On July 2, 2004, the Securities and Exchange Commission (“SEC”) adopted new Rule 204A-1 and amendments to Rule 204-2 and Form ADV under the Investment Adviser’s Act of 1940, as amended (the “Adviser’s Act”) and amendments to Rule 17j-1 under the Investment Company Act of 1940, as amended (the “Company Act”).   The new rule and related rule amendments require investment advisers registered with the SEC (“Advisers”) to implement a written code of ethics designed to set forth standards of conduct and promote compliance with federal securities laws. The codes of ethics must also address personal trading issues.

Rule 204A-1: Codes of Ethics

Standards of Conduct and Compliance with Laws
Rule 204A-1 requires an Adviser’s code of ethics to establish a standard of business conduct that the Adviser expects from all its supervised persons.   The rule does not mandate the establishment of a specific standard, only that the standard created must reflect the Adviser’s fiduciary obligations and those of its supervised persons, and must require compliance with applicable federal securities laws. By setting out minimum requirements under Rule 204A-1, the SEC has given Advisers enough latitude to design codes of ethics appropriate for their advisory businesses. Accordingly, Advisers are free to set higher standards for their employees, such as those established by professional trade groups.

Protection of Material Nonpublic Information
Each Adviser’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. While obligated to safeguard sensitive client information, Advisers may provide necessary information to service providers such as broker-dealers, accountants, custodians, and fund transfer agents.

Personal Securities Trading of Access Persons
To protect against the misuse of confidential information about client transactions or holdings, Rule 204A-1 mandates that each Adviser’s code of ethics must require the Adviser’s “access persons”  to report their securities transactions and holdings  to the Adviser’s chief compliance officer or other designated persons.  An Adviser’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.
Personal Trading Procedures.

Although Rule 204A-1 does not specify particular provisions to be incorporated into personal trading procedures, the SEC recommends that Advisers consider the following factors when drafting their personal trading procedures:

  • Prior written approval before access persons can implement a personal securities transaction (“pre-clearance”);
  • Maintenance of lists of issuers of securities that the Adviser 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 Adviser has inside information, and prohibitions on any trading (personal or for clients) in securities of those issuers;
  •  “Blackout periods” when client securities trades are being implemented or recommendations are being made and access persons are not allowed to make personal trades;
  • Reminders that investment opportunities must be offered first to clients before the Adviser or its employees may act on them, and procedures to implement this principle;
  • Prohibitions or restrictions on “short-swing” trading and market timing;
  • Requirements to provide the Adviser 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.

Initial and Annual Holding Reports
The code of ethics must require a complete report of each access person’s securities holdings, at the time the person becomes an access person and at least once a year thereafter. The report must be current as of a date not more than 45 days prior to the individual becoming an access person (initial report), or the date the report is submitted (annual report).

Quarterly Transaction Reports
The code of ethics must require quarterly reports of all personal securities transactions by access persons, which are due no later than 30 days after the close of the calendar quarter. An Adviser may excuse access persons from submitting transaction reports that would duplicate information contained in trade confirmations or account statements, so long as the Adviser has received those confirmations and account statements not later than 30 days after the close of the calendar quarter in which the transaction takes place.

Exemptions to the Reporting Requirements
Under Rule 204A-1, there are three exceptions to personal securities reporting. Specifically, 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; and
  • In the case of an advisory firm that has only once access person, so long as the Adviser maintains records of the holdings and transactions that Rule 204A-1 would otherwise require to be reported.

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.   Reportable Securities consist 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 - bankers’ acceptances, 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 Adviser or a control affiliate acts as the investment adviser or principal underwriter for the fund; and
  • Shares in units of a unit investment trust if the unit investment trust is invested exclusively in unaffiliated mutual funds.

To combat short-term trading in fund shares, an issue in recent SEC enforcement actions, Rule 204A-1 requires access persons to report holdings and transactions in mutual funds advised by the Adviser or an affiliate of the Adviser.

Initial Public Offerings and Private Placements
An Adviser’s code of ethics must require that access persons obtain the Adviser’s prior approval before they can directly or indirectly invest in an initial public offering (“IPO”) or private placement.  Because most individuals may not have the chance to invest in these types of securities, this requirement is aimed at precluding the misappropriation of investment opportunities that should be offered first to eligible clients, and preventing portfolio managers from receiving personal benefit for directing client business or brokerage.

Reporting Violations and Enforcement
Pursuant to Rule 204A-1, each Adviser’s code of ethics must contain provisions that require supervised persons to report any code violations immediately to the Adviser’s chief compliance officer or, as long as the chief compliance officer receives periodic reports of all code violations, to an authorized person designated in the code of ethics.  Moreover, the SEC encourages Advisers to establish procedures that support supervised persons who report violations, and protects them from possible retaliation.

Educating Employees About the Code of Ethics
An Adviser’s code of ethics must require that it provide each of its supervised persons with a copy of the code of ethics and any amendments thereto.  Supervised persons, in turn, must provide the Adviser with their written acknowledgment of their receipt of the code and any amendments.

Although not specifically required, the SEC expects Advisers to ensure that employees have received adequate training on the principals and procedures in their codes of ethics.

Adviser review and Enforcement
An Adviser’s chief compliance officer, or person under his authority, should have primary responsibility for enforcing the code of ethics.  Enforcement of the code must include reviewing access persons’ personal securities holdings and transaction reports.  

Rule 204-2:  Recordkeeping
In addition to adopting Rule 204A-1, the SEC has amended Rule 204-2 to require Advisers to maintain copies of the:

  • 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; and
  • Records of decisions approving access persons’ acquisition of securities in IPOs and limited offerings.

The Adviser must keep these records in an easily accessible place for at least five years after the last date they were in effect, the first two years in an appropriate office of the Adviser. The SEC has not imposed a requirement that records of access persons’ personal securities reports be maintained electronically in an accessible computer database, but most Advisers will likely maintain their records electronically in order to effectively review their records and monitor compliance with their codes of ethics.

Form ADV
The SEC has amended Item 9 of Form ADV Part II to require Advisers to describe their codes of ethics and provide any client or prospective client with a copy of the code upon request.  The amended Form ADV will allow clients to better understand an Adviser’s internal controls with respect to sensitive client information, and enable them to choose Advisers with ethical standards akin to their own. In addition, the increased transparency will encourage Advisers to comply with the codes of ethics they disclose.

Rule 17j-1
To avoid unnecessary overlap, the SEC has amended Rule 17j-1 of the Company Act to state that an access person need not submit a separate report under Rule 17j-1 to the extent the information contained in the report would duplicate information required to be recorded under Rule 204-2 of the Adviser’s Act.  In addition, Rule 17j-1, as amended, provides the following:

  • Information in initial holdings reports must be current as of a date no more than 45 days prior to the individual becoming an access person, and in the case of annual holdings reports, as of a date no more than 45 days prior to the submission of the report;
  • Quarterly transaction reports are due no later than 30 days after the close of the calendar quarter;
  • Access persons do not need to make quarterly transaction reports for transactions effected pursuant to an automatic investment plan; and
  • Access persons include advisory persons of a fund  or its Adviser, and if the Adviser’s primary business is investment advisory, the Adviser’s directors, officers and general partners.

Effective Dates
The new rule and amendments will become effective on August 31, 2004.  The compliance date for such rules and rule amendments is January 7, 2005, at which time all Advisers must have adopted codes of ethics, received an initial holdings report from each access person, and arranged for the submission of quarterly transaction reports.

Please do not hesitate to contact any of  the above members of our Broker-Dealer Practice if we can be of assistance in reviewing your code of ethics to ensure compliance with the SEC rules.