Sec Division Of Examination Issues Risk Alert Pertaining To Potential Deficiencies Regarding Use And Monitoring Of Material Non-Public Information
On April 26, 2022, the Division of Examinations (“EXAMS”) of the U.S. Securities and Exchange Commission (“SEC”) published a Risk Alert to provide investment advisers, investors, and other market participants with information concerning notable deficiencies that the staff has cited 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. Deficiencies related to Section 204A and the Code of Ethics Rule have been among the most commonly observed by EXAMS. See EXAMS Risk Alert, The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment Advisers (Feb. 7, 2017).
Section 204A and the Code of Ethics Rule
Section 204A requires all investment advisers, registered and unregistered, to establish, maintain, and enforce written policies and procedures that are reasonably designed, taking into consideration the nature of the adviser’s business, to prevent the misuse of material non-public information (“MNPI”) by the adviser or any person associated with the adviser. See Section 204A of the Investment Advisers Act of 1940; see also Investment Adviser Codes of Ethics, Investment Advisers Act Release No. 2256 (July 2, 2004) (“Code of Ethics Adopting Release”). The Code of Ethics Rule requires investment advisers that are registered or required to be registered under the Advisers Act to adopt a “code of ethics” (or “code”) that sets forth, among other things, the standard(s) 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). The Code of Ethics Rule requires certain supervised persons, called “access persons,” to report their personal securities transactions and holdings to the adviser’s chief compliance officer (“CCO”) or other designated persons. Access persons” are any supervised persons who have access to non-public information regarding client transactions or reportable fund holdings, make securities recommendations to clients or have access to such recommendations that are non-public, and, for most advisers, all officers, directors and partners. See Advisers Act Rule 204A-1(e)(1).
The Risk Alert also reminds advisers that the Code of Ethics Rule requires advisers to adopt a code of ethics that includes:
- Standard(s) of business conduct that the adviser requires of all its supervised persons that reflect the adviser’s fiduciary obligations and those of its supervised persons;
- Provisions requiring supervised persons’ compliance with applicable federal securities laws; Provisions requiring access persons to report, and the adviser to review, their personal securities transactions and holdings periodically;
- Provisions requiring supervised persons to report any violations of the code of ethics promptly to the chief compliance officer or another designated person; and
- Provisions requiring the adviser to provide each supervised person with a copy of the code of ethics and any amendments, and requiring the supervised persons to provide the adviser with a written acknowledgment of their receipt of the code and any amendments.
Compliance Issues Related to Section 204A
The SEC has identified the following deficiencies and weaknesses associated with Section 204A:
- Policies and procedures related to Alternative Data. Exams staff observed 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. “Alternative data” refers to many different types of information increasingly used in financial analysis, beyond traditional financial statements, company filings, and press releases. Alternative data does not necessarily contain MNPI. Examples of “alternative data” include information gleaned from satellite and drone imagery of crop fields and retailers’ parking lots, analyses of aggregate credit card transactions, social media and internet search data, geolocation data from consumers’ mobile phones, and email data obtained from apps and tools that consumers may utilize.
- Policies and procedures related to so-called “value-add investors.” “Value-add investor” refers to clients or fund investors that are corporate executives or financial professional investors who may have MNPI. “Value-add investor” refers to clients or fund investors that are corporate executives or financial professional investors who may have MNPI. EXAMS staff 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.
- Policies and procedures related to “expert networks.” “Expert network” refers to a group of professionals who are paid for their specialized information and research services. EXAMS staff observed advisers that did not appear to have or did not appear to implement adequate policies and procedures regarding their discussions with expert network consultants who may be related to publicly traded companies or have access to MNPI, including: Tracking and logging calls with expert network consultants; Reviewing detailed notes from expert network calls; and Reviewing relevant trading activity of supervised persons in the securities of publicly traded companies that are in similar industries as those discussed during calls.
Compliance Issues Regarding the Code of Ethics Rule
The SEC has identified the following deficiencies and weaknesses associated with the Code of Ethics Rule:
- Identification of access persons. EXAMS staff observed advisers that did not identify and supervise certain employees as access persons in accordance with the Code of Ethics Rule. EXAMS staff also observed adviser codes that did not define “access person” or accurately reflect which employees are considered access persons.
- Access persons did not obtain required pre-approval for certain investments. EXAMS staff observed adviser access persons that purchased beneficial ownership in initial public offerings and limited offerings without requisite pre-approval.
- Personal Securities Transactions and Holdings. EXAMS staff observed deficiencies related to the required reporting of access persons’ personal securities transactions and holdings.
- Written acknowledgement of receipt of the code and any amendments. EXAMS staff observed instances where supervised persons were not provided with a copy of the code or did not provide written acknowledgement of their receipt of the code or any amendments. In other instances, the code did not contain provisions to reflect the written acknowledgment requirement of Rule 204A-1(a)(5).
The SEC noted in the Risk Alert that in response to the issues identified in deficiency letters, many of the advisers modified their codes of ethics and written policies, procedures and practices to address the issues identified by EXAMS staff. Additionally, the SEC indicates that advisers should review their practices, policies, and procedures in this area and ensure they are in compliance with provisions of the Advisers Act and the rules thereunder.