Investment Advisory Codes of Ethics
By January 7, 2005, all investment advisers registered with the Securities and Exchange Commission ("SEC") must comply with new Rule 204A-1 under the Investment Advisers Act of 1940 (the "Advisers Act") and keep related books and records under amended Rule 204-2 (Final Rule: Investment Adviser Code of Ethics; Release No. IA-2256, File No. S7-04-04, 7/2/04). The Division has received several inquiries concerning the extent to which the new rule and related recordkeeping requirements apply to investment advisers registered under the Connecticut Uniform Securities Act ("CUSA").
Although CUSA and its Regulations do not require that state-registered investment advisers prepare a separate code of ethics, ethical concerns should be integrated into a state-registered investment adviser's supervisory and compliance procedures as well as its business operations as more fully discussed in this policy statement.
Discussion: SEC Rule 204A-1 and its Impact on State-Registered Investment Advisers
SEC Rule 204A-1 contains a basic code of ethics requirement and more specific internal reporting and operational requirements that SEC-registered investment advisers must observe to prevent conflicts of interest. Correspondingly, amendments to SEC Rule 204-2(a) require SEC-registered investment advisers to retain as required records a copy of their code of ethics; records concerning code of ethics violations and their disposition; records concerning personal securities transactions by certain advisory personnel; and evidence in the form of an acknowledgement that supervised persons received a copy of the code of ethics.
The Basic Code of Ethics Requirement
Rule 204A-1 requires SEC-registered investment adviser to establish, maintain and enforce a written code of ethics containing, at a minimum, a standard of business conduct that the adviser requires of its "supervised persons" as defined in Section 202(a)(25) of the Advisers Act, and retain the code of ethics as a required record under amended Rule 204-2(a). The standard must reflect the investment adviser's fiduciary obligations and those of its supervised persons. In the implementing release, the SEC noted that: "The rule does not require the adviser to adopt a particular standard" and that "[a]dvisers are free to set higher standards for their employees, such as those established by professional or trade groups" such as the Financial Planning Association, the Association for Investment Management and Research, the Certified Financial Planner Board of Standards, the Investment Counsel Association of America and the American Institute of Certified Public Accountants (Release, at n. 6) In addition, the implementing release pointed out that the code of ethics "should be more than a compliance manual" and should "set out ideals for ethical conduct premised on fundamental principles of openness, integrity, honesty and trust." The rule also requires that supervised persons comply with applicable federal securities laws such as the Securities Act of 1933, the Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002, the Investment Company Act of 1940, the Advisers Act, Title V of the Gramm-Leach-Bliley Act, and the Bank Secrecy Act.
Neither CUSA nor its Regulations contain an express requirement that Connecticut-registered investment adviser prepare a separate, written code of ethics and the department is not mandating that one be prepared at this time. However, laced throughout CUSA and its Regulations are several proscriptions against unethical conduct. Section 36b-5(f) of CUSA prohibits persons receiving compensation or other remuneration for advisory or solicitation services from engaging in "any dishonest or unethical practice in connection with the rendering of such advice or in connection with such solicitation." Under Section 36b-15(a)(2)(H) of CUSA, an investment advisory registration may be revoked, suspended or restricted if the registrant has "engaged in dishonest or unethical practices in the securities or commodities business." Section 36b-31-15c of the Regulations provides examples of misconduct deemed to be dishonest or unethical for purposes of Section 36b-15(a)(2)(H) of CUSA. Section 36b-27(a) of CUSA permits the Commissioner to, among other things, issue a cease and desist order and require restitution and disgorgement upon a finding that the respondent "engaged in a dishonest or unethical practice in the securities or commodities business." To avoid running afoul of these prohibitions, the Division would encourage state-registered investment advisers to incorporate ethical considerations into their existing compliance/supervisory materials and, most important, communicate those considerations to investment adviser agents on a regular basis.
Internal Reporting of Personal Securities Transactions
SEC Rule 204A-1 requires that "access persons" report their personal securities transactions to the SEC-registered investment adviser and that the investment adviser review those transactions. An "access person" is a "supervised person" 1) having access to nonpublic information about the portfolio holdings of any "reportable fund" (i.e. a fund for which the investment adviser served as investment adviser or a fund whose adviser or principal underwriter controls the investment adviser, is controlled by the investment adviser or is under common control with the investment adviser); 2) involved in making client securities recommendations; or 3) having access to nonpublic client securities recommendations. Directors, officers and partners of the investment adviser are presumptively "access persons."
There are two types of reports that access persons must prepare under SEC Rule 204A-1: 1) a "Holdings Report" and 2) a "Transaction Report." Neither report is required for securities held in accounts over which the access person had no direct or indirect influence or control.
The Holdings Report covers the access person's current securities holdings. The report must be submitted to the chief compliance officer or other designated person 1) no later than 10 days after the person becomes an access person; and 2) at least once each twelve month period thereafter on a date selected by the SEC-registered investment adviser. The Holdings Report contains information on the title and type of securities; as applicable, the exchange ticker symbol or CUSIP number; the number of shares; the principal amount of each reportable security in which the access person has any direct or indirect beneficial ownership; the name of any broker, dealer or bank with whom the access person maintains an account in which any securities are held for the access person's direct or indirect benefit; and the date the access person submits the report.
The Transaction Report covers "reportable securities" in which the access person had (or, as a result of the transaction acquired) any direct or indirect beneficial ownership. The term "reportable securities" does not include direct obligations of the U.S. government; bankers' acceptances; bank CDs; commercial paper; 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" (i.e. those with whom the investment adviser had an affiliation as described elsewhere in the rule); and shares issued by unit investment trusts that are invested exclusively in one or more open-end funds, none of which are "reportable funds." In addition, Transaction Reports do not have to be filed for: 1) transactions effected pursuant to an automatic investment plan such as a dividend reinvestment plan; or 2) if the report would duplicate information in broker trade confirmations or account statements that the investment adviser holds in its records, provided that the investment adviser receives the confirmations or statements no later than 30 days after the end of the applicable calendar quarter. Transaction reports must be submitted to the chief compliance officer or other designated person quarterly and within 30 days after each calendar quarter ends. The report covers transactions occurring during the quarter and includes: the date of the transaction; the title of the reportable security; as applicable, the exchange ticker symbol or CUSIP number; the interest rate; the maturity date; the number of shares; the principal amount of each reportable security involved; the nature of the transaction (purchase; sale; any other type of acquisition or disposition); the price of the security at which the transaction was effected; the name of the broker, dealer or bank with or through whom the transaction was effected; and the date the access person submits the report.
Insofar as personal securities transactions are concerned, CUSA and its Regulations do not impose formal internal reporting or review requirements as does SEC Rule 204A-1. This is not to say, however, that firms should not develop a mechanism for addressing personal securities transactions. In the Division's online description of its Investment Adviser Examination Program, records of personal securities transactions are specifically listed as being subject to review during a Division examination. Moreover, in outlining typical examination deficiencies, the Division noted that an investment adviser's compliance/supervision manual "should encompass all aspects of the business such as . . . the disclosure of any conflicts of interest, the review of personal securities transactions, and any other items that are necessary to have procedures that ensure compliance with the various securities laws."
While the SEC did not prescribe specific requirements for an adviser's code of ethics insofar as personal transactions and other matters are concerned, the implementing release mentioned the following which may assist state-registered advisers in addressing ethical concerns:
- Requiring prior written approval from the firm before a personal securities transaction can be placed
- Maintaining a list of securities issuers that the adviser is recommending for client transactions and prohibiting personal trading in securities of those
- Maintaining a "restricted list" of issuers about whom the adviser has inside information, and prohibiting any trading (personal or for clients) in securities of those issuers
- Prohibiting advisory personnel from placing personal securities transactions during "blackout periods" corresponding to when client securities trades are being placed or recommendations are being made
- Reminding advisory personnel that investment opportunities must first be offered to clients before the adviser or its personnel may act on them.
- Prohibiting or restricting market timing or "short-swing" trading
- Requiring trading by advisory personnel only through certain broker-dealers, or limiting the number of brokerage accounts permitted
- Providing the investment adviser with duplicate trade confirmations and account statements
- Assign new securities analyses to employees whose personal holdings do not present apparent conflicts of interest.
- Limiting the acceptance of gifts by advisory personnel
Pre-approval of Participation in an IPO or Limited Offering
SEC Rule 204A-1 requires that access persons obtain the investment adviser's approval before they directly or indirectly acquire beneficial ownership in any securities in either an initial public offering ("IPO") or a limited offering.
Neither CUSA nor its Regulations expressly require that preapproval be obtained for IPOs and limited offerings. However, state-registered investment advisers should be mindful that an investment adviser agent's participation in an IPO or limited offering may be disadvantageous to the client and present a conflict of interest.
SEC Rule 204A-1 requires that all supervised persons report any violation of the investment adviser's code of ethics promptly to the firm's chief compliance officer. If another person is designated to receive the report in lieu of the compliance officer, the compliance officer must also receive a report of the violation so that he or she is not circumvented in the reporting process. Whistleblower records are not required records under revised SEC Rule 204-2(a).
CUSA and its Regulations do not contain a "whistleblower" provision..
Internal Dissemination of Code
SEC Rule 204A-1 requires that each SEC-registered investment adviser provide each supervised person with a copy of the adviser's code of ethics and any amendments to the code. Supervised persons must, in turn, provide the investment adviser with a written acknowledgement that they have received a copy of the code of ethics, including amendments.
Although CUSA and its Regulations do not require that state-registered investment advisers prepare a separate code of ethics, ethical concerns should be incorporated into the firm's supervisory and compliance procedures. Section 36b-31-6f of the Regulations obligates each investment adviser to amend its written supervisory procedures as appropriate within a reasonable time after relevant changes occur and communicate the amendments throughout its organization.
Form ADV Amendments
As part of its adoption of new Rule 204A-1, the SEC announced an amendment to Part II, Item 9 of Form ADV. The change would require investment advisers to describe on Schedule F their code of ethics and indicate that they would provide a copy to any client or prospective client upon request. In describing the change, the implementing release noted: "We expect few clients will request a copy of the code, and that the cost to provide it will be minimal."
The Division notes that the codes of ethics to which some state-registered investment advisers adhere by virtue of their status as certified public accountants or members of certain financial planning professional organizations should be readily available to prospective clients and clients should a request be made. In incorporating ethical principles into their supervisory/compliance manuals, other investment advisers may wish to consider preparing, on a voluntary basis, a client document that summarizes the adviser's ethical restrictions and business values.