The Investment Company Institute
March 15, 2004
Mr. Jonathan G. Katz
Re: Investment Adviser Codes of Ethics (File No. S7-04-04)
Dear Mr. Katz:
The Investment Company Institute1 appreciates the opportunity to express its views on the Commission's proposed new rule, Rule 204A-1 under the Investment Advisers Act of 1940.2 The proposed rule would require all registered investment advisers to adopt codes of ethics. Advisers would be required to set forth in their codes of ethics: standards of conduct for advisory personnel; provisions reasonably designed to prevent access to material nonpublic information; and a requirement that access persons of the adviser report their personal securities transactions and holdings, including transactions in any mutual fund managed by the adviser.
The Commission and the industry have considered issues relating to personal investing activities on several occasions during the past 10 years.3 Recent events involving personal investing activities of certain industry participants indicate that it is timely and prudent to revisit these issues. The Institute agrees that, in light of these events, further measures to reinforce the duty to place investors' interests first are necessary. As a preliminary step, last October, the Institute urged its members to amend or clarify their codes of ethics to include oversight of transactions by senior fund personnel in shares of funds offered or sponsored by the company. The Commission's proposal, in part, would codify the Institute's recommendation. This and the other aspects of the Commission's proposal should promote the protection and confidence of investors.
The Institute generally supports the proposal. We have several specific comments that are intended to harmonize personal trading reporting obligations under the proposed rule with those under Rule 17j-14, and to respond to questions posed in the Proposing Release.
In summary, the Institute's comments are as follows.
Each of these comments is discussed more fully below.
I. Standards of Conduct
Proposed Rule 204A-1(a)(1) would require each code of ethics adopted under the rule to set forth a standard of business conduct that the adviser requires of all its supervised persons. The standard would be required to reflect the adviser's fiduciary obligations and those of its supervised persons and to require compliance with applicable federal securities laws. The Institute supports the proposed requirement.
We recommend one technical change to the proposed requirement. The Commission should make clear that, in the case of investment advisers that do not advise investment companies, "applicable federal securities laws" means the Investment Advisers Act of 1940 and the rules adopted thereunder and not the other statutes and rules included in Rule 204A-1's proposed definition of federal securities laws.5 Our recommended approach would make Rule 204A-1 more consistent with the Commission's recently adopted rule that requires each registered investment adviser to adopt and implement compliance policies and procedures.
With regard to the standard of conduct requirement, the Proposing Release requests comment on whether the code of ethics should require supervised persons to comply with all applicable laws and regulations, rather than only the federal securities laws. We do not believe that this would be necessary or appropriate. Requiring employees to comply with all applicable laws and regulations would cover many areas that have no relevance to the Commission's objectives in proposing Rule 204A-1 (e.g., employment laws, Occupational Safety and Health Administration regulations, Fair Credit Reporting Act). In addition, such a requirement could cause adviser codes to be unnecessarily lengthy and difficult to administer.
The Proposing Release also asks whether the Commission should specify a particular standard of conduct that all codes of ethics must incorporate and, if so, what standard should be adopted. We do not believe that it would be appropriate for the Commission to specify such a standard. Rather, we believe that each investment adviser should have the flexibility to articulate a standard of business conduct that best suits its business model.
II. Protection of Material Nonpublic Information
Proposed Rule 204A-1(a)(3) would require that each code of ethics include provisions reasonably designed to prevent access to material nonpublic information about the adviser's securities recommendations and client securities holdings and transactions by persons who do not need such information to perform their duties. The Proposing Release explains that tight controls on access to sensitive client information are the first line of defense against misuse of that information. The Proposing Release requests comment on whether the Commission should use an alternative formulation.
The Institute supports the objective of the proposed requirement to limit access to those who "need to know," but we are concerned that this approach would be too restrictive for many advisory firms. For example, in smaller advisory firms, all employees may be located on the same floor and share the same computer system. It may not be possible to physically segregate the individuals who "need to know" from those who do not, and it may not be cost-effective to have a separate computer system for client account-related information. In addition, some firms have an "open" corporate culture in which research and data are shared. These firms may have determined that preventing the flow of information is detrimental to the investment process and thus not the best way to achieve the ultimate goal of preventing misuse of material nonpublic information.7
We believe that each advisory firm should determine how best to protect material nonpublic information with the goal being to prevent misuse of that information. Having specific procedures to prevent access to this information is not the only way to achieve that goal. For example, an advisory firm that chose to permit greater access to material nonpublic information could deem a broader universe of employees to be access persons, thus requiring them to report, and the adviser to monitor, their personal securities transactions and holdings. In addition, such a firm could have a robust educational program geared toward informing access persons of their duties with respect to material nonpublic information. Accordingly, the Institute recommends revising the proposal to require that each code of ethics include provisions reasonably designed to prevent misuse of material nonpublic information about the adviser's securities recommendations and client securities holdings and transactions.8
The Proposing Release requests comment on whether computer files containing nonpublic information should be required to be identified and segregated. We do not believe that the Commission should adopt such a requirement. Rather, as stated above, each individual advisory firm should have the flexibility to determine the most appropriate means for protecting material nonpublic information, tailored to its own individual circumstances.
III. Personal Securities Trading
A. Persons Subject to the Reporting Requirement
Proposed Rule 204A-1(d) would require the code of ethics to call for the adviser's "access persons" to periodically report their personal securities transactions and holdings to the adviser's chief compliance officer. Under the proposal, "access person" is defined to mean: (A) any of the adviser's "supervised persons" (1) who has access to nonpublic information regarding any clients' purchase or sale of securities, or information regarding the portfolio holdings of any reportable fund,9 or (2) who is involved in making securities recommendations to clients, or who has access to such recommendations that are nonpublic; and (B) if the adviser's primary business is providing investment advice, all of its directors, officers and partners are presumed to be access persons.10
The Proposing Release requests comment on whether there is a significant need for Rule 204A-1 and Rule 17j-1 to be as uniform as possible. The Institute believes that there is such a need. Uniformity is important in order to make administration of codes of ethics requirements more straightforward for investment advisers that advise both investment companies and other clients and to diminish the potential for confusion and errors on the part of personnel in such organizations with respect to their reporting of personal securities holdings and transactions. Our comments are intended, in part, to promote uniformity between the requirements of Rule 17j-1 and those of proposed Rule 204A-1 with respect to the reporting obligations of the directors, officers, partners, and employees of investment advisers.
The Institute recommends revising certain aspects of the proposed definition of "access person" to more closely track the definition of that term in Rule 17j-1 and to more precisely identify, and require reporting of personal securities transactions and holdings by, those advisory employees who have information about clients' securities transactions that they potentially could use for their own benefit. In particular, we recommend, among other things, eliminating the term "supervised persons" and instead using (and defining) the term "advisory person." Our proposed definition of "advisory person" would contain several elements of Rule 17j-1's definition of that term, as discussed below.
We recommend that proposed Rule 204A-1 define "advisory person" to encompass, among other persons, any employee who, in connection with his or her regular functions or duties, obtains nonpublic information regarding any clients' purchase or sale of securities, or nonpublic information regarding the portfolio holdings of any reportable fund.11 Our proposed definition (particularly the italicized language) would permit an adviser to identify those employees who, as part of their day-to-day responsibilities, obtain non-public information.12 These are the employees who are in a position to use this information to their own advantage and so these are the employees whose securities transactions should be reported to, and monitored by, their investment adviser-employer.
This portion of our proposed definition of "advisory person" would refer to persons who obtain (rather than have access to) non-public information. This recommended change is based on the premise that only when a person actually obtains non-public information could he or she potentially use it in a way that would run counter to the interests of a fund or other advisory client. By designing the definition to capture those employees who actually obtain non-public information that could be used in such a harmful way, we believe that advisers will be better able to focus their monitoring efforts toward those employees who potentially pose the most risk.13
The Institute also recommends amending Rule 17j-1 to incorporate a legal presumption (as in proposed Rule 204A-1) that, if an advisory firm's primary business is providing investment advice, then all of its directors, officers, and partners are access persons. As noted in the Proposing Release, Rule 17j-1 has special rules for advisory firms that are "primarily engaged" in a business other than advising funds or advisory clients, and uses a revenue-based test to establish the advisory firm's primary business.14 The Proposing Release asks if Rule 17j-1 should be amended to replace the current revenue-based test for determining an adviser's primary business with a legal presumption as in proposed Rule 204A-1. The Institute believes that it should. The recommended approach should simplify efforts to comply with Rule 17j-1 and make the two rules more consistent.
Definitions of "access person" and "advisory person" for purposes of Rule 204A-1 that reflect the foregoing recommendations are set forth in the attached appendices.15
B. Personal Trading Procedures
The Commission has recognized the need to give advisers flexibility to adopt codes appropriate for their businesses and, therefore, it has not proposed any specific provisions regarding personal trading (with one exception).16 The Institute believes that it is essential for each advisory firm to have the latitude to craft a code and procedures that are most effective in light of its particular business structure and operations and, therefore, strongly supports the proposed approach.17
C. Reportable Securities and Beneficial Ownership
Proposed Rule 204A-1(e)(9) would exempt from reporting requirements money market instruments, direct obligations of the United States government, money market fund shares, and shares of other types of mutual funds where the adviser or a control affiliate does not act as the investment adviser or principal underwriter for the fund. The Proposing Release explains that these securities would be exempt from the rule's reporting requirements because they appear to present little opportunity for abuse. The Institute agrees with the Commission's assessment and supports the proposed approach.
Consistent with that approach, we recommend not including as a reportable security shares issued by short-term bond funds that offer check-writing privileges. Like money market fund shares, which are proposed to be exempt from the rule's reporting requirements, the value of these fund shares typically does not vary day-to-day and, therefore, such funds appear to present little opportunity for abuse. Because these funds often are used as an alternative to money market funds or checking accounts, it is likely that there would be numerous transactions to report. Given the lack of potential for abuse, any benefit associated with treating these securities as reportable securities is outweighed by the costs of doing so.18
The Proposing Release asks if transactions in index funds and investments in variable annuity contracts should be excluded from reporting obligations. The Institute believes that transactions in funds underlying variable annuity contracts should be covered to the same extent as other mutual funds, as they present the same risk of abuse as other funds. In addition, we believe that transactions in index funds should be subject to the rule's reporting obligations. Index funds may be sampled (i.e., the fund may not purchase each and every security in the appropriate index). Therefore, their securities holdings may not be fully transparent and, thus, these funds could permit similar opportunities for abuse as other funds.
D. Reporting of Investment Company Shares
As discussed above, proposed Rule 204A-1 would require all advisers' codes of ethics to call for reporting of holdings and transactions in certain affiliated mutual funds. The Proposing Release asks whether reporting of holdings and transactions in all mutual fund shares should be required. The Institute supports the Commission's approach of limiting reporting requirements to certain affiliated funds.19 We believe that trading in the shares of mutual funds that are not affiliated with the adviser pose little risk for the abuse the Commission seeks to address. Advisory personnel would not be in a position to have access to nonpublic information about the portfolio holdings of these funds and so requiring them to report on these holdings and transactions goes beyond the intent of the rule. To do otherwise would unnecessarily complicate an adviser's ability to comply with the rule.
Consistent with the approach of limiting reporting obligations to "access persons" who truly have access to nonpublic information, we recommend narrowing the definition of "reportable fund" to avoid imposing reporting requirements that are broader than necessary to achieve the objectives of the rule.20 For example, many advisers that advise funds have affiliated advisers that do not advise funds. Under the proposal, an employee of Adviser A who has access to nonpublic information about a private client's purchase or sale of securities (but who does not have access to any nonpublic information regarding the portfolio holdings of any reportable fund) would be required to report any of its holdings in any fund whose adviser or principal underwriter controls Adviser A, is controlled by Adviser A, or is under common control with Adviser A. That person is not in a position to have access to nonpublic information about the portfolio holdings of any of these funds and so requiring them to report on these holdings and transactions goes beyond the intent of the rule. Accordingly, we urge the Commission to refine the definition of "reportable fund" as set forth in Appendix A (attached).
E. Timing of Personal Securities Reports
Proposed Rule 204A-1 would require each access person to report his or her securities holdings at the time the person becomes an access person and the information reported would be required to be current as of the date the person becomes an access person. We are concerned that the proposed currentness requirement would require access persons to manually develop a list of their holdings, which is more burdensome and more susceptible to errors than permitting access persons to provide their most recent account statement showing their securities holdings. Accordingly, we recommend permitting each access person to report his or her securities holdings at the time the person becomes an access person and requiring the information reported to be current as of a date no more than 45 days prior to the date the report is submitted.21 We recommend a 45-day period because we believe that this is the amount of time needed to allow an access person to use his or her most recently received account statement. Under our recommended approach, for example, if a person becomes an access person on June 1st of a given year, he or she would be required to provide an account statement(s) for the period ended April 30th (and not the statement for the period ended May 31st, which the person would not yet have received).22
Proposed Rule 204A-1(b)(1)(ii) would require access persons to report their securities holdings at least once each 12-month period after their initial holdings report. The Institute recommends that the proposal be modified to require access persons to submit holdings reports "annually" rather than "once each 12-month period." The recommended change would provide some flexibility for advisory firms regarding what month during any given year its access persons would be required to report their holdings while still assuring that access persons report their holdings once during any given calendar year. We also note that the change would make this provision consistent with the annual holdings report requirement under Rule 17j-1.23
The proposed rule also would require access persons to make quarterly reports of all personal securities transactions no later than ten days after the close of the calendar quarter. An access person would not be required to submit a transaction report if the report would duplicate information contained in broker account statements so long as the statement is received no later than ten days after the end of the applicable calendar quarter. The Proposing Release requests comment on the required timing of these reports.
It is our understanding that, in practice, it takes approximately three weeks for advisers to receive monthly statements regarding their access persons' personal securities transactions when these securities are held in external brokerage accounts. As a result, for securities held in this type of account, it is possible to comply with the ten-day requirement for the first two months of a quarter, but not for the last month of any given calendar quarter. In recognition of this, the Institute recommends that the proposal be changed to require that broker account statements (in lieu of quarterly reports) be submitted as soon as reasonably practicable, but in no event later than 30 days after the end of each calendar quarter. For the same reasons and to promote consistency, we recommend that a conforming change be made to Rule 17j-1.
IV. Reporting of Violations
Proposed Rule 204A-1(a)(5) would require supervised persons to promptly report any violations of the code to the adviser's chief compliance officer or another person designated in the code. The Institute recommends permitting the reporting of any code violations to the adviser's chief compliance officer or one or more other persons designated in the code. The recommended approach would allow each advisory firm to designate the most appropriate person or persons, given its particular structure.24 We also support the Commission's proposed approach of requiring reporting of any violations rather than requiring codes of ethics to call for reporting of "apparent" violations. Requiring the reporting of apparent violations would establish an overly vague standard, resulting in difficulties in monitoring and enforcement.
V. Acknowledgement of Receipt of the Code
Proposed Rule 204A-1(a)(6) would require an adviser to provide each of its supervised persons with a copy of the code of ethics and any amendments thereto, and each supervised person to acknowledge, in writing, receipt of the code. The Proposing Release explains that an adviser's procedures for informing its employees about its code are critical to obtaining good compliance and avoiding inadvertent violations of the code. The Institute supports the proposed requirement but requests that the final rule permit acknowledgements to be in either written or electronic form. This change would ease compliance efforts for advisers and their personnel while providing a record for advisers and the Commission regarding employees' receipt of the code. Further, in response to the Commission's request for comment, we do not believe that the rule should require codes to contain procedures for educating employees about the code and to inform employees about changes made to the code. Advisory firms currently use various means to educate their employees about their ethical and reporting obligations. Because there is a range of appropriate choices, we believe decisions like these should be left to individual advisory firms, not mandated by Commission rule.
Rule 204-2(a)(13) under the Advisers Act would require advisers to keep copies of their codes, their supervised persons' written acknowledgements of receipt of the code, records of violations of the code, and records of actions taken as a result of violations. In addition, advisers would be required to keep a record of the names of their access persons, holdings and transaction reports made by access persons, and records of decisions approving access persons' acquisitions of securities in IPOs and limited offerings. The Institute supports these proposed recordkeeping requirements.
Under the proposal, advisers would be required to keep records of access persons' personal securities reports (and duplicate brokerage confirmations or account statements in lieu of those reports) electronically in an accessible computer database. The Proposing Release states the Commission's understanding that requiring electronic records to be kept would not be costly or burdensome and specifically requests comment on this point.25 The Institute has serious concerns regarding the adoption of an electronic recordkeeping requirement. It is our understanding that such a requirement would involve a significant economic undertaking for most, if not all, investment advisory firms. Some investment advisers receive electronic feeds of information regarding their access persons' personal securities reports from broker-dealers. However, brokers are not required to, and many do not, provide this information electronically. In addition, not all advisers are set up to receive this information electronically. Advisers may find it necessary to hire an additional employee (or dedicate existing staff) to enter data received on paper into the adviser's computer system solely for the purposes of this new requirement. For those advisers that do not have a system in place for receiving this information, there would be the additional cost of building a system to receive the information that is available electronically from brokers. For all of these reasons, we recommend that the Commission delete from proposed Rule 204-2(a)(13)(i) the phrase "to be maintained electronically in an accessible computer database."
VII. Amendments to Form ADV
The Commission has proposed amending Form ADV to require advisers to describe their codes of ethics and, upon request, to furnish clients with a copy of the code. The Proposing Release requests comment on whether a general disclosure requirement is adequate. The Institute believes that such a general disclosure requirement is adequate and recommends that the Commission permit any adviser to make its code accessible to clients by posting it on the adviser's website as an alternative to furnishing clients with a copy upon request.26 The recommended approach will ease costs for advisers without depriving clients of the benefit of access to the adviser's code.27
VIII. Compliance Date
The Commission has not proposed a transition period in connection with the proposed requirements. The Institute recommends that the Commission provide for a compliance date ranging from 9 to 12 months after adoption, depending on the nature of the new requirements. For example, as discussed above, many funds do not have the capability to keep records of personal securities transactions electronically and they would need sufficient lead-time to comply with such a requirement. The requested time period is consistent with the time provided by the Commission in other instances where advisers have been required to comply with significant new responsibilities under the federal securities laws.28
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The Institute appreciates the opportunity to comment on this significant proposal. If you have any questions or need additional information, please contact me at (202) 326-5824, Frances M. Stadler at (202) 326-5822 or Dorothy M. Donohue at (202) 218-3563.
Amy B. R. Lancellotta