that which they achieve for client accounts; and
- An investigation of any substantial disparities between the percentage of trades that are profitable when access persons trade for their own accounts and the percentage that are profitable when they trade for client accounts.
Responsibility for enforcing the code must rest with the adviser's chief compliance officer or persons acting under his authority.
Under Rule 204A-1 and related amendments to Rule 204-2, advisers must keep copies of their codes of ethics, records of violations and actions taken as a result thereof, and copies of supervised persons' acknowledgement of receipt of the code. To encourage reporting of violations, advisers need not maintain copies of whistleblower reports, and instead may simply keep a record of the circumstances of the violation. Advisers must also keep records of the names of all access persons, their holdings and transactions reports, and records of any decisions approving an access person's acquisition of securities in IPOs and limited offerings.
Rule 204A-1 does not require advisers to maintain these records electronically. Under Rule 204-2, advisers must retain these records in an easily accessible location for five years, subject to any applicable special holding requirements. The records must be stored in an appropriate office of the adviser for the first two years. Codes of ethics must be retained for five years after the date on which they were last in effect. Supervised person acknowledgements must be retained for five years after the person ceases to be a supervised person. Lists of access persons must include the names of every person who was an access person of the adviser within the past five years.
Related Amendments and Changes from the Original Proposal
What Other Rule Amendments Did the SEC Adopt in Connection with the Adoption of Rule 204A-1?
In addition to adopting new Rule 204A-1, the SEC adopted amendments to its related rules and forms under the Act and the 1940 Act.
The Commission amended Item 9 of Part II to Form ADV to require advisers to describe their code of ethics to clients and to provide clients with copies of their codes upon request.
The SEC also amended Rule 17j-1 under the 1940 Act, the rule requiring advisers that advise registered investment companies to adopt codes of ethics, to provide that:
- No report would be required under Rule 17j-1 to the extent that it would duplicate information required to be recorded pursuant to the Act's recordkeeping rules;
- Information in access persons' initial and annual holdings reports must be current as of 45 days prior to the date the person became an access person for the initial report, and current as of 45 days prior to the submission of each annual report;
- Quarterly transaction reports are due no later than 30 days after the close of the calendar quarter, rather than 10 days as is currently required; and
- Quarterly transaction reports need not be submitted for transactions effected pursuant to an automatic reinvestment plan.
Rule 17j-1 currently requires initial holdings reports to be current as of the date the person becomes an access person and annual holdings reports to be current as of 30 days prior to submission. See 1940 Act Rule 17j-1(d)(i) & (iii), 17 C.F.R. §270.17j-1(d)(i) & (iii).
In addition, the Commission is doing away with Rule 17j-1's revenue-based test that advisers use to exclude certain officers, directors, and general partners from the definition of "access person". It is replacing it with the same presumption included in Rule 204A-1 – that all directors, officers, and general partners of an adviser are access persons if the adviser's primary business is providing investment advice.
How do the Final Rules Differ from the Commission's Initial Proposal?
The final version of Rule 204A-1 and the related amendments differ from the SEC's initial proposal in four important ways. See Proposed Rule: Investment Adviser Codes of Ethics, Investment Advisers Act Release No. IA-2209, (Jan. 20, 2004).
- First, Rule 204A-1 does not require advisers to include in their code of ethics provisions that limit access to material nonpublic information about the adviser's recommendations and client securities holdings and transactions to individuals who need the information to perform their duties. The SEC had included this provision in its proposed rule, but left it out of the final version of Rule 204A-1 in response to advisers' concerns about the feasibility of segregating employees to the extent necessary to comply with the requirement.
- Second, the SEC increased the time periods under the securities holdings and transactions reporting requirements.
- Third, the SEC did not include in the final rule a proposal that would have required access persons that did not execute any personal securities transactions in a given quarter to submit a report confirming the absence of any transactions. The SEC eliminated this proposed requirement in response to commenters' concerns that reports confirming the absence of transactions were unnecessary and overly burdensome.
- Finally, the SEC did not adopt a proposal that would have required advisers to maintain records of access persons' holdings and transactions reports in an electronic database. The SEC chose not to adopt this amendment to Rule 204-2 in response to commenters' concerns that it would require them to input larger quantities of data manually.
Rule 204A-1 is the SEC's latest effort to reinforce the fiduciary obligations and principals that govern investment adviser conduct. Although Rule 204A-1 grants advisers some flexibility in meeting the reporting, enforcement, and recordkeeping requirements, these provisions will nonetheless impose extra burdens on advisers, their access persons, and other advisory staff. Therefore, advisers should consider taking steps to develop their code of ethics and related procedures soon to ensure compliance by January 7, 2005.