On April 26, 2022, the Division of Examinations (the “Exams Division”) issued a Risk Alert regarding what it characterized as findings of “notable deficiencies” in their examinations of investment advisers related to Section 204A (“Section 204A”) of the Investment Advisers Act of 1940 (the “Advisers Act”) and Rule 204A-1 (the “Code of Ethics Rule”) thereunder. As explained in more detail below, registered advisers should take steps to ensure that their procedures and codes of ethics take into account the Exam Division’s findings, including the Exam Division’s recommendations to establish issuer restricted lists and procedures to ensure that clients are offered initial investment opportunities prior to employees.
Section 204A requires all investment advisers, registered and unregistered, to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the misuse of material non-public information (“MNPI”) by the adviser or any person associated with the adviser, taking into consideration the nature of the adviser’s business. All registered advisers (or advisers that should be registered) must adopt a “code of ethics” that sets forth, among other things, the standard of business conduct expected from the adviser’s “supervised persons” (e.g., employees, officers, partners, directors and other persons who provide advice on behalf of the adviser and are subject to the adviser’s supervision and control). Chief Compliance Officers and those who employ them should periodically review the requirements of the Code of Ethics Rule to make sure that their code both addresses the requirements of the rule and accounts for the business practices of the adviser.
The Risk Alert provides examples of deficiencies and weaknesses found in the examinations of advisers. These include advisers that used data from non-traditional sources (“alternative data”), but did not appear to adopt or implement reasonably designed written policies and procedures to address the potential risk of receipt and use of MNPI through alternative data sources. The Exams Division also observed advisers that did not have or did not appear to implement adequate policies and procedures regarding investors (or in the case of institutional investors, key persons) who are more likely to possess MNPI, including officers or directors at a public company, principals or portfolio managers at asset management firms, and investment bankers. Additionally, some advisers that use “expert networks” were also found not to have implemented policies and procedures to address the potential receipt of MNPI from expert network consultants who may be related to publicly traded companies.
With respect to the Code of Ethics Rule, the Exams Division found certain deficiencies, including advisers that did not identify and supervise certain employees as “access persons” in accordance with the Code of Ethics Rule. The Exams Division staff also observed adviser codes that did not define “access person” or accurately reflect which employees are considered access persons. Adviser enforcement of their code of ethics was also found to be lacking in certain instances, including cases of access persons that purchased beneficial ownership in initial public offerings and limited offerings without requisite pre-approval, and failures to obtain required reporting of access persons’ personal securities transactions and holdings. Advisers are required to provide a copy of the code of ethics to each access person and obtain an acknowledgement of receipt of the code; however, in some cases, access persons either did not receive the code or did not subsequently acknowledge receipt.
The Exams Division advised registrants that they should consider incorporating provisions into their codes to include “restricted lists” of issuers about which the advisory firm has inside information, and prohibit any trading in securities of those issuers while they remain on the restricted list. The Exams Division staff observed instances where employees traded securities of companies that were on the adviser’s restricted list. The Exams Division also advised registrants to consider incorporating procedures to ensure that investment opportunities must first be offered to clients before the adviser or its employees may act on such opportunities. The staff observed situations where the adviser or its employees purchased securities at a better price, ahead of the adviser’s clients in contravention of the adviser’s code, and probably in breach of the adviser’s fiduciary duty pursuant to Section 206 of the Advisers Act.
These latter two points from the SEC staff regarding what registrants should “consider” with respect to their codes of ethics need to be taken seriously by advisers. The SEC does not lightly make specific suggestions with respect to advisers’ fiduciary duties. Accordingly, registrants should view these suggestions as action items and respond accordingly in order to avoid deficiencies and/or enforcement referrals in future examinations.
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