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GT Alert

New SEC Rule Will Require Investment Advisers to Adopt a Code of Ethics

July 2004
By Steven M. Felsenstein, Greenberg Traurig, Philadelphia Office

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In another action responsive to the ethical issues that have surfaced in the past few years, the U.S. Securities and Exchange Commission has adopted a final rule under the Investment Advisers Act of 1940 requiring each registered investment adviser to adopt a Code of Ethics meeting standards set forth in the rule. Each code will be required to set standards of conduct for associated persons of the advisory firm, require reporting of personal securities transactions by certain personnel, require pre-clearance by those personnel of certain transactions, and establish record-keeping requirements to document compliance. The adopting release issued this month (IA-2256) adopts Investment Advisers Act Rule 204A-1. The new rule takes effect at the end of August, and compliance will be required by January 7, 2005.

Steven Felsenstein
"Each code will be required to set standards of conduct for associated persons of the advisory firm, require reporting of personal securities transactions by certain personnel, require pre-clearance by those personnel of certain transactions, and establish record-keeping requirements to document compliance."

While many registered investment advisers already have adopted a code of ethics, particularly advisers to registered investment companies that have been subject to a similar rule under the Investment Company Act of 1940, the new rule will reach all registered advisers. In addition, the recent vote by the SEC to propose a yet-to-be published rule that would require investment advisers to hedge funds to register, many for the first time, will mean that a new universe of investment advisory firms might have to comply with the code of ethics requirement. Many of those firms are not familiar with SEC standards as they are applied to things such as a code of ethics, and it can be expected that there will be a substantial learning curve for many of these new registrants in this area as well as many others.

The Standard to be Applied

In adopting the new rule that was proposed last January, the SEC did not specify a particular standard that firms would be required to adopt. Rather, the SEC is directing each firm to adopt standards that reflect the nature and scope of the business done by that firm and applicable state and federal fiduciary laws. Naturally, each code will have to meet minimum standards included in the rule, but the SEC’s release encourages the adoption of more aspirational standards. The release states that: “A good code of ethics should effectively convey to employees the value the advisory firm places on ethical conduct….”

Advisers also will have to establish procedures to monitor and evaluate compliance with the code. Adoption of a code without adequate steps to implement the code would leave the firm subject to proceeding for failure to supervise in the event of any misconduct by a covered person. The SEC also would expect that the firm’s procedures will clarify how the firm will make use of the reports made by access persons to monitor the behavior of such persons. The firm would be expected to evaluate comparative results for access persons and accounts they manage, and investment actions that raise questions of access to inside information. The firm also will have to monitor the effectiveness of the code on a continuous basis. This could require the chief compliance officer and management to take into account any changes in the business of the firm or the scope of that business, the nature of the firm’s clients, the nature of the investment activities of the firm, and developments in the investment industry and securities markets.

Reporting of Personal Securities Transactions

The new rule adopts the concept of “access persons” and requires them to report their personal securities transactions to the advisory firm. Though modeled largely on provisions already in place under the Investment Company Act rule, the new rule does not specifically mandatory use of certain provisions. Thus, each advisor will have to decide whether and to what extent to mandate practices such as pre-clearance of all trades by access persons, blackout periods, penalties for failures to comply, etc. Of course, a decision to forgo arguably relevant practices could be difficult to defend, particularly if something bad has happened.

Under the rule, “access persons” are firm personnel that have access to non-public information concerning client transactions, those who are involved in making recommendations that are not yet public, and those with access to information regarding investment company clients. In order to permit the transaction reporting by access persons to be effective, such persons will be required to file initial and annual holding reports, and quarterly transaction reports. As with other regulated securities businesses, duplicate confirms can substitute for some of these requirements. The code will have to require that access persons get advance permission from the firm before investing in initial public offerings or private placements.

For many employees in securities businesses, including some investment advisory firms servicing investment companies, prior disclosure of their personal securities transactions to their firms is already an accepted practice. However, for many other employees the requirements of the new rule will be a new and uncomfortable intrusion. Firms that find themselves in this position should consider starting now to educate employees about what is coming.

Reporting of Violations

The rule requires that employees must promptly report violations of the code to the compliance officer of the firm, and notes that firms must affirmatively act to foster an environment supportive of compliance, and firms must consider how to protect employees from retaliation for reporting activities required by the code. The reporting requirement will interface with another recently adopted rule requiring each adviser to have a chief compliance officer, and it is fundamental to the rule that each firm has an affirmative duty to educate employees about the code, the standards imposed under the code, and the procedures that implement the code. Employees will be required to sign a form to acknowledge receipt of the code, and each firm will have to consider whether to hold periodic meetings to reinforce the process.

Record-Keeping and Disclosure

The new rule amends the record-keeping rules applicable to advisers. It reduces some requirements in other existing rules to reflect the relocation of those requirements in the new rule. The rule requires that records of violations be maintained, and this may have liability implications for an adviser in the event of a dispute with clients or regulators. The firm also must maintain records of any action it takes to approve investments by access persons. It should be expected that such records will receive careful scrutiny from SEC examiners when they inspect registered firms.

The new rule also imposes a disclosure requirement in Part II of Form ADV. The new disclosure will inform clients about the code that an adviser has adopted. Whether this will result in any significant inquiries from clients remains to be seen, but in the event of a dispute with a client, the firm will have to be prepared to demonstrate that it acted in accordance with its disclosure concerning the code.


© 2004 Greenberg Traurig

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This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.