Rule 204A-1, Investment Adviser Codes of Ethics (the “Rule”), with a compliance date of January 7, 2005, required reporting by access persons, of their securities holdings and transactions in any securities, with some exceptions such as:
(i) Direct obligations of the Government of the United States;
(ii) Bankers’ acceptances, bank certificates of deposit, commercial paper and high quality short-term debt instruments, including repurchase agreements;
(iii) Shares issued by money market funds;
(iv) Shares issued by open-end funds other than reportable funds; and
(v) Shares issued by unit investment trusts that are invested exclusively in one or more open-end funds, none of which are reportable funds.
The Rule makes one other reporting exception, in paragraph (b)(3), an exception from all of the reporting requirements with respect to securities held in accounts over which the access person had no direct or indirect influence or control. The question frequently comes up as to exactly what that means. Does this mean an account at some other adviser for which the supervised person has no influence or control? If so, does that mean the supervised person cannot instruct the external adviser with regards to his/her objectives and constraints, or that after the discussion the supervised person cannot meet with the external adviser again to make decisions regarding the direction of the account? I don’t think so. I think it simply means that the supervised person cannot talk with the external adviser about specific securities that may be considered for trading at the supervised person’s firm, which may include funds if the supervised person’s firm trades in funds. I also think the same logic applies when considering a blind trust, which is typically a legal arrangement in which a trustee manages funds for the benefit of somebody who has no knowledge of the specific management actions taken by the trustee and no right to intervene in the trustee’s management. At some point in time, someone has to provide guidance to the external adviser, perhaps not on an ongoing basis, but annually.
In most firms, this requirement is addressed by having the supervised person certify in writing to the firm that they do not have direct or indirect influence or control. At this point, I know you are wondering where I’m going with this. Compliance professionals will ask the question as to whether a certification is sufficient, and in most cases, it may be. And since the supervised persons with these types of accounts are often an owner or someone else in a position of authority at the firm, it may be difficult to ask for more than a certification, although, in my experience, some firms do require statements from the custodians of these external accounts. This doesn’t mean that we don’t trust those supervised persons with accounts managed by external advisers; we trust but verify!!
On June 26th, the SEC’s Division of Investment Management issued a Guidance Update entitled, “Personal Securities Transactions Reports By Registered Investment Advisers: Securities Held In Accounts Over Which Reporting Persons Had No Influence Or Control,” which addressed this very issue:
“The staff believes that the fact that an access person provides a trustee with management authority over a trust for which he or she is grantor or beneficiary, or providing a third-party manager discretionary investment authority over his or her personal account, by itself, is insufficient for an adviser to reasonably believe that the access person had no direct or indirect influence or control over the trust or account for purposes of relying on the reporting exception.” (Italics added)
“Although the fact that a trustee or a third-party manager has management or discretionary investment authority…would not, by itself, enable an adviser to rely on the reporting exception…the adviser may be able to implement additional controls to establish a reasonable belief that an access person had no direct or indirect influence or control over the trust or account…In the staff’s view, such policies and procedures should be reasonably designed to determine whether the access person actually had direct or indirect influence or control over the trust or account, rather than whether the third-party manager had discretionary or non-discretionary investment authority.”
Advisers may consider, for example:
- obtaining information about a trustee or third-party manager’s relationship to the access person;
- obtaining periodic certifications by access persons and their trustees or discretionary third-party managers regarding the access persons’ influence or control over trusts or accounts;
- providing access persons with the exact wording of the reporting exception and a clear definition of “no direct or indirect influence or control” that the adviser consistently applies to all access persons; and
- on a sample basis, requesting reports on holdings and/or transactions made in the trust or discretionary account to identify transactions that would have been prohibited pursuant to the adviser’s code of ethics, absent reliance on the reporting exception.
The Guidance Update concludes with the statement that, “The staff encourages advisers to consider this guidance when determining whether an access person had direct or indirect influence or control over a trust or account for purposes of relying on the reporting exception.”
I think the SEC examination staff will most probably have an interest in firms exempting supervised persons from transaction reporting in these types of accounts, especially if those firms have not considered this update from the Division. (http://www.sec.gov/investment/im-guidance-2015-03.pdf)
As a side note, those of you not following the comments on Department of Labor’s Fiduciary Proposal (comments have been hot and heavy both for and against), but wondering how the SEC might react, should read Commissioner Dan Gallagher’s comment letter to the DOL (http://www.sec.gov/news/speech/2015/gallagher-dol-comment-ttr-7-21-15.pdf). It expresses his views and not necessarily that of the Commission, but I think a very worthwhile read. It is only three pages long and ends with the statement:
“DOL should scrap the Fiduciary Proposal and start working in a meaningful way with the Commission to address the DOL’s concerns about broker fees for retirement accounts. The Fiduciary Proposal will harm investors, plain and simple, and an SEC rulemaking under Section 913 of Dodd-Frank will only make a bad situation worse. Let’s end the rampant nanny-statism that is motivating both of these rulemakings and instead focus on a disclosure regime that empowers investors and allows brokerage firms to continue to offer a menu of services to all types of investors, not just the affluent. Despite the rancor surrounding this debate, it is my hope and belief that the DOL and SEC can find a reasonable path forward.”